Global economy on the mend but “new normal” will not match pre-2007 levels
Commentary by Jac Laubscher, Economic Adviser for Sanlam Ltd in South Africa
A number of reports that surfaced in the past two weeks painted an interesting picture of the efficiency of capital allocation and international capital flows when viewed together. Some of the reports focused on the macroeconomic environment, while others dealt with the business of asset management. The conclusions have important implications for the future of the South African economy because of its dependence on foreign capital.
The first report dealt with the revision of MSCI’s Emerging Market Index*, which is widely used as a benchmark in international equity investment. Global funds following this index are estimated at US$1,6 trillion.
The big news is the intended inclusion of China’s locally listed A-shares (or more correctly, the shares of 222 large-cap companies deemed adequately compliant with international standards of corporate governance, even though almost two thirds of them are owned by local or central government) in the index for the first time, starting in less than 12 months.
The initial weighting for China A-shares will be a mere 0,73% (equivalent to US$20 billion in net inflows), but it is unlikely to stop there. Bear in mind that China A-shares have the second-highest total market capitalisation in the world after US equities. Further increases in weighting will, however, depend on progress with improved corporate governance in China, as well as China’s progress with liberalising the renminbi, opening up its capital markets, and allowing greater freedom in cross-border capital flows.
MSCI has not released any timetable for its future plans in this regard. However, it has been estimated by Goldman Sachs that if China A-shares follow the same path as South Korea in gradually being included in the index their weighting will rise to 9% (equivalent to $230 billion in net inflows) in the next five years. But, if China’s weighting was to reach a level with which investors are not comfortable (China already accounts for almost 30% of the index through e.g. Hong Kong-listed companies), “EM excluding China” funds will in all likelihood make their appearance.
The implication is that as China’s weighting in the MSCI index increases, the respective weightings of its other constituents, including South Africa, will automatically decline.
Furthermore, there is a possibility that Saudi Arabia will also be included in due course. It is an open question how investors will respond: will they put additional money to work in the emerging-market universe to invest in China A-shares, or will they reallocate capital to China from other constituents?
The second report dealt with the release of the British Financial Conduct Authority’s review of the UK’s asset management industry. Although the review took place in the context of the UK’s institutional structure, the principles it addresses are of a universal nature.
As has almost become customary, the review is critical of active asset managers, but its criticism is not aimed at active investment management in principle; it rather takes the active asset sector to task for its business model, including closet index tracking. The general conclusion seems to be that the review will encourage even greater use of passive index-tracking funds, although it does not do so explicitly.
However, investors will do well to heed the words of John Authers, investment commentator of the Financial Times: “Indices are not impartial or abstract constructs; they are an expression of someone’s opinion, and this should not be forgotten.”
This point is taken further by Merryn Somerset Webb, editor-in-chief of Money Week, in commenting on passive investors: “The style of investing they think they have embraced does not actually exist. There is no such thing as passive. Someone has to decide what is an emerging market, someone has to decide which emerging markets are the most important and someone then has to decide which stocks define each emerging market.”
With the review being critical about what it sees as inadequate competition among active asset managers, it makes no reference to the fact that passive investment is a highly concentrated (oligopolistic) market sector.
Interestingly, the review is not limited to asset managers but also addresses the roles played by investment consultants and fund platforms in the placement of investment capital. Although the review is concerned with the effect the decisions of asset managers, investment consultants, fund platforms, and the screening committees of index compilers have on the returns earned by investors, there is also a macroeconomic side to this, viz. their impact on the efficiency of the allocation of capital in the global economy.
The third report sets out the growing evidence that the global economy is on the way to normalisation after 10 years of emergency treatment in the wake of the financial crisis of 2007/08. But it will be a new normal and not a return to the pre-2007 position.
For the developed world this new normal will mean higher economic growth with less worry about its sustainability, but nevertheless at a lower average rate. Potential growth has been negatively affected by the slowing of productivity growth, brought about by a step change in technological development. The further effect the threatened pullback from globalisation will have on global growth is still unclear but it is bound to be negative.
With that will come a return to moderate inflation, with the fear of deflation being expelled.
Once again the effect of a weakening of international competition in response to creeping protectionism on inflation will only become clear over the medium term but “lowflation” will be the norm for the time being.
The result will be a normalisation in monetary policy and interest rates, although at a lower level than pre-2007. Moderately higher inflation and short-term interest rates will be reflected in higher long-term rates (bond yields), but again the upward movement will be constrained. One should therefore be careful not to exaggerate the normalisation theme.
As for the emerging-market universe as an asset class, indications are that investors will start to reassess its defining characteristics. Up to now emerging markets have basically been a play on global growth with investor interest very much focused on commodity markets. However, the countries that form part of this group have evolved in different directions in the past 10 years and unthinkingly grouping them together will gradually become untenable.
But what will the new criteria of distinction be? Two possibilities come to mind: the potential for the domestic economy to drive growth, and governance standards at the level of both individual companies and government. John Authers states that already the way “active emerging-market funds were weighted compared to the MSCI benchmark suggests that governance indeed weighs more on investors’ decisions than geography or industrial sector. They are very underweight state-controlled companies, and overweight stocks with dispersed ownership.”
This leads to the conclusion that the allocation of international capital flows, in particular where portfolio investment is concerned, could be heading for a shake-up that will have important implications for South Africa given its perennial low savings rate and dependence on such flows. In spite of the low growth the economy achieved in the past five years, averaging a mere 1,5% per annum, South Africa’s current account deficit has averaged 4,8% of GDP over this period.
If it wants to achieve the kind of growth rates that will have a meaningful impact on unemployment and poverty, South Africa has no option but to continuously boost its attractiveness to international investors. In an environment where the forces influencing international capital flows are changing, this will require a focused approach.
Firstly, this means that all stops must be pulled out to protect the country’s remaining investment grade credit ratings and regain those lost recently. The starting point in stabilising government finances must be to critically reassess government expenditure, asking pertinent questions about the cost-benefit relationship. It seems that the size of government can be reduced without any loss in efficacy, and the cabinet and parliament should come up for scrutiny first.
Secondly, South Africa is already highly ranked as far as corporate governance standards in the private sector are concerned. However, the same cannot be said of state-owned enterprises and general government. If governance standards were increasingly to become a reference point for investor decisions as suggested above, the public sector will have to up its game.
Thirdly, South Africa will have to realise that its future does not lie with natural resources. Less and less international capital will be attracted by the mining and minerals sector. In order to limit the current account deficit its export mix will have to be diversified to make it less reliant on commodity exports. With free trade in manufactured goods under threat, the logical way to go is to expand the role of the services sector in earning valuable foreign currency.
Fourthly, black economic empowerment will have to be approached dynamically rather than just rearranging the chairs already on the deck. Creating new enterprises through partnerships, including international partners to draw in direct investment, should be a priority.
If South Africa cannot at least widen, but preferably escape from, the constraint on economic growth caused by its dependence on international capital, it will struggle to be the master of its own destiny and may well remain stuck in a low-growth trap.
* The MSCI Emerging Markets Index was created by Morgan Stanley Capital International (MSCI) to measure equity market performance in global emerging markets. It is a float-adjusted market capitalization index that consists of indices in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates.