201112 Perspectives Special Edition en[1]

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SPECIAL EDITION 2012NON-NORMAL IS THE NEW NORMAL


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The world has changed dramatically since 2008. Theinitial fnancial crisis, rooted in housing-market bubbles,especially in the US, and all the toxic assets acquiredlock, stock and barrel primarily by the worlds leadinginvestment banks, degenerated into a debilitating crisis oconfdence worldwide with its epicentre in Europe: distrustinitially o the banks, then o eurozone politicians who have

been ar too slow to come up with permanent and crediblesolutions to deal with the unsustainable levels o debt runup by certain member states.

The worsening economic and political situation in Greeceis etched deeply into everyones psyche, as is the speed atwhich the problems spread to other peripheral eurozonestates. Financial markets have lost confdence in a steadilylengthening list o countries, including some regarded untilnow as among the saest havens in the world. At the time owriting, France is in danger o being stripped o its triple-A

status and even Germany, or the frst time in the modernera, has run into problems persuading investors to buyits 10-year Bunds, a turn o events that would have beenunthinkable not all that long ago.

Against the backdrop o a double decoupling in growthand ination between economies in the developed andemerging worlds, Pictets Wealth Management InvestmentCommittee met on 12-13 October, bringing together ourown in-house investment experts with external specialists oworld renown, to spend time reappraising and thoroughlyanalysing the whole situation and outlook. The key points

and conclusions rom our discussions have been presentedin this inaugural Special Edition issue o Perspectives.

We hope that this new annual publication will providerelevant and instructive insights into the global economicand fnancial situation and outlook which, we are quitesure, will have a major bearing on your long-terminvestment decisions.

Philippe BertheratPartner, Pictet & Cie

FOREWORD


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PERSPECTIVES SPECIAL EDITION 2012

11

23 SECULAR OUTLOOKYves Bonzon, Chief Investment Officer, Pictet & Cie

THE NEW PARADIGM OF INDEBTEDNESS Christophe Donay, Head of Asset Allocation & Macro Research,

Pictet & Cie

46 MOVING FROM THE GREAT MODERATION TO THE GREAT DIVERGENCE:THE VOLATILITY FACTOR ON FINANCIAL MARKETS

78 DEFLATION IS NOT A FATEFUL INEVITABILITY: A PARADIGM SHIFT IS CONCEIVABLE

911 CALCULATING EXPECTED LONG-TERM RETURNS ON ASSET CLASSES

THE EUROPEAN FINANCIAL CRISIS

1215 EUROPE NEEDS FISCAL ACTIVISM AND AN ACTIVIST ECB

Avinash Persaud, Chairman, Intelligence Capital

FISCAL DEFICITS

1821 THE BEGINNING OF FINANCIAL REPRESSION

Russell Napier, Consultant Global Macro Strategist, CLSA Asia-Pacific Markets

EXCHANGE RATES

2225 THE INTERNATIONAL MONETARY SYSTEM: WHO NEEDS A SYSTEM?

Charles Wyplosz, Professor of Economics, University of Geneva

FINANCIAL MARKETS

2627 Viewpoints from Jonathan Wilmot, Chief Global Strategist, Credit Suisse

HOW TO TAKE ADVANTAGE OF ASYMMETRIC PAY-OFFS

2831 Viewpoints from Vinay Pande, Chief Investment Adviser, Deutsche Bank

CONTENTS


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SECULAR OUTLOOK

2

Howard Marks pithy assertion draws attentionto a actor o paramount importance or the wholeinvestment process. But, frst, beore pressing play- back, we need to ast rewind. Very early in mycareer in the late 1980s, I chanced upon Gary Shil-lings seminal book entitled Is Infation Ending? AreYou Ready?. In it, he described those mechanismslikely to result in a structural disinationary trendin developed economies lasting several years, evendecades, and explained why the rampant inationo the 1970s was just a temporary spike.

I was particularly receptive to Shillings argumentsand ormed a frm belie that the monetary patternor the next 10 to 20 years would involve a structuraldecline in ination in the West. I was convinced thattechnological shocks could be a source o disina-tion, even deation, with the upshot that jobs wouldnot be created at the same robust pace as produc-tivity gains. At that time, most highly respectedfgures in the world o asset management hadearned their stripes during the dramatic bear marketor bonds which culminated in 1981 when yields on10-year US Treasury bonds soared above 15%.Prices o many asset classes were still bearing thescars gouged by the accelerated ination o the1970s.

In the early 1990s, another inuential work was pub-lished, this time by Bennett Stern III, who laid downthe oundations o the Economic Value Added mod-el which came to be known as EVA. Then, in themid-1990s, Deutsche Bank published its CROCImodel and Credit Suisse its CSFB-Holt database,both drawing inspiration rom EVA theory, and themarket anomaly evaporated: The market plays back.As Howard Marks is a bottom-up investor, his as-sessment is applicable to stock-picking, but the prin-ciple is the same when deciding on asset allocationsand macroeconomic investment management. Theclimate we are operating in has been evolving ast

and radically in the atermath o the severe shocksto the economic and fnancial system and in re-sponse to regulatory changes. Only those processes

Yves BonzonChief Investment Officer, Pictet & Cie

The market plays backwas the reply fromHoward Marks, founder of Oaktree CapitalManagement, to a question at our annualPictet Alternatives seminar in late Septemberat The Dolder Grand Hotel in Zurich.


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that are re-engineered to keep up with shits in theinvestment environment on markets can hope toadd value over time. Comprehending how corre-lations between assets come together and becomedismantled, understanding the shiting patterns ovolatility, analysing the pools o capital that steer thepricing in asset classes and how these pools evolveare all undamental to building a solid rameworkor reading the markets. Adopting this approachalso provides the competitive edge in ocusing ona time horizon slightly longer than the average orinvestors, who seem increasingly obsessed by short-term perormance.

The purpose behind this Special Edition o Pictet &Cies Perspectives can be summarised as ollows:understanding and identiying the structuralorces at work in the global economy and on fnancialmarkets; knowing in which direction monetarygravity is pulling; anticipating what governments

and economic policymakers responses might be tosuch orces.

For the last three years, we have been pinpointingdeation as the number one risk hanging overWestern economies. When it comes to monetarypolicy, there are widespread ears the EuropeanCentral Bank, the Bundesbanks true heir, willpersevere with its war on ination in todays changedclimate. Only a ew days ago, Philipp Hildebrand,current Chairman o the Swiss National BanksGoverning Board, told a sizeable audience inGeneva: I anything, we ace strong defationarydynamics, underscoring his thesis with the statement

that infation is no issue. We can but hope that oureurozone neighbours will come to understand pret-ty soon the concept o balance-sheet recession and adisorderly liquidation o assets, and will share theSNBs assessment.

Every decade ischaracterisedby a differenteconomic andinvestingenvironment.

KEY TRENDS FOR THE 2010S

1960s 1970s 1980s 1990s 2000s 2010s

ECONOMIC

ENVIRONMENT

Bretton Woods Floating FX Disinflation Fall of Berlin Wall EMU Managed Western

deleveragingOil shock Plaza Globalisation Great global imbalance Emerging market

discrimination

Inflation Arbitrage Internet Chinas rise Smart grid

E-trading Structured credit Asset-price targeting

End of $ paper standard?

INVESTMENT

ENVIRONMENT

US Nifty Fifty stocks Small caps Government

bonds

Indexing Hedge funds TAA

Oil stocks Nikkei Nasdaq EM equities Gold

Gold, CHF and JPY Hang Seng SMI Commodities EM local debt

USD EUR Oil services

Developed quality blue chips

Time is o the essence or solving this debt crisis thatbegan in the private sector and is now centred onsovereign debt. The authorities must make strenu-ous eorts to stipulate how losses incurred romthe excess debt are to be spread using the normalmethods: printing money; transerring wealth romcreditors to debtors; restructuring debt. As yet, notmuch progress is being made on this ront owing tothe clash o interests among the various parties. Theconstant pendulum swings rom deation scaresto reationary attempts and back have led to whatsome have dubbed the new normal, basically anon-normal or bimodal distribution o returns onassets. Very ew investment processes seem to haveeectively made allowance or this radically dier-ent investment environment.

Furthermore, in many cases, statutory regulationsare driving the transition towards an investmentapproach adapted to this new paradigm. But, rath-

er than moaning about the glass being hal-empty,I preer to view it as an opportunity or dieren-tiation by managing both risks and the resultantopportunities in such a way that distinguishes usclearly rom the consensus. This belie has persuadedus today to construct asset allocations or ourportolios ounded on diversifcation throughstrategies and risk actors rather than via the moreconventional route o diversifcation by asset class,a concept with its roots more in legal considerationsthan economic rationale.

Gary Shillings latest book is entitled The Age oDeleveraging. The reationary battle has barely

begun.


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THE NEW PARADIGM OF INDEBTEDNESS

4

DE LA GRANDE MODRATION LA GRANDE DIVERGENCE:FACTEUR DE VOLATILIT DANS LES MARCHS FINANCIERS

MOVING FROM THE GREAT MODERATION TO THE GREAT DIVERGENCE:THE VOLATILITY FACTOR ON FINANCIAL MARKETS

The volatility o assets, especially equities, increasedsteeply ollowing the sub-prime crisis. Implied vola-tility or the S&P 500 index averaged 16% between2003 and mid-2007, but that average has climbed to

25.7% or the period since then. Shits in the volatil-ity regime reect a rise or all in risks which can bedivided into undamental and market risks. In thisarticle, we will be ocusing on undamental risks(shits in volatility and market risks orm the subjecto our Topic o the Month article in our December2011 issue o Perspectives).

The 2008 economic and fnancial crisis signalled a dis-tinctive break in the regime, bringing about a paradigmshit or economies in the West. The macroeconomicenvironment has become ar more unstable, with thecrisis o mushrooming debt in European countriesonly accentuating the violent swings between up-trends and downtrends on fnancial markets.

This tearing o the macroeconomic backcloth is allthe more worrying as economies in the West werecoming out o a 25-year period rom 1982 to 2007during which volatility in economic growth had

radically diminished: recessions that occurred werehal as long and hal as deep as those in previousdecades. Likewise, ination volatility had droppedby 66% over the same 25 years. The steadily declin-ing volatility o macroeconomic variables between1980 and 2008 can be explained by the economicconcept o the Great Moderation, a theory frst ex-pounded in the late 1990s, which argued that dimin-ishing volatility o macroeconomic variables couldbe attributed to a combination o three actors.

How the Great Moderation came aboutThe frst o these actors is associated with the eec-tiveness o monetary policy. Adoption o monetarypolicy guided by the precept o ination targeting

Since 2008, the Great Moderation has given way to the Great Divergence. But new economicthinking and technological shocks could well call it into question. We take these paradigm shiftsinto consideration in calculating our long-term expected returns.

Christophe DonayHead of Asset Allocation & Macro Research, Pictet & Cie


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PERSPECTIVES DITION ANNUELLE 2012

SINCE 2008, DEVELOPED ECONOMIES HAVE ENTERED AN OVER-INDEBTEDNESS REGIME

SOLVENCY TERRITORY

Economic growth

financed through debt

2011

GREAT DIVERGENCE

Debt is out of control without drasticmeasures to cut debt or to boost

economic growth

France

Greece

Japan

IrelandGermany

United Kingdom

USA

Portugal

Italy

SwitzerlandNorway

New ZealandSweden

Australia

Spain

Trajectoryofpublicdebt

Trajectoryofnominaleconomicgrowth

1.5%, 85.4%

0.7%, 162.8%

1.5%, 220%

2.2%, 108.1%1.5%, 81.7%

2.1%, 84%

2.7%, 101%

0.4%, 101.6%

0.7%, 120.5%

1.6%, 38%2.7%, 40.9%

2.9%, 35.3%2.2%, 36.3%

3.3%, 22.8%

1.7%, 69.6%

1980

GREAT MODERATION

Debt-to-GDP ratios start

to increase in developed economies

INSOLVENCY TERRITORY

Debt becomes incontrollable

unless drastic measures are taken


frst implemented by the US Federal Reserveand then by most o the worlds central banks had helped to exorcise the demon o ination. Coreination in the US dropped rom 12% to 2% between1980 and 2003. With ination kept steady at around2%, it became much easier or businesses to havereliable inationary expectations in making capital-

spending plans, or households to make decisionson whether to save or spend, and or governmentsto orm budgeting policy.

The second actor is connected to institutionalchanges in the way economies were regulat-ed. One o the most signifcant was the Reaganadministrations 2Ds policy o deregulation and decompartmentalisation, which unleashed f-nancial innovation and led to the demise o theGlass-Steagall Act.

The third, which does not sit at odds with the

frst despite what some economists claim, relatesto the so-called Good Luck theory. This covers awhole range o actors that contributed towardslowering volatility in the economic environment, but which are attributed to serendipity or happycoincidence. Such actors iclude the absence o oilcrises, technological breakthroughs and innovations(petrochemicals, microprocessors, etc.) and geopo-litical stability.

The Great Moderation had one essential virtue orinvestors: it created considerable stability in GDPgrowth and ination, improving visibility quitenoticeably. These are precisely the two actors that

dictate levels o long-term returns rom the variousasset classes (see the article entitled Calculatingexpected long-term returns on asset classes onpage 9). These two actors are the indispensableoundations o a strategic asset allocation.

The new Great Divergence paradigmThe Great Moderation has now, however, givenway to a new paradigm: the Great Divergence, aswe shall call it. This relates to the mountains o gov-ernment debt amassed as a result o the divergentgrowth trajectories taken since the early 1980s bypublic borrowing and economies: government bor-

rowing has been expanding ar too ast or economicgrowth, culminating in crippling debt overruns. TheUS total outstanding debt/GDP ratio stood at 170%in 1980 whereas it is now almost up to 350%. I welook solely at sovereign debt, the public debt/GDPratio was running at 35% in 1980 whereas today itis up at 101%. On the other side o the equation, theUS economy generated real GDP growth o 3.3% p.a.between 1980 and 2001, whereas it has averaged halthat (+1.6%) since 2001. In other words, in the last ewyears the eectiveness o debt accumulation in gen-erating economic growth has been dwindling. As aresult, fnancial market operators consider that West-

ern countries could, sooner or later, deault and thatthese enormous public debt mountains are a serioussystemic risk or the world as a whole. In the case oeurozone countries alone, borrowings o over 3,000billion euro would need to be cleared to bring publicdebt ratios down to 60% o GDP, the level regardedas the key threshold or the long-term viability andsustainability o budget defcits. This trio o actorsthat had previously ensured economic stability in theGreat Moderation world have each crumbled awayor dierent specifc reasons and are now turninginto generators o economic instability.

Monetary policies have abandoned the realms o in-

ation targeting to venture into the uncharted andhazardous territory o quantitative easing. What im-pact will QE have on ination? How will the value ocurrencies o countries practising this extreme ormo monetary easing be aected? These questions

5

Sources: Pictet & Cie; Datastream


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remain unanswered at present. In any event, themonetary conditions that vouchsaed the stable in-ation regime are no longer in place. Even the veryeectiveness o monetary policy in regulating theeconomic cycle is being called into question.

Over-indebtedness is also casting serious doubtson governments abilities to regulate the economiccycle eectively. The Western world has learnedits Keynesian lessons by heart: i a recession bites,stimulating ailing economies by increasing publicspending will be an eective remedy. However, judi-cious application o Keynesian budget policy presup-poses that governments possess adequate borrowingcapabilities to fnance deepening public defcits. Aswe alluded to above, this room to manoeuvre hasvanished. Whats more, the Keynesian approach hasbeen supplanted by austerity fscal policies. Insteado regulating the economic cycle, these programmesare deepening and prolonging recessions.

Lastly, the relatively stable state o international rela-tions is a thing o the past; the cards are now beingre-dealt between East and West. Asias emergenceas a global economic powerhouse has destabilisedthe delicate balance o the international currencysystem ounded on, initially, the gold standard and,at present, the US dollar. The solidity o the dollarsstatus is at times called into question while the juryis still out on the renminbis likely status. The euro,hailed as a new reserve currency a decade ago, todayaccounts or over 25% o central bank oreign-exchange reserves worldwide. The uncertainates o both the eurozone and the euro itsel haveinjected an extra element o instability into theinternational monetary regime (see the articles byAvinash Persaud and Charles Wyplosz on pages12 and 22, respectively).

Great Divergence and asset classesThe unsettled economic climate is signifcantlyheightening uncertainty and distorting those riskactors that inuence the risk premiums priced intoassets. This is having two major implications orasset allocation.

The Great Divergence has altered the traditional

respective statuses o asset classes. Bonds issued by Western countries are no longer regarded asideal sae havens because soaring public debt hasincreased the risk o deaults. As a result, the riskpremium priced into bonds is steadily rising,altering the ranking or investment purposes osome sovereign debt, including those deemed untilquite recently to be solid, such as French OATs. Theintensiying crisis in Europe during summer 2011even led to a negative risk premium on GermanBunds even as they continued to beneft rom theirsae-haven status. However, this might well soon be questioned. Financial markets persistent andwell ounded doubts about European governmentsability to solve the eurozone debt crisis are mounting

steadily, so even the impeccable standing o GermanBunds may be challenged. The German govern-ments trouble in placing bonds or 6 billion euro withinvestors on 23 November 2011 sent a warningsignal which will need to be heeded. So ar, onlyUS Treasury bonds appear to have been spared, butthey too may soon be aected by mounting anxie-ties o fnancial markets over ballooning public debt.The US is not immune, as its public debt ratio at theend o 2011 is the same as or France and Germany,i.e. close to 85%. Moreover, the interlocking o theEuropean and American banking systems couldeasily see the contamination rom one continent tothe other.

