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Great Global Shift Whitepaper
Great Global Shift Whitepaper
Great Global Shift Whitepaper
lisa shalett
Chief investment Officer, Merrill lynch Global Wealth Management
break, between the spiraling debt crisis in the eurozone, gridlock in Washington, slowing global growth, persistent unemployment and turmoil across the middle east. it can be both disorienting and discouraging. How do you make sense of the stream of apparently unrelated crises coming from so many directions? At merrill Lynch, we think a good place to start is with the understanding that these seemingly unconnected issues are very connected. they are all part of an ongoing, fundamental transformation in the worlds economic, political and social institutions. in this whitepaper, the eurasia Groups ian Bremmer and our own Lisa shalett offer a wide-angle view that brings to light the larger pattern of the global economy, revealing a rebalance of economic power on par with some of the most significant paradigm shifts in history. inevitably, change on this scale comes with a great deal of disruption and additional risks, along with new opportunities. in fact, whats happening in the world right now calls into question many tenets of investing and managing risk that have prevailed for decades. the quality of insight that merrill Lynch can provide is rareand especially importantin an era when around-the-clock news and instant analysis seem ever present. it is always our aim to give you a more thoughtful, forward-looking point of view, as well as real solutions that can help you make informed investment decisions. once youve read this whitepaper, i invite you to make it the foundation of your next conversation with your financial advisor. make use of its insights as you work together to adapt your financial life to a new world and its new rules.
John thiel
HeAd of U.s. W eALtH m AnAGement And tHe PRi vAte BAnk inG And in v estment GRoUP
Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation (BAC). Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value MLPF&S is a registered broker-dealer, a registered investment advisor and Member SIPC.
MarC bryan-brOWn
T h e g r e aT g l o b a l s h i f T
sense of equilibrium. the history of modern commerce has taught us all about cycles. Historically, recessions lead to the inevitable reflation. Crashes contain the seeds of comebacks. markets mend, GdPs rise again and job creation does become real rather than just a piece of political rhetoric. And yet, as much as wed like to believe otherwise, theres no denying that this time its different. since the end of World War ii, a powerful West, dominated by U.s. hegemony, grew accustomed to equating itself with the world. the preeminence of Western institutionsnAto, the World Bank, the international monetary fundmeant that global priorities were our priorities. the West set the conditions for economic reform, transparency and the rule of law. even the soviet Union, the U.s.s chief rival for global influence during the Cold War, was primarily a military rival that never posed a true threat to Western economic power.
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Americas place in the global economy was like that old New Yorker cover depicting the view from ninth Avenue, across the heartland, to a tiny distant Asia. on a personal level, when we invested for our families and our futures, operating in a West-centric, dollar-dominated world didnt eliminate the cyclical ups and downs, but it did at least make them seem familiar. so its only natural that as we talk about economic recovