Investors turn to equities amid global uncertainty
Principal Global Investors CEO Jim McCaughan says the traditional home bias and preference for fixed-income instruments is giving way to cross-border trends.
During the Hong Kong leg of his recent Asia tour, New York-based Jim McCaughan, CEO at Principal Global Investors, spoke with AsianInvestor about his outlook for the US economy as well as the shift in US monetary policy and how that has affected institutional demand.
What is your assessment of the US economy?
McCaughan: The Federal Reserve has actually done a very nice job at easing credit conditions and supporting the systemic risks in the banking system without provoking enormous increases in money supply. A lot of what they have done in buying in mortgage-backed bonds and swapping the inventory in the Bear Stearns rescue has been done in such a way that it doesnÆt pump too much money into the system. So in the US, you are still seeing modest growth in money supply at a time when the headline inflation rate has been hit by gasoline prices.
What should be monitored when it comes to US inflation?
ItÆs probably important that the headline inflation rate is moving up in grain prices, which are at their extreme high, as well as metals. But in the US context, business is so competitive that companies have to absorb the increase in input prices, and the end prices of goods and services have been remarkably subdued. We think they will continue to be subdued because of competition in the system. ItÆs a very competitive economy.
We are not as afraid of inflation as many are. In fact, we think the Fed may be overdoing the inflation and risk balance in the way they are thinking about interest rates. But they have done a very good job in avoiding monetary inflation. And to an extent, so have the Europeans, particularly the UK.
There has been much debate over whether the US is in recession or is merely experiencing a slowdown. What is your view?
Do I think that you will see a recession in terms of negative GDP growth? Absolutely not. I think there is too much positive momentum in terms of productivity and competitive growth in competition. I think some of the negative growth drivers will be Brazil and China, rather than the US.
Employment numbers are a good indicator of a recession. In the US, the employment numbers are not in deep recession territory. I think what youÆll do in six to 12 monthsÆ time is look back and say the US recession started in November 2007. And I donÆt think it will be a deep recession, but it might last longer than usual at 12 months rather than six months.
The reason I say that is the US housing market is in all kinds of trouble. And in that one market, there is such enormous over-supply, there is really two years of inventory over-supply. And after that, people canÆt get mortgages to buy it, even if they want to. So the US housing market is going to be a major drag on the US economy.
And those are the reasons I would have said for some time that we are moving into recessionary territory in the US. But I donÆt think it becomes global recession. I think there are enough positive things going elsewhere.
What is the FedÆs likely course of action in the second half of this year?
I think itÆs going to be much more direct in its support of mortgage market û directly buying bonds, directly supporting through Federal Home Loan Bank and through the FedÆs discount window, directly supporting these systemic troubles in the economy.
I think that will work. YouÆve also got the tax refunds, the fiscal stimulus. ThatÆs really directed to the people that have low incomes that will tend to spend it. So that will tend to have more impact in keeping the economy going.
What is your outlook for the US dollar?
The dollar gets very weak and everybody gets very upset, especially the Americans travelling. But the good side of that is exports are now very competitive. The US becomes more competitive as an exporter and you are getting in a situation that hasnÆt been seen in decades, which is export growth.
What is your reaction to what appears to be the rising protectionist sentiment in the US?
As you look at the things that have made markets prosper over the last 20 or 30 years, two of them are under some degree of attack: one of them is free trade and the other is low taxes. The US government has got a nasty fiscal position, and whichever administration is in, there will be upward pressure on taxes just because of the government deficit.
If the US becomes protectionist and imposes high taxes, which I think it will, then that will be very negative for investors. But those are just economic realities that will need to be watched.
How has investor sentiment changed under this economic backdrop?
The amount of activity we are doing has changed slightly. Previously, a lot of the activity was in fixed income and in real estate globally. ThatÆs changed dramatically in the last 12 months. I think itÆs partly because investors have become somewhat concerned with real estate because of the choking of sources of finance and the slowing down of mortgage finance. They are also very uncertain about fixed income, given not only the increase in spreads, but also the lack of marketability of fixed income.
With continued economic growth in this region, many people are seeing the volatility level as strategic opportunity to get into equities. And so, if you want to have a new pipeline of new business compared to a year ago, equities is big now.
Have Asian investors increased their home bias?
Home bias is understandable and legitimate. But this phenomenon everywhere in the world û this is not just in Asia û has been eroded. US pension funds with 15% non-US allocation are now moving into 20%. European funds with 20% non-European allocation are now moving into 30%. That is the global phenomenon now. There is a surge in diversification during uncertain times.
How would you view the aggressive targets North Asian institutional investors are setting for mandates in midst of the current market mayhem?
There is a tendency to move towards performance objectives that are 2- 3% above a given index, or even in absolute returns with hedging. YouÆre right to identify a move towards more aggressive mandates. But I would suggest thatÆs a pretty strong worldwide phenomenon. And the techniques that investment managers have to use include research, qualitative and quantitative portfolio management techniques, risk controls, hedging techniques. Some have described that as being a convergence of hedge fund and long-only management.
Many market players are lamenting the increasingly low margins of fees in Asia. Has that somewhat tarnished the outlook for the Asian asset management industry?
Of course large institutions demand competitive fees. ItÆs not just in Asia. The US public funds have for decade or two been one of the toughest markets in terms of fees. I would say the Asian institutions just have to look at the fees demanded by the large US public funds, and theyÆll see that there is a lot of this going on. Our challenge is to demonstrate added value, which makes even those large institutions want to pay for our services.