Lastly, price volatilities o the various asset classeshave been rising in this world o the Great Diver-gence. This points towards increasing chanceso tail risks. It is broadly accepted that increa-sing implied volatility (as measured by the VIX

Index) coincides with declines on stock markets.Experience o the last ew decades has, however, castdoubt over this rule o thumb, as, or instance, whenthe dotcom bubble burst. A world o structurallyhigher volatility would suggest that returns romrisk-based assets, notably equities, are likely to belastingly low. High volatility eeds through into hy-brid assets as well, such as corporate bonds both oinvestment grade and, even more noticeably, thoseclassifed in the high-yield segment, explaining thehigh degree o correlation between asset classes. Thebenefts o applying the time-honoured principle oensuring broad portolio diversifcation to providestability to the overall return on investments will begravely jeopardised by high volatilities spreadingthroughout asset classes.

It would, however, be misguided to believe thatthe Great Divergence in Western economies isinevitably destined to drag on or years. Furtherparadigm shits are quite conceivable as shocksoccur. As the room to inuence demand throughfscal and monetary manoeuvres has becomelimited, it is instructive to look at possible paradigmshits that could have a direct impact on supply andwhich might occur beore too long. We will look atthese in the ollowing article.


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The economic and fnancial crises ollowing each oth-er in ever quicker succession and turning ever moreserious, rom the initial sub-prime crisis in the US tothe current euro debacle, have resulted in severe over-indebtedness throughout economies in the devel-oped world just when they are no longer generatingstrong enough growth. As governments have takena proportion o private-sector debt onto public-sectorbooks, public debt is running at well over 60% o GDP, but economies are registering nominal GDP growthbelow 5%. In such circumstances, the level o debt is

ballooning uncontrollably in several European states.Even big powers such as the US and Japan are not saerom the maelstrom o spiralling debt.

As a result, the prevailing economic winds are dea-tionary and the risk o debt deation is grave indeed.

Measures adopted so ar to solve the debt crisis havesolved nothing. In act, they have had the oppositeeect. The austerity programmes involving a mix otax rises and public-spending cuts implemented byseveral countries have just caused economies to sloweven more worryingly. As a result, tax revenues arealling and indebtedness is rising, producing exactly

the opposite o the desired outcome.

What are the exit routes rom this over-indebtedness?The economic paradigm or developed economiesoers little hope o a rapid exit rom the indebted-ness into which governments are currently locked.Breaking out o the debt impasse presupposes thatthe huge quantities o debt can be dealt with usingmethods other than those chosen so ar. Stimulatingeconomic growth through reation is regarded asthe most virtuous route to take. How could growthin the developed world be revitalised? What resheconomic policy approach could be implemented to

pull countries out o the vicious downward spiral odeclining tax income ==> spending cuts ==> rising

government debt, the consequence o Keynesian re-sponses designed to drag economies out o recession?

Answering these questions is neither a straightor-ward exercise nor a pious hope as coming up withanswers to such questions is part o the process osolving the debt crisis. Moreover, the answers will bedecisive in seeking to calculate expected returns romasset classes. Beore trying to fnd answers, we shouldbear in mind that every decade brings with it unex-pected surprises and shocks, so we should perhapsbegin with yet another question: what would we havepredicted in 2000 when the US economy was expand-ing so impressively on the back o all the new inor-mation and communications technologies? At thattime, one line o thinking maintained economic cycleswould come to an end as a result o constantly risingproductivity. The atmosphere o optimism in the UScould see no obstacles to prevent this rom eedingthrough in various ways: business investment; ag-gressive, but selective immigration; households vig-orous consumer spending.

Perhaps we might have suggested the telecom, me-dia and technology sector was overheating and somecorrection was overdue? However, we would havebeen accused o being absurd i we had oated the

idea that we might be heading or a structural growthdownturn in developed economies, a ull-blown col-lapse o the US housing market, a ar-reaching eurocrisis, doubts being cast over the solvency o countriesas wealthy as the US or France, the adoption o zerointerest-rate policies and several rounds o quantita-tive easing by central banks, serious deationary risksor, fnally, dislocations in the Wests industrial and so-cial abric.

Plausible structural shocks or the coming 10 yearsStructural shocks are hard to predict, let alone imag-ine what orm they might take. This unpredictabilityderives rom the act that, by their very nature, they

run counter to the economic mechanisms generallyat work at the time. Just as an attitude o gloom anddoom in the frst decade o this century would havebeen regarded as out o place early in the period wheneconomies were expanding so strongly, so optimismis o the agenda today when economic mechanismsand indecisiveness among policymakers have para-lysed economies in the developed world. Conse-quently, the most obvious approach to take wouldjust involve projecting those mega-trends in play orthe last ew years orward into the next decade. I wewere to go down that road, economies in the devel-oped world would be heading or a period o punish-

ment, pain and abnegation, leading to debt deation.

DEFLATION IS NOT A FATEFUL INEVITABILITY:A PARADIGM SHIFT IS CONCEIVABLE


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However, the asset allocator has to throw o thisstraitjacket on thinking and try to identiy and assessthose phenomena that might reasonably be expectedto cause breaks in the underlying trend over the longterm. As orces are currently predominantly dea-tionary, searching or possible rupture points involves

detecting sources o positive shocks liable to reversethese deationary economic pressures. Identiyingwhat these shocks might be is vital when it comes tolong-term strategic asset allocations. Such shocks andrupture points tend to be at the root o shits in regimeaecting real economic growth and/or ination (seethe article on the roles o growth and ination in ex-pectations or long-term returns on assets on page 9).

We envisage fve dierent types o conceivable shocksover the decade ahead. Some could provide stimulusto economic growth whereas others would apply aharsh brake. Future political choices and the direc-tion and nature o economic policy will enable eachcountry to prepare the ground or a positive shock tohappen or not.

1. Shocks o a demographic nature. These have beenin evidence or some time. The ageing o popula-tions not just in the developed world, but also inseveral emerging economies like China, is an in-evitable process. This shock, by nature, is negative.According to estimates, it slices roughly one per-centage point a year o potential economic growth.It would be hard or countries acing the problemo a greying population to alter this trajectory the only real way would be a deliberate pro-immi-

gration policy.

2. Currency shocks. We would primarily suggest therisk o debasement o paper currencies (chiey theUS dollar and euro).

3. Legal and institutional shocks. These could in-volve a whole range o aspects such as a much reerspirit o entrepreneurship throughout the world,especially in emerging economies. Institutionalis-ing and respecting rights to private property ormkey ingredients o this shock and are, moreover, vi-tal prerequisites or urther expansion in emergingeconomies.

4. Shocks down to new economic knowledge/thinking. We would include mainly changes inthe style o monetary and fscal policies underthis heading. In particular, central banks couldswitch their monetary stances rom being gearedto ination targeting towards price leveltargeting or even asset price targeting. Moreo-ver, fscal policy could evolve away rom theKeynesian approach to a new orm o supply-side economies so as to avour research anddevelopment, the ount o innovation. This woulduel robust growth in investment in capacity.

Capital spending to expand production capac-ity is dierent rom investment in productivity

and replacement spending on account o the jobcreation that comes with it.

5. Shocks caused by radical innovations and break-throughs in technology. This could cover the areaso nanotechnologies, neuroscience, biotechnology,

not to mention new inormation and communica-tions technology, such as the quantum computer.

Western economies stand at a crossroads with twohighways opening up ahead. I there is no paradigmshit, no positive shock, they will crumple under thesheer weight o debt, lose ground steadily againstemerging economies beore, ultimately, becomingimpoverished. On the other hand, they could seize theinitiative again to relaunch their economies. There isno better driver o sustainable and sustained growththan innovation (approach posited by the theoryo endogenous growth). This could take over romKeynesian economic policies applied by governments

deprived by top-heavy debt rom being able to wieldthe reationary levers. O course, innovation cannotbe decreed into existence, but its dynamics ollow awell understood historical path. A mix o supply-sideeconomic policies geared towards putting in placeconditions to encourage research the source o allinventions would ultimately increase the chanceso seeing innovation germinate and stimulate resh,sustainable growth.

