We are at an interesting junction in the markets, with this non-trivial rally in front of significant uncertainties around the world: elections in the US next week as well as very relevant announcements expected from the Fed, while global rebalancing is being ‘designed’, the EU discussing major institutional reform and the developing world continues to chug along. Additionally, we spent time at the IMF Annual Meetings in Washington a few days ago. Thus, with so much to cover, I will try to be concise, and leave a more elaborate discussion for the monthly letter to clients next week (or for future posts).

Let us restrict this discussion to 5 global macro investment themes / risks / uncertainties:

1-    Currency wars, protectionist wars

This is certainly one, if not the global macro policy debate of the moment, and it was very present in most panels and conversations in the IMF meetings earlier this month. As we wrote on October 6 of last year, upon returning from Istanbul’s IMF meeting, it was also a theme back then. The difference is that now there seems to be a bit more impetus for action on the part of G7 governments, as well as some negative political noise.

EM countries learnt in the crisis that self insurance is worth it, and that reserve accumulation is a safe (though expensive) line of defense vis-à-vis external shocks. At the same time, a portion of EM (especially Asia) has a strong bias towards keeping their currencies “competitive”, especially if China does not allow for a much faster appreciation. So, on the EM side, we are bound to see all sorts of measures and continued reserve accumulation to slow down the inevitable currency appreciation (which will produce noise here and there, and some countries could force their hands and make more serious mistakes). However, it is very important to note that fundamentals point to appreciation in real terms, and that it could happen with inflation. In the case of China, for example, it is starting to happen through higher wages, which is a desirable development to be noted by the US.

The key here is the mistaken view of G7, especially the US. Focusing on forcing rebalancing, looking at current account surpluses and deficits as “imbalances” to be corrected is a flawed economics. Capital should flow to countries with promising investment prospects, producing current account deficits in those (reflecting higher investments than domestic savings). Countries where investment is significantly lower than domestic savings are countries that export capital. Here, the elephant in the room is the US, with a current account deficit that is explained by its fiscal deficit.

Not to expand too much on this, our view is that there is a non-trivial risk that this tensions lead to a wave of protectionist measures, the result of a coordination failure around some flawed macro analysis. But we do not exaggerate this risk. For example, the recent measures in the US congress respond more to politics around the upcoming elections than a real trend (steps towards declaring China a currency manipulator, which would allow for protectionist measures).

2-    US sources of risk

US policy is a source of risk at the moment: fiscal policy seems to go on the wrong direction, tax policy is producing uncertainty, regulatory reforms have produced distortions but details remain uncertain, exaggerated monetary policy efforts to produce growth, and international policy efforts seem to respond to central planning motivations. Next week’s congressional elections should help alleviate some of these risks, but it will take some time to assess how a Republican congress works with a Democratic White House.

The fiscal debate in the US is incredibly different than the one in Europe, and explains the appreciation of the euro versus the dollar since early June. Europe has sent clear signals of fiscal prudence, taking the view that a fiscal adjustment could help growth when medium-term sustainability is in question. The US seems to be more Keynesian and insensitive to the level of the deficit. I think this is a mistake, and next week’s elections could alleviate this problem. However, it will take more time for real fiscal consolidation signals to appear.

The Fed has clearly stepped in the field with the announced intentions to produce QE2. This exaggerated monetary policy efforts are the result of the combination of the dual mandate at the Fed (price stability and full employment) with the impatience produced by focusing on the Japanese experience. Our view is that in the short-term the Fed will disappoint markets with smaller QE2 than expected, but the medium-term force towards a weaker dollar and higher inflation is clearly there.

3-    EU sources of risk

The EU has chosen to move towards fiscal discipline as a response to its euro crisis, and has started a serious debate about reforming the institutions under the euro. Germany seems to be pushing for a scheme in which a country like Greece could/should restructure its debt, with burden sharing (the private sector withstanding part of the costs). Those reforms could include penalties to countries deviating from fiscal rules (no voting, etc.). France and others seem to oppose such a draconian approach, but we believe it is the only route to make the euro credible in the long run. Thus, we should expect some noise due to the risk of debt restructuring, but this time it would happen within a broader scheme that strengthens European institutions, and the world would be better prepared to absorb such news commensurate to what they are: the restructuring of debt from a small country. Noise nevertheless, and the institutional reform debate is just starting.

Economic data from Europe, especially the UK, is showing that the fiscal adjustments are not a drag on growth (as most applied economists in the US think). For once, Europe is teaching the US a lesson in economics, believe it or not.

4-    Equities versus bonds

This has been the year of bonds, so far. Rates collapsed in G7, and continue to come off almost everywhere else. In a recent letter to clients we highlighted the risk of what some call a ‘bond bubble’. We believe that one of the most serious portfolio decisions over the next few months is a drastic move from bonds to equities and other real assets. We think the short-term risks (some above) warrant keeping a cautionary stance in our portfolios. The recent rally, sparked by the US QE2 announcement, is to a large extent also warranted by a decent earnings season under way. Our bond positions have very low duration, and our bias is towards reducing bonds and increasing equities and other real assets. The timing of that move is key, and not imminent. Our equity allocations remain around 30% (diversified globally).

5-    Emerging Markets versus Developed Markets

The preference for emerging markets assets is now mainstream. The EM meetings at the IMF Annual Meetings were a testament to this, with more people than ever before, and clear signs of growth in assets under management across both the intensive and extensive margin (same old players receiving more money, as well as new players). This trend is bound to continue, mostly due to global liquidity, but also due to fundamentals, especially in the local currency and rates side. As the trend runs its course, currencies appreciate and rates come off, P/E ratios converge or exceed those in G7, volatility on those markets should go lower than that of G7. We will follow this process in order to maintain an above average exposure without imposing excessive volatility to portfolios.

In sum, the next few weeks should be very exciting an interesting in the markets. We have increased exposure gradually over the last few weeks, but the real rebalancing is yet to come.

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