There may be trouble ahead!

As the economic downturn proves far deeper than imagined, so pension funds must factor in a slower recovery says Emma Oakman

Stimulating consumer spending is crucial for recovery and Western government debt is escalating to historic levels as administrations pump money into faltering economies. How quickly consumer spending rallies remains key, as does fiscal and monetary re-tightening once the downturn lifts. Governments could be tempted to hold interest rates down, laying the foundations for another bubble.Asia, although hindered by slowing trade, has money to spend and is implementing reforms to empower its poorest consumers.

The outlook is mixed, but pension funds must decide when and how to re-enter the fray. "The global economy faces a big challenge," says Ezra Sun, Asian fund manager at Veritas. "Western deleveraging will significantly impact growth for some time yet." History suggests the faster G7 economies fall, the faster they recover. "The speed and strength of recovery is inversely related to the scale of the decline," says Simon Ward, chief economist at New Star Asset Management.

Ward believes G7 economies are headed for further weakness extending into the first half of 2010 as economic stimuli reverse, constraints in the credit supply continue and the nine-year business investment cycle troughs. They will only see recovery begin in late 2010: "Those reliant on external borrowing are going to struggle." Andrew Milligan, Standard Life Investments' head of global strategy, says: "Banks and households, which spent years increasing liabilities, have to rebuild balance sheets. It is hard to say what the normal level should be and how long it will take. The effects of policy-making and deleveraging are still uncertain, and a series of rolling recoveries and relapses is likely." Rather than unwinding, leverage is simply moving home. "Gearing is shifting away from consumers and corporates to governments, which will have to continue increasing spending if things deteriorate further," says Sun.

If they fail to manage balance sheets properly inflation could return sharply. "The only solution for over-leveraged governments," he argues, "is to inflate their way out."Near-zero interest rates could therefore be sustained in many major economies. "Western governments are terrified of deflation and will do anything to stop it," he says. "They will look at the lessons from Japan and keep rates low for a long time, increasing the danger of another bubble."
Over-leveraged governments could also fall into a debt trap if interest repayments exceed income.In the UK, tax increases designed to reduce national debt could dampen spending and threaten any recovery, but delays would significantly increase budget deficits.

Raising debt is currently cheap as investors clamour for safe assets and interest rates fall. As inflation and risk-appetite return, the cost of borrowing increases. "It is not hard to sell government bonds at the moment," says Milligan. "Looking ahead to economic recovery in two to three years, government borrowing worldwide will remain phenomenal."

At that point, corporates borrow to fund growth and investors move into riskier assets, which dampens demand for government bonds. "Investors will face both pleasant and unpleasant effects from higher bond yields and will have to deal with inflation volatility," Milligan says. This assumes that economic stimuli will generate recovery, and so far the evidence is limited. Little extra disposable income from falling interest rates is actually being spent. "There is some doubt whether government stimuli will have a meaningful impact on economic growth," says Peter Hensman, global strategies at Newton Investment Management.

Western household debt was secured on property in the belief that prices would continue rising. "This assumption has been battered, causing a fundamental shift in consumers' thinking." Catherine MacLeod, chief economist at BDO Stoy Hayward Investment Management adds: "There is little danger of price inflation. Price-setters are struggling to entice households to spend. We’ve seen the fastest rise in unemployment in 16 years, a collapsing housing market, a household savings rate of 0.4% and negative real income growth."

Western economies face similar troubles to those of Asia in 1998, when too much leverage caused a severe downturn. This time, the outlook is more promising. "We expect Asia can produce a domestic-consumption led opportunity in the short-term," Hensman says. "In the medium-term Asian growth will create the next economic cycle."
But as William De Vijlder, global CIO at Fortis Investments, warns. "Trade is the swing factor. Asia's operational gearing is quite high and corporate earnings are more sensitive to the economic cycle, which affects capital expenditure."
Sun sees Asian governments' attempts to stimulate spending as encouraging. "China is implementing a targeted policy addressing the consumer sector," he says. Farmers, for example, are receiving subsidies for purchasing home appliances.

China's agricultural land reform will also be instrumental in driving its growth for the next 15 years, similar to the 1990s urban reforms. Farmers can now use previously government-owned land to trade rent or as collateral to mortgage or borrow. Asia is also in good fiscal shape. "Spending will be affordable for a few years in countries with strong balance sheets like China, Singapore and Australia. The majority of Asian countries can afford to spend and will," Sun says. He urges pension funds to look closely at the region. "The case for investing is becoming stronger every day given Western deleveraging." Many asset managers believe the price is right in Western equity and corporate bonds markets. "From a long-term perspective, so many asset classes are cheap or very cheap," says De Vijlder.
Why are investors not yet seizing these opportunities? Firstly, concerns around corporate earnings and growth mean uncertainty about when value is likely to be realised; secondly, credit default rates will increase, although the market is pricing in too high a rate; thirdly, market technicals like deleveraging have a continued negative impact.

"Pension funds should be aware opportunities exist on a pure fundamental basis," De Wijlder adds. "It is important to be exposed to these areas when markets turn." The challenge, he suggests, is knowing when invest. While early movers benefit from initial gains, those moving too early risk extreme volatility.

WRITTEN BY EMMA OAKMAN, A FREELANCE WRITER