Calculating long-term returns expected rom assetclasses over a 10-year period and constructing stra-tegic asset allocations or the long term are as much

an art as they are a science. They also necessitate be-ing grounded in realism as well as looking orwardto what might happen. Realism obliges us to con-template the likelihood that, until one o the posi-tive shocks does materialise, then developed-worldeconomies will continue to be controlled by the orceso excess public debt, under-utilised production ca-pacities and lacklustre demand as a result o stuntedgrowth in income, exacerbated by a credit crunch.The poisonous cocktail o these three orces will seeWestern economies subjected to the yoke o debt de-ation. A deensive strategic asset allocation, built onlow-volatility and quality assets backed by solid bal-ance sheets and geared towards capital protection,

would be what is needed. On the other hand, i oneor more o the positive shocks outlined earlier were tomaterialise, it would signifcantly alter the rules o thegame or the strategic asset allocation: it would needto be reshaped to increase its sensitivity to economicgrowth.

For this reason, it is crucial we take due account opotential materialisation o such shocks in our mod-els or calculating expected long-term returns on assetclasses. That is one good reason to continue readingthrough this Special Edition o Perspectives as the ol-lowing article investigates this topic in greater depth.


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9

CALCULATING EXPECTED LONG-TERM RETURNS ON ASSET CLASSES ANDTHE IMPORTANCE OF IDENTIFYING REGIME SHIFTS

Portolio construction is ounded on expectations oreturns and the assumption o risk. Calculating the

likely levels o returns rom asset classes is a peculiarexercise as it has a bearing on how successul the per-ormance o a strategic asset allocation will be over along period.

In evaluating expected returns rom asset classesit is vital that proper allowance is made or all eco-nomic and fnancial actors that might inuenceinvestment returns. Our analysis is based on aninvestment time-rame o seven to ten years. Thatinvestment horizon matches the needs o long-termasset managers seeking to arrive at a strategic assetallocation. We are not reerring here to more tacticalasset allocations which, by defnition, have shorter

time horizons o less than 12 months.

Many empirical models or calculating expectedreturns are predicated on the hypothesis o meanreversion or a more or less nave projection o his-torical rates o return. These straightorward ap-proaches have ensured that such models have be-come popular in the investment community. Forinstance, many pension unds are known to usethe working hypothesis that a portolio comprising60% in bonds and 40% in equities, historically, hasdelivered an average annual return o 8% over thelong run. This is based on bonds providing histori-

cal nominal returns o 5%. Expected returns on equi-ties, by extrapolation, work out at 12%. However, as

yields on long-dated US Treasury bonds have sunkbelow 2%, such projections are obviously complete-

ly unrealistic today. This example shows that inves-tors seeking to calculate expected returns rom assetclasses must not be blind to current circumstancesnor blinded by past perormance.

It became clear we needed to ormulate our ownproprietary model or calculating projected returnsto avoid these pitalls and maintain vital exibilityin shaping asset allocations to take account o anyshocks that might cause major shits in trends ineconomies and on fnancial markets. Our purposehere is to present the broad outlines o our approachto the calculations and provide an illustration o itapplied to equity markets in the developed world.

What parameters need to be taken into considera-tion to calculate expected returns?Our model is built on two undamental hypotheses.First, market pricing is dictated by the laws o supplyand demand. For instance, i governments or centralbanks intervene directly in bond markets (this topicis covered in Russell Napiers article, The beginningo fnancial repression on page 18), expected returnsrom various asset classes will be signifcantly alteredand calculating will become that much more awk-ward. Fears on this score are not being blown out oproportion judging by the recent example o the ban

imposed by European countries on holding nakedcredit deault swaps, i.e. without having, in paral-


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lel, the underlying sovereign bonds. Second, it mustbe easible to calculate expected returns using non-complex and observable economic and fnancial datathat can be ormalised and reasonably orecast in a

top-down scenario.

Construction o the Pictet-WM model oers three ad-vantages over models o the mean-reversion type.First, our model takes into consideration all the majortrends eaturing in our long-run macroeconomic sce-nario. In the model, we have consistently and com-prehensively actored in parameters as diverse andas signifcant as the monetary and fscal policy mix,economic growth prospects, the ination outlook,exchange-rate developments, technology/innova-tion shocks, deation, debt levels, etc. The modellingexercise boils down to translating and reworking key

predicted economic trends into expected returns romasset classes.

Second, our model enables us to simulate expectedreturns according to various hypotheses concern-ing how a number o key macroeconomic variablesmight behave. Third, we model shits in regime liableto have an impact on economies and be transmittedinto fnancial markets. We have to accept that, in thelonger run, the chances o there being a paradigmshit are high. Over a long period, our approachmakes it possible to combine two successive regimes:the regime in place at the outset o the decade, whichwe could describe as the deation mode (see the

opening article Secular Outlook on page 2), and thepossibility o a shit to a dierent regime during the

course o the decade. We have outlined some o thepotential shocks that might lead to a paradigm shitover the coming decade in the article entitled, Dea-tion is not a ateul inevitability: a paradigm shit is

conceivable on page 7).

The real challenge in the modelling exercise is howto integrate macroeconomic undamentals into ourcalculations o expected returns straightorwardly,comprehensively and consistently. Fortunately, wehave pinpointed two key common parameters ordetermining expected long-term returns rom equi-ties, government bonds, corporate bonds, commodi-ties and currencies. The two variables are the regimesgoverning (1) real economic growth rates and (2)prices. Each regime can take three dierent orms.The interplay o one regime with the other enables

us to characterise the economic environment overall.

Price regime Regime of real economic growth

Disinflation:inflation close to 0%

Deflation:growth of around 1%

Standard inflation at 2% Standard: growth running at potential(3% in the US case)

High inflation at 4% Robust growth running noticeably above

potential (4% in the US case)

THE STATE OF THE ECONOMY CHARACTERISED BYTWO VARIABLES


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PERSPECTIVES DITION ANNUELLE 2012PERSPECTIVES SPECIAL EDITION 2012

As we move into the second decade o the 21st cen-tury, prices and growth in the developed world arein deation mode. In contrast, underlying inationin emerging economies is running above targets setby central banks and real economic growth is closeto potential. Emerging economies are, thereore, insustained growth mode.

The signifcance o these two regimesThe model described above can be applied to mostasset classes. We have used it or money-marketinstruments, government bonds, equities in devel-oped markets, currencies and commodities.

The instability witnessed on historical returns sug-gests the role played by shits in the ination andgrowth regimes are crucial. US equities delivered atotal real average return o 6.6% p.a. between 1926and 2011, signiying equities outperormed bonds by around 4 percentage points a year. I we break

that down into shorter periods, we soon see that theexcess return varies quite dramatically: or instance,it rose as high as 12% between 1924 and 1959, buthas been limited to just 1.5% since 1969. I we breakdown these shorter periods even urther, we candetect a robust link between returns on the variousassets in the dierent permutations o price and eco-nomic growth modes.

In the table below, we have presented simulated ex-pected returns or US equities (S&P 500) accordingto the various ination and growth regimes.

Cells in the table with no percentage correspond to

economic scenarios that would be unrealistic: orexample, we are highly unlikely to experience acombination o robust economic growth andwidespread disination at the same time.

Under the deation regime, expected returns calcu-lated or equities on developed-world markets overthe next 10 years look no more encouraging than themeagre returns generated over the past decade. With atotal expected nominal return o just 2.7%, an investorin equities would in eect be expecting to gain littlemore than the yield provided by dividends beingpaid out. On a brighter note, i we take the scenario

envisaging an innovation shock uelling accelerated

Under the deflation regime, expected returnscalculated for equities on developed-worldmarkets over the next 10 years look nomore encouraging than the meagre returns

generated over the past decade.

Anaemic growth

G R = 1%

Standard growth

G R = 2.5%

Innovation shock

G R = 4%

Disinflation

= 0.5%

2.7%

Standard inflation

= 2%

5.6% 13%

High inflation

= 4%

3.8% 6.6% 9.7%

RESULTS FROM PICTET MODEL FOR ANNUAL EXPECTED RETURNS OVER 7 YEARS FOR US EQUITIES (S&P 500)

Source : Pictet & Cie

economic growth o 4% and stable ination runningat 2%, the annual average expected long-run returnrom equities would amount to 13%. The gap is huge:a compound return o 13% on capital o 100 over 10years would see that capital expand to 340, comparedto just 130 in the case o a meagre 2.7% compound

return.

There are plenty o risk actors exerting an inuenceover long-term returns on asset classes. This wouldtake us down entire new avenues o research and ana-lysis. I we look beyond our two selected growth andination modes, we could incorporate actors suchas liquidity, volatility and correlation modes, returnasymmetries or behavioural biases in investors (de-rived rom fnancial behavioural research). Integratingall these risk actors into the model would fne-tuneand improve the estimates o expected long-term re-turns. However, the cornerstone o successul invest-ment in the long run is built on capabilities and exper-

tise in anticipating possible regime shits.