It comes back to performance and designer products. One talks about growing competition in asset management, but in the end, the real competition isnÆt on fees. The real competition is on results. And if you donÆt get good results, you donÆt have a business really. So we feel the pressure is very much there.
What is your assessment of the US economy?
McCaughan: The Federal Reserve has actually done a very nice job at easing credit conditions and supporting the systemic risks in the banking system without provoking enormous increases in money supply. A lot of what they have done in buying in mortgage-backed bonds and swapping the inventory in the Bear Stearns rescue has been done in such a way that it doesnÆt pump too much money into the system. So in the US, you are still seeing modest growth in money supply at a time when the headline inflation rate has been hit by gasoline prices.
What should be monitored when it comes to US inflation?
ItÆs probably important that the headline inflation rate is moving up in grain prices, which are at their extreme high, as well as metals. But in the US context, business is so competitive that companies have to absorb the increase in input prices, and the end prices of goods and services have been remarkably subdued. We think they will continue to be subdued because of competition in the system. ItÆs a very competitive economy.
We are not as afraid of inflation as many are. In fact, we think the Fed may be overdoing the inflation and risk balance in the way they are thinking about interest rates. But they have done a very good job in avoiding monetary inflation. And to an extent, so have the Europeans, particularly the UK.
There has been much debate over whether the US is in recession or is merely experiencing a slowdown. What is your view?
Do I think that you will see a recession in terms of negative GDP growth? Absolutely not. I think there is too much positive momentum in terms of productivity and competitive growth in competition. I think some of the negative growth drivers will be Brazil and China, rather than the US.
Employment numbers are a good indicator of a recession. In the US, the employment numbers are not in deep recession territory. I think what youÆll do in six to 12 monthsÆ time is look back and say the US recession started in November 2007. And I donÆt think it will be a deep recession, but it might last longer than usual at 12 months rather than six months.
The reason I say that is the US housing market is in all kinds of trouble. And in that one market, there is such enormous over-supply, there is really two years of inventory over-supply. And after that, people canÆt get mortgages to buy it, even if they want to. So the US housing market is going to be a major drag on the US economy.
And those are the reasons I would have said for some time that we are moving into recessionary territory in the US. But I donÆt think it becomes global recession. I think there are enough positive things going elsewhere.
What is the FedÆs likely course of action in the second half of this year?
I think itÆs going to be much more direct in its support of mortgage market û directly buying bonds, directly supporting through Federal Home Loan Bank and through the FedÆs discount window, directly supporting these systemic troubles in the economy.
I think that will work. YouÆve also got the tax refunds, the fiscal stimulus. ThatÆs really directed to the people that have low incomes that will tend to spend it. So that will tend to have more impact in keeping the economy going.
What is your outlook for the US dollar?
The dollar gets very weak and everybody gets very upset, especially the Americans travelling. But the good side of that is exports are now very competitive. The US becomes more competitive as an exporter and you are getting in a situation that hasnÆt been seen in decades, which is export growth.
What is your reaction to what appears to be the rising protectionist sentiment in the US?
As you look at the things that have made markets prosper over the last 20 or 30 years, two of them are under some degree of attack: one of them is free trade and the other is low taxes. The US government has got a nasty fiscal position, and whichever administration is in, there will be upward pressure on taxes just because of the government deficit.
If the US becomes protectionist and imposes high taxes, which I think it will, then that will be very negative for investors. But those are just economic realities that will need to be watched.
How has investor sentiment changed under this economic backdrop?
The amount of activity we are doing has changed slightly. Previously, a lot of the activity was in fixed income and in real estate globally. ThatÆs changed dramatically in the last 12 months. I think itÆs partly because investors have become somewhat concerned with real estate because of the choking of sources of finance and the slowing down of mortgage finance. They are also very uncertain about fixed income, given not only the increase in spreads, but also the lack of marketability of fixed income.
With continued economic growth in this region, many people are seeing the volatility level as strategic opportunity to get into equities. And so, if you want to have a new pipeline of new business compared to a year ago, equities is big now.
Have Asian investors increased their home bias?
Home bias is understandable and legitimate. But this phenomenon everywhere in the world û this is not just in Asia û has been eroded. US pension funds with 15% non-US allocation are now moving into 20%. European funds with 20% non-European allocation are now moving into 30%. That is the global phenomenon now. There is a surge in diversification during uncertain times.
How would you view the aggressive targets North Asian institutional investors are setting for mandates in midst of the current market mayhem?
There is a tendency to move towards performance objectives that are 2- 3% above a given index, or even in absolute returns with hedging. YouÆre right to identify a move towards more aggressive mandates. But I would suggest thatÆs a pretty strong worldwide phenomenon. And the techniques that investment managers have to use include research, qualitative and quantitative portfolio management techniques, risk controls, hedging techniques. Some have described that as being a convergence of hedge fund and long-only management.
Many market players are lamenting the increasingly low margins of fees in Asia. Has that somewhat tarnished the outlook for the Asian asset management industry?
Of course large institutions demand competitive fees. ItÆs not just in Asia. The US public funds have for decade or two been one of the toughest markets in terms of fees. I would say the Asian institutions just have to look at the fees demanded by the large US public funds, and theyÆll see that there is a lot of this going on. Our challenge is to demonstrate added value, which makes even those large institutions want to pay for our services.
It comes back to performance and designer products. One talks about growing competition in asset management, but in the end, the real competition isnÆt on fees. The real competition is on results. And if you donÆt get good results, you donÆt have a business really. So we feel the pressure is very much there.
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