11


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12

EUROPE NEEDS FISCAL ACTIVISM AND AN ACTIVIST ECB

A policy response to recapitalise the banks and promoteeconomic growth is required to break out of a vicious spiralof decline. Expelling Greece from the euro, default or inflationwill not do the trick.

The present train o events in European markets be-gan with what was essentially a liquidity crisis. Butcapital has been destroyed and there are institutionsthat are short o capital. Getting out o this crisis re-quires Europe to deal with the capital problem.

The European Central Bank can help with the li-quidity crisis, but that just kicks the can down theroad or a while. To solve the capital problem, thefscal authorities have to be involved and it requirescourageous politicians to take bold decisions. Untilthere is a policy response to the capital problem, thecrisis will continue and Europe will keep on mud-dling through.

I am an optimist, however: I believe there will bea policy response because there is no alternative.The path will be political ull o udges, with lotso complications and lots o relie rallies. But whilethere are no magic bullets, there are solutions to thepolicy problem and I want to oer some thoughtsabout what they could be.

The frst step is to identiy what the problem is thatwe are trying to solve. Financial crises ought to beperiods o great learning, because the perceived wis-dom on issues such as fnancial innovation and se-

curitisation has been shot out o the water. But crisesare not occasions or great learning because they areso complex that everybody can pick out one aspectthat reinorces their previous prejudices about whatthe solution should be. As a result, there are lots osolutions in search o a problem.

My view o the problem is that we are in a viciousspiral. There is a global recession, there are weakeconomies, and there is a lack o fscal credibility.As a result, governments are unable to deliver a bigfscal stimulus to stimulate growth, and it is veryhard or the private sector to be the risk-taking mo-tor o growth during recessions. So low growth is

entrenched, which urther undermines fscal cred-ibility. The challenge is to break this vicious spiral.

That is the problem acing Greece, and there is noway that it can get out o this spiral o decline withzero to negative growth or the next fve years. Somepeople have concluded that they should let someoneelse deal with the problem, let someone else deal withthe fscal credibility, let someone else deal with globalgrowth, let someone else deal with the banking is-sues. But kicking Greece out o the euro is not thesolution it is a punishment. Youve done wrong,you have to take the consequences, and the best con-sequence I can think o is kicking you out o the club.

Having begun my career as a currency strategist, Iwas a rather unlikely person to conclude that the

euro was a really good idea when it was launched.But in my discussions with governments, especial-ly in small emerging markets, I saw how the bestbrains in their central banks were struggling to workout where their currencies should be. Exchange ratevolatility preoccupied those countries when they

Avinash PersaudChairman, Intelligence Capital


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Guaranteeing all thedebt of Europeangovernments will notsolve the problem oftrying to create fiscallysustainable growth outof a recession. Nor willholding down the debtto some level, say 60%

of GDP a countrywith debt at or below60% of GDP does notneed that guarantee.should have been ocused on the real drivers o

growth in their economies such as giving their coun-try the skills needed to compete internationally.

The US and the UK adamantly deend the right todevalue their exchange rates, but where has it gotthem? Manuacturing exports in the UK are justa raction o 10% o GDP, and it is the same in theUS. Total manuacturing output in the UK is below14%, and at a similar level in the US. I think weknow why: using the exchange rate to boostcompetitiveness is a sop, a distraction which stopscountries doing the real things they need to do. Sowhen the US was struggling to sell gas-guzzlingpickup trucks with the steering wheel on the wrongside to the Japanese, they concluded that the prob-lem was that the yen was too weak.

That is why I thought the euro was a good idea. Andit is why many Germans thought the same and didwhat you are supposed to do in a fxed currency.Having joined with an overvalued Deutschmark,they ocused on productivity and are now hugelycompetitive unlike other countries in Southern

Europe. So the solution to the ailure to do what isneeded to get the economy growing is not to opt outo the euro and devalue. I a countrys debts are inthe euro, leaving the single currency means deault-ing, which is not going to drive growth. The devalu-ation route is a punishment, not a solution.

Issuing common bonds or the eurozone does notsolve the problem either it certainly does notsolve the problem o fscal discipline. Maybe therewill be a time when Europe moves to fscal union, but politically this is not the time or a commonbond. On the contrary, there is a very worrying risein nationalism across Europe.

The problem we are trying to solve is to creategrowth in Europe fscally sustainable growth

out o a recession. Guaranteeing all the debt oEuropean governments will not do that. Nor willholding down the debt to some level, say 60% oGDP a country with debt at or below 60% o GDPdoes not need that guarantee. We need to fnd a waythat supports growth fscally without adding to theburdens o national economies.

And ination is not an easy way out. The balancesheet o the US Federal Reserve has exploded withquantitative easing, but the money is not gettingthrough to the economy. Governments can try to in-ate their way out o the debt, but in the middle o arecession it is hard: monetary policy is working ullsteam ahead, but it is pushing a brick with string.

Finally, deault is no solution either. It could under-mine European banks which are heavily exposed tosovereign debt (encouraged by awed banking reg-ulation which allowed every sovereign to be the sa-est risk in capital adequacy ratios). I banks deaultas countries deault, that will not solve the growthproblem.

In act the banks may have to be recapitalised toavoid a collapse in the fnancial system. Bank lend-ing would not necessarily pick up, because there areno borrowers. We are in a balance-sheet recession,where borrowers aced with the lowest interest rateso a lietime are choosing to repay debt. But even ithe banks will not be a source o great lending, weshould make sure they do not cause a complete col-lapse o the fnancial system.

So we need to fnd a way o recapitalising the banks one that hurts the shareholders, sending the rightsignals to improve behaviour in the uture. Myproposal would be or the ECB to issue a 20-year

zero coupon bond, using its better credit ratingto print the cash. The proceeds would go into aund to put capital into the banks in the orm o


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14

community preerence shares. So although the banksare not making money, they would be recapitalisedwithout having to pay interest. When things turnedround, however, the frst share o profts would goback to the und and repay the ECBs zero couponbond with interest.

Meanwhile, spurring growth without a politicalunion could be achieved by a much expandedEuropean Investment Bank. The EIB has a rolein building inrastructure around Europe withunding that is very modest in relation toEuropean GDP. Its role could be made muchgreater by raising its unding to 3% o European GDP,weighting its investments towards countriessuering most in the recession.

The advantage o my proposals is that they do notbail out Greece, but they also do not allow the banksto ail. And while Greece would have deaulted on

50% o its debt, there would be massive inrastruc-ture spending rom a central European InvestmentBank to support growth and jobs. All the memberstates would put up capital or the EIB to supportgrowth and the banks would be recapitalised in away where the ECB gets its money back when thosebanks recover.

The point I want to make is that there are solutions tothe capital problem. It requires an activist ECB andit requires fscal activism. There was a time we weretrying to create a Europe on automatic pilot withmonetary policy on automatic pilot and with fscalpolicy eectively on automatic pilot. But in the longrun, that approach cannot generate the response toglobal shocks and create the growth that is needed.We need greater activism in the system.

I think that our politicians will umble their waytowards the solutions. And I think, sadly, they needcrises to be the fre behind them, to push them to dosomething which they do not have the courage to donow, and to do it right. But I do think that ultimatelya solution will be ound.

My proposal would befor the ECB to issue a20-year zero couponbond, using its bettercredit rating to printthe cash. The proceedswould go into a fund

to put capital into thebanks in the form ofcommunity preferenceshares.


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FISCAL DEFICITS

18

THE BEGINNING OF FINANCIAL REPRESSION

As the fiscal deficit rises, the US government is finding it harder to fundits spending. With foreign central banks reducing purchases ofUS Treasuries, financial repression will fill the gap by forcing the privatesector to buy government debt.

In this presentation, I will be pessimistic about thestock market going down, but unortunately I willbe even more pessimistic than that because I see thegovernments role in markets going up. My bearishorecast is that governments are coming back intothe markets and interering with our business and that they will be around or a very long time.

I want to start with the ownership o US Treasuriesby oreign central banks. The US government hasbeen issuing large amounts o Treasuries since theend o the Clinton presidency, and oreign central banks have been buying much o it. The Peoples

Bank o China simply prints renminbi in the morn-ing and in return gets dollars to buy Treasuries its ree unding. And it is not just the Peoples Banko China, it is Saudi Arabia, Taiwan, Korea, HongKong, Brazil and even Switzerland until recently.

But oreign central bank unding o the defcit haspeaked. Because China has been undervaluing itscurrency, it in eect provides fnance to the USAwhich buys Chinese goods. But an exchange ratedoes not remain undervalued orever, because theincrease in the supply o renminbi eeds throughto domestic ination and higher wages. Combinedwith demographic change, Chinas competitivenessis eroding and its surplus is alling. And the day thatChina no longer has a surplus, it will not buy anymore Treasuries.

In act, it will start selling them to keep its exchange

rate competitive since the alternative o devaluationwould be unacceptable politically. So China willsell Treasuries and buy back renminbi to hold itsexchange rate down. That would push up the risk-ree interest rate in the US and reduce the supply o

Russell NapierConsultant Global Macro Strategist, CLSA Asia-Pacific Markets

FOREIGNERS FAITH IN US RESTRAINS THE FED

Source: Datastream

Net private-sector lending to the USA

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

(US$bn)


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China will sell

Treasuries and buyback renminbi to holdits exchange ratedown. That would pushup the risk-free inter-est rate in the US andreduce the supply ofmoney in China. Thatis deflation and itcould come to passless than three years.

money in China. That is deation and it couldcome to pass in less than three years.

The question or the US is how it will then und thegovernment, since 40 cents in every dollar o spend-ing is currently borrowed. It can simply print the

money which will generate ination, or it can askUS citizens to buy it.

The challenge is magnifed by the growth in ed-eral debt. Government fgures orecast that it willrise to 100% o GDP by 2021 and then plateau. Butthe calculations assume that GDP grows by 3.5% inreal terms or the whole ten years. I ination nev-er gets above 2.4% throughout the entire period, ithere are no recessions and i the long bond yield isnever above 4.5%, public debt still remains at 100%o GDP. For the country to reduce the debt level, itseconomy will have to grow much aster at rates

not seen since the Second World War.

So how will the government und its growing def-cit? The last time when debt climbed so much wasthe Second World War, and that led to 80% o allbank loans going to the government. The only waythat America ever supported this amount o debtin its history was by massively squeezing out theprivate sector.

The debt was subsequently reduced by trashing bond investors through ination. This was alsohelped by strong economic growth, uelled by apostwar explosion o consumption ater the end o

rationing and price controls. But a consumer boomis not an option now with current levels o consumerdebt. I some new technology comes along that can

push real economic growth to 5% or the next tenyears, the problem would be solved but it wouldhave to be a major technological breakthrough, anew orm o growth to make the ederal debt levela non-issue.

The US can only und the growing ederal debt iit makes the purchase o government debt com-pulsory. And one way that it can do this is throughthe new vogue or macro-prudential regulation,which sounds like motherhood and apple pie butis a way to orce debt into the private sector. As aresult o tougher international capital adequacy rulesdesigned to avoid another fnancial crisis, fnancialinstitutions will be required to hold more govern-ment debt.

Another strategy used ater the war was to man-date bank deposit rates with the rationale o avoid-

ing destabilising competition or savings. Therates were consistently set below ination, helpinggovernments to und themselves at negative realinterest rates. A variant has just been introducedby the Italian government in a new fscal packagewhich imposes higher taxes on all fnancial instru-ments apart rom government bonds. Whether it isthrough the stick or the carrot, the fnancial sectorhas to be orced into the government debt market.

However, one urther condition is needed i govern-ment debt is to be orced on the private sector. Theaverage maturity o US government debt is aboutour and a hal years, so bond investors will take

their money out o the country i the government iscreating ination while paying negative rates. SinceI think it is inevitable that western democracies will


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FISCAL DEFICITS

20

get into the business o inating away their govern-ment debt, there will have to be exchange controls torestrict the ree movement o capital.

We can already see that the Greeks cannot stand bywhile capital is leaving, because it is creating dea-tion. And the Swiss cannot live with the capital ar-riving because it either raises the exchange rate orboosts ination. Sooner or later, the politicians willsay that they should just stop it rom moving rather than adjusting to capital, capital should ad- just to us. Ater a period that peaked in the 1980swhen many politicians decided that the market wassuperior to government, we have reached a tippingpoint where they are now moving in the oppositedirection.

So ater the banking crisis comes the fscal crisis andthen fnancial repression where governments orceinvestors to buy their debt. The public sector has

bailed out the private sector, but now the privatesector must bail out the public sector. And that willbe a nasty surprise.

I central banks print more money or the bail-out,the stock market will rise. But as fnancial repressionincreases, the markets will realise who will actuallypay in the long run. It will be the private sector, andcorporations will be attractive targets. PresidentObama has already identifed big companies orhigher taxes: and the amount o corporate tax as a

percentage o GDP is one o the lowest ever at a timewhen corporate profts are close to a post-war high.This is a good time to sell US equities!

Many people see equities as an asset, but they arenot: they are the fne sliver o hope between assetsand liabilities. And in the modern world, its a fnersliver o hope than ever beore because o gearing.In periods o deation, bankruptcy risk rises sharplybecause revenues all while fxed costs do not or allmore slowly. But whether we have a big deation-ary shock, or ination which ends in deation, stockprices all.

What positive developments could make my prog-nosis wrong? I can see our possibilities:

A surprise recovery in US residential real estate.It is a very cheap market relative to earnings andfnance is cheap i you can get it. At some stage

the market will clear and a stable to rising housingmarket would make people a lot more excited.

Growth in commercial bank balance sheets. It ishard to see how the economy can grow stronglywithout growth in bank credit and growth in themoney created by expanding bank balance sheets.I the banks start working again in the US, therewill be reason or optimism.

President Obama has

already identified bigcompanies for highertaxes: and the amountof corporate tax as apercentage of GDP isone of the lowest everat a time when corpo-rate profits are closeto a post-war high.


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Rebalancing o sectors. As Chinese wages rise,manuacturing in the West is becoming very com-petitive, very quickly. Tourism is also coming backquickly, driven by tourism rom mainland China.

Game-changing technological developments suchas an incredibly cheap source o energy wouldraise the non-inationary growth rate.

But these are uncertain and I predict that Chinawill be running a defcit within three years, sellingTreasuries and buying renminbi. That would providethe deationary shock, which would be ollowed byalling equities and then government measures ofnancial repression to sell the debt. Manipulating the bond market, orcing banks and insurance compa-nies to buy government debt and capital controls willbe the response to uel high levels o nominal growth.

The unding o US government aces an enormous

crisis. The oreign central bankers are doing less o it,so the American people will have to step in. And theresulting deationary consequences will be bad orgrowth and or equities.


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EXCHANGE RATES

22

THE INTERNATIONAL MONETARY SYSTEM: WHO NEEDS A SYSTEM?

The international monetary system is blamed for exchange-ratevolatility, currency wars, global imbalances, the domination of thedollar and recurrent financial crises. But the present arrangementsusually produce outcomes that reflect underlying economic reality.

We live in a world where there is no recommendedexchange-rate regime. Every country is ree to dowhat it wants: most developed countries let their ex-change rates oat, while most developing countrieseectively have fxed or managed exchange rates.

There are agreed rules o conduct within this non-system, under the surveillance o the InternationalMonetary Fund which has to certiy that countriesare not manipulating their exchange rates. And a-ter the start o the fnancial crisis, the G20 agreed tocoordinate policy more deeply, moving away rom aree-or-all. But member countries are not willing to

enter into any remotely binding agreements.

The question is whether there is anything wrongwith this. Those who wish to create a new interna-tional system put orward fve main criticisms o thenon-system which I will deal with one by one.

The frst is that the non-system generates too muchexchange-rate volatility. It is certainly true that therewas zero volatility under the Bretton Woods fxedexchange-rate regime, which tied currencies to theUS dollar which was convertible into gold. But thatwas beore globalisation, when there were capital

controls and fnancial markets were smaller. Theworld has changed considerably since 1971 whenthe US ended the convertibility o the dollar togold, and we cannot return to fxed exchange ratesglobally.

What we now have is periods when nothing muchhappens on exchange rates, ollowed by bursts oexcitement when exchange-rates move a lot. Butthere are good reasons or the volatility, which re-ect changes in the structure o economies. In otherwords, there is exchange rate volatility and there aregood reasons or it so there is very little that wecan do about it.

The second criticism is that the non-system leads tocurrency wars, when countries are accused o hold-

ing down their exchange rates which makes othercountries exports less competitive. There is a con-stant debate on this between the Chinese and theAmericans which resembles the debate betweenthe US and Japan 30 years ago. Switzerland hasthis year intervened to hold down its exchange ratewhich had appreciated as a sae haven amid turmoilon the markets. Brazil says that US monetary policythrough quantitative easing is pushing up the realagainst the dollar.

Yet these movements reect underlying economicperormance. The dollar has been weak because the

US economy took a terrible hit in 2008, and the ex-change rate movement is part o the adjustment pro-cess. Brazils economy is booming and overheatingis leading to ination, so letting the real appreciateis the best thing or the world. Exchange rates o-ten misbehave, but in the last our or fve years theyhave been doing what you would expect them to doto spread the burden: countries that have current-account surpluses have exchange-rate appreciation,and the converse is true.

Third, critics say that the international monetarynon-system generates global imbalances. The huge

surpluses in China and huge defcits in the USA in-evitably lead to fnancial crises, they say, that willrequire a considerable all in the dollar to restoreUS competitiveness. Yet it is ascinating that aterthe US housing bubble burst and house prices col-lapsed, there was not very much depreciation in thedollar. And it is very clear that that when the USeconomy got into trouble in 2007-08, it had nothingto do with the dollar it was the bursting o thehousing bubble which built up through the actionso the US mortgage industry.

In my view, it is very not clear that there is anythingwrong with the US running defcits and China run-

ning surpluses. They are at dierent stages o de-velopment and have dierent ways o operating.China has huge savings that sometimes exceed 50%

Charles Wyplosz,Professor of Economics, University of Geneva


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23

Everyone is now lookingat the renminbi, andmaybe one day it willbecome a worldcurrency. But fornow it is not convertibleand China still has acentrally plannedeconomy.

o GDP or reasons that are well understood; house-hold saving is zero in the USA because o its bizarrefnancial system. I theres something wrong withthe US mortgage industry, that is not a global prob-lem. And I fnd it hard to believe that appreciationo the renminbi would cut savings rates in China:indeed, the renminbi has appreciated 30% overthe last two years and there is still a current-accountsurplus.

As China is becoming rich, it is a huge saver andit is much better to have 1.5 billion people becom-ing rich and saving rather than being extremelypoor and not saving anything. This enormous poolo savings will reduce long-term interest rates, andalthough that makes borrowing cheaper in the USA,that is a great opportunity to borrow and invest inproductive capacity.

Fourth, there is a perennial discussion about wheth-

er the domination o the dollar in world markets isdesirable. I think there is nothing wrong with it though since it is a competitive market, it may notlast. But or now, while the percentage o oreignreserves held in dollars rises and alls, it is largelystable overall. The euro has not increased its marketshare over the constituent currencies since monetaryunion, while the Japanese yen has been going downater its years o glory.

Everyone is now looking at the renminbi, and may-be one day it will become a world currency. But ornow it is not convertible and China still has a cen-

trally planned economy. And while there is alwaystalk o expanding Special Drawing Rights (SDRs),the international reserve asset created by the IMF,they are not money. A ew billion people use dollars,but SDRs are used by just 187 central banks. Rightnow, there is no challenger to the dollar, which ishere or many years to come.

The fth and last criticism is that the internationalexchange-rate non-system is crisis-prone. Therehave been enormous, devastating crises constantlyover the last 30 years or so Latin America in the1980s, Asia in the late 1990s, the US in 2001 and 2007-08, and now Europe. But my view is that we cannotascribe these crises to exchange rates. Each crisis canbe explained through domestic policy mistakes.

In Latin America during the 1980s, countries werefxing their exchange rates and stoking inationthrough excessive monetary creation. There were

huge currency mistakes in Asia, where countrieswere borrowing in US dollars creating an enormousweakness that eventually exploded. The US sub-prime crisis could have been averted with properregulation supervision and consumer protection.

The IMF may have made mistakes in Latin Americaand Asia and ailed to warn o the pressures build-ing up. But even when it did have concerns, itswarnings went unheeded. The unctioning o theIMF has been less than glorious, but does that meanwe need a new international monetary system?


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EXCHANGE RATES

24

Europes crisis is home-made the result o fscalindiscipline with poorly thought-out governance inthe eurozone. Levels o public debt have risen by30% o GDP on average since the fnancial crisis,which was the correct response to avoid a remakeo the Great Depression. But many countries hadalready built up debts beore 2007 that were veryhigh or no very good reason. Many Europeancountries ran budget defcits every or almost everyyear Greece last had a surplus in 1972 and Francein 1974.

You cannot operate a monetary union with memberstates not committed to fscal discipline, and thisdeep weakness in the eurozone is the reason orthe current crisis. Meanwhile, the European CentralBank has never seen its role as being to backstop thecrisis. And the crisis has suered rom extreme po-liticisation, with France and Germany meeting regu-

larly to come up with communiqus that show theyhave no grasp o the situation. Resolving a fnancialcrisis is a technical issue, but they bring politics intoit and as a result every country is pulling in its owndirection.

My view is that there is no clear case that the non-system we have is not working, and I do not see anyalternative in any case. The big issues are nationalpolicy mistakes, and while we would like to have abenevolent dictator telling countries to stop makingmistakes, they are sovereign entities that cannot beorced to do anything they do not want to do.

The world balance o power is clearly movingtowards Asia, and as a consequence the inter-national fnancial organisation that overseesthe system will have to change. But this will takedecades. What I oresee is evolution, rather thansuddenly overthrowing the existing non-systemand replacing it with a new one.


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FINANCIAL MARKETS

26

Viewpoints from Jonathan WilmotChief Global Strategist, Credit Suisse

If the world is going tosurvive, we will end up in asituation where the long-termlegacy of the debt crisis is anunderstanding by politiciansthat if a fiscal authority wants tobe solvent it has to run primarybudget surpluses in perpetuity.

Q: How do you see asset values?

Some interesting things are happeningon asset valuations. US house prices,measured in terms o gold, are at a secu-lar low only seen once beore in the last

100-odd years. US equities are pretty lowalso when measured in terms o gold,nearly as cheap as they were in 1979.

In outright terms, equities are not socheap at the moment and bonds are ex-tremely expensive. So equities are verycheap relative to bonds. This reects anall-time low in risk appetite, which isan almost 180 reversal o the situationin March 2000 which makes me eelthat we may be at some sort o turningpoint. Perhaps people are ar too gloomy

about equity returns over the next dec-ade, when bonds will very soon not bethe place to be.

Q: Are you optimistic or pessimistic

about the economic outlook?

I look at this in the context o my own ac-count o the evolution o the world econ-omy, which has been my ramework orthe last 20 years or more. The structureo the world economy is becoming more

and more like that in the 19th century:lots o innovation, new markets, newsources o labour, new sources o sup-ply, international capital ows on a hugescale, oscillation between confdence andgrowth in the emerging markets, fnan-cial shocks, bubbles and capital owingback to the core again.

That sort o oscillation took place veryoten in the 19th century but two thingshave changed now. First, the role o gov-ernment is very dierent. And the role o

central banks is very dierent bank-ing panics were two a penny in the 19th

century, but we hadnt had one since theSecond World War until 2008, which wasthe frst proper banking panic since theGreat Depression.

The point, though, is that i the world isgoing to survive, we will end up in a situ-ation where the long-term legacy o thedebt crisis is an understanding by poli-ticians that i a fscal authority wants tobe solvent it has to run primary budget

surpluses in perpetuityand the moredebt you have now the bigger the pri-mary surplus that you have to run. It is


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difcult to be sure about that they will inpractice do this, but it would take us backto the ideal o 19th century governmentsand banks.

Second, the banking system in the 19 th

century had to hold a lot o capital andoperate with a lot o liquidity because itwas not underwritten by the state to the

same extent as now. Let me just makeclear that that did not stop bubbles. It didnot stop people rom getting overexcited by the latest investment ashion and itdid not lead to stability. In act, it waspretty inefcient, in many ways, to havea situation like that. But in an odd way,we are now trying to move the bankingsystem back towards that model.

Now what were the economic conse-quences between 1850 and around 1907o operating on the 19th century model?

We got, or the most part, deationarygrowth, massive and brutal structuralchange, and lots o volatility. So 20 yearsago, I made a rather bold prediction thatlong-bond yields would go to 3% every-where, on the grounds that i that washow the economy was going to work, wewould end up in that sort o deationarygrowth despite central bank inationtargets, despite all the things that movethe political system to be biased towardsination in the money system.

I was wrong in one respect because atereach bubble, we have ended up fghtingdeation with more and more monetary

0

2

4

6

8

10

12

1849 1859 1869 1879 1889 1899 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009

Trend = 6.2%

Sources: Credit Suisse; the BLOOMBERG PROFESSIONALservice; Thomson Reuters DataStream

Standard Deviation = 5.38%

LONG-RUN EQUITY RETURNS, MEASURED IN GOLD

stimulus, to the point where we havedriven real bond yields down to avoiddeation. The question now is whetherwe can survive the latest crisis and haveanother ten years o the same systemoperating eectively through gently ac-celerating ination to reation, without agreat deationary bust.

Q: Is this a good time to invest?

From an investor point o view, the worldthat we now live in is a paradox becausemy valuation indicators suggest that iwe avoid systemic collapse, this couldbe an extreme decade or equity returns.So maybe gold is not the place to be, orexample.

It is clearly the case that the global fnan-cial system aces a number o very spe-cifc threats o which the eurozone crisisis the greatest. It could drive us not justinto recession but into something much,much worse and that is the ear thathaunts investors. On top o that, thereis the huge inequality o wealth and in-come in both the Western world and thedeveloping world, which is a source opotential political unrest, ailure or even break-down. That means there is a po-litical uncertainty on top o more genericuncertainty about how the system is go-ing to evolve and operate.

In my judgement, those uncertaintiesare greater than any time since I startedworking 30 years ago. Investors hate un-

certainty and it is hard to see a middleway through it. Either the world ends upin depression and that will be the end oglobalisation. Or it will end up in a sur-prisingly good place, although gettingthere will eel horrible. Managing moneyin that sort o environment is not a picnic,even i youre bullish.


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Viewpoints from Vinay Pande,Chief Investment Adviser, Deutsche Bank

The political justification forthe euro was an attempt tounify a continent where peoplehad an incredibly bad recordof internecine warfare in the20th century, an unquestionablylaudable objective. But theworst way to try to achieve

political unification or a meetingof minds is through money.

Q: How will the euro crisis play out?

I recently asked our economists this veryquestion what was going to happen tothe euro? They said there were three pos-sibilities. The frst could be characterisedas muddle, muddle, muddle they

gave this a roughly 70% chance o beingthe outcome. Europes leaders come upwith a wonderul insurance scheme now,but therell be another scheme ater threeweeks and another three months later. Iit were possible to postpone a compre-hensive solution long enough, perhapspartial solutions could buy time until areturn o world growth could rescue theeuro. Think o policymakers with a pailull o meat running away rom a pack owolves (the impatient market), throwingpieces o meat out at regular intervals todistract the wolves, until the policymak-

ers are rescued. And who knows? Somegood may eventually come o this i itresults in more mobile labour markets in

Europe and more responsible fscal poli-cy in each country.

The second possibility (to which theygave a roughly 20% probability) is thatthe wolves come so close that the entirepail o meat needs to be emptied in aninstant. That would be a common eurobond, or a vast amount o QE by the ECB rom the point o view o the conser-vative core o Europe a cheque writtenon a piece o elastic that stretches romplanet Earth to Mars, and they ear whatthe proigate periphery would do withthat. (O course, in the periphery it isnot viewed this way and is consideredthe most obvious solution.) Third is adisorderly breakdown, with a small 10%probability. Countries like Greece arepushed against a wall; they fnd the pro-

cess unbearable and deault. The conse-quences could be extraordinarily bad notjust or the eurozone, but or the wholeworld economy. They gave a zero prob-ability to a ourth possibility: a negoti-ated, orderly dissolution o the euro suchas could possibly be achieved by a dualcurrency route being adopted by eitherthe core or the periphery.

Speaking purely or mysel, I dont believe the risks are quite that skewedto the frst outcome and away rom theothers, but, yes, I agree it is thepreponderant possibility.

Q: What went wrong with the euro?

There was a crack in the wall rom thestart, a set o weaknesses which werewell agged by, or example, US econo-mists in the 1990s. Whether they wereliberal or conservative, they said theproject was awed in its design and con-struction and would lead to something

like the present crisis. There was also,o course, political objection by Conser-vatives in the UK. The periphery o theeuro area has since experienced a relativeloss o competitiveness vs. the core insome eurozone economies o the order o15%, 20% or even more. This is obviouslya bad situation but, in the past, wouldnot necessarily have been the end o theworld. The problem was that the crackin the wall proved a disaster when themalevolent aspects o globalisation ledto an earthquake. Over the last decade,the enormous trade defcits recorded by

the US took the dollar rom parity vs.the euro to 1.60; that is the earthquakeI am reerring to. Overlay the 20% loss o


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competitiveness on this 60% dollar moveand you begin to appreciate that thesecountries would struggle against almostany competitor, never mind Germany.The key thereore is to see the problem incontext. The context is globalisation andthe risks and opportunities it has created.In that sense the euro crisis is like theearlier sub-prime crisis. Something simi-lar happened in the US during the 1960sand 1970s when it racked up enormousdefcits or the same reasons it has doneso more recently. Except the US dollarcurrently seems to have no difculty, aswe speak, in fnding oreigners to unda current-account defcit that dwars thato the euro area. Are the Chinese andAmericans brothers, in a sense thatGreeks and Germans are not? Thepolitical justifcation or the euro was

an attempt to uniy a continent wherepeople had an incredibly bad record ointernecine warare in the 20th century,an unquestionably laudable objective.But the worst way to try to achievepolitical unifcation or a meeting o mindsis through money. In my experienceyou cannot unite over money; you fghtover it. There is a undamental dangerin trying to achieve unifcation througha bureaucratic compromise hashed outin smoke-flled corridors. That seems tobe the perception o Eurosceptics. Notethat I am not suggesting it cant happen,o course, but that there are great vulner-abilities created in this process.

Q: How do you see the next decade in

globalfinancial markets?

Globalisation has created a tension between winners and losers. When thewinners are succeeding, there is astgrowth; when the losers drag the globaleconomy down, we have low growth orrecession. It is worth remembering thatin the last ten years we have had six yearso the highest growth rate in human his-tory, especially between 2003 and 2008.When 2.5 billion people emerge romthe deep ditch they dug or themselves300 years ago, this has to be a positiveprocess and there are ample opportuni-ties. But this is a Ricardian process wherethere are winners and losers: the winnersare the ones located in the intersection o

the Ricardian exchange where they enjoythe benefts o cheap labour, cheap capi-tal, cheap commodities, technology andorganisation. The losers are not confnedto the developed world, but certainlyinclude labour acing wage competitionand long-term savers acing depressedinterest rates and elevated liabilities inthe developed world. This tension is cre-ating an intensely binary outcome worldwith bimodal returns across risk assets.However, by the end o the decade,we will be likely to be living in a verydierent world one where engineer-

ing growth through low exchange ratesand low interest rates in countries like

Sources: Bloomberg Finance LP, Standard & Poor's, Deutsche Bank GMR

S&P 500 price index rolling 1-yr returns for the period Jan 00 Dec 10

Actual distribution

Theoretical Normal

0.00

0.01

0.02

0.03

0.04

Returns %

Density

Mean -0.16

Median 5.39

Max 68.57

Min -48.82

Std. Dev 19.66

Skewness -0.13

Kurtosis 2.74

-80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80

LIVING IN A NON-GAUSSIAN WORLD: EXAMPLE OF A BIMODAL DISTRIBUTION

In the past, this wouldnot have been theend of the world, butglobalisation turnsthe crack in the wallinto an earthquake.Over the course ofthe last decade, theUS enormous tradedeficits have causedthe dollar to plummetagainst the euro. Thesingle currency wentfrom parity to as highas 1.60 at one point.


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China is no longer possible becausethey run into severe raw-material short-ages; elementary things like water, ood,energy. This would be a situationanalogous to the one in the late 1960swhen Europe and Japan ran out osurplus labour. We will then be headinginto an era o lower real growth glob-ally, in which emerging-market exchangerates are rapidly appreciating. Andalthough my primary ear today is o therisk o deation or at least disination, Iear that by 2020 the risk will be one oination in the developed markets as theappreciation o emerging-market curren-

cies exports ination to the West.

Q: How do you hedge yourportfolios?

The world has become very unstable inGDP terms and much more unstable inearnings terms. Where theres a good out-come, profts are extraordinary and so,thereore, are returns on equities and highyield debt. When the economy sinks, pro-its collapse, equities collapse, high-yield

collapses risk assets collapse. This pro-duces bimodal distributions o return out-comes. The most powerul deence against

disaster in a portolio is to invest in assetsthat because o the environment or a valu-ation that is depressed or elevated pres-ent asymmetric pay-os. Interesting longpositions lie in assets where i bad thingshappen, their valuation goes down onlyso much, but i good things happen, itgoes up a lot. An asset that goes up verylittle i good things happen but collapses ibad things happen is an interesting short.I combine these to produce an efcientasymmetric-type portolio with a smile.I layer onto this option strategies, otenshort-dated, that take advantage o oppor-tunities where this asymmetry, or bimodal-

ity, is inappropriately priced in volatilitymarkets.


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EDITORIAL TEAMPICTET & CIEWilhelm SissenerKalina Moore

Design and editorialconsultancyStphane BobProduction MultimediaWinkreative

REPORTERJohn Willman

English translation/revisionStephen BarberHavard DaviesDaniel SteffenKeith Watson

PHOTOGRAPHYLoan Nguyen

CONTRIBUTORS


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201112 Perspectives Special Edition en[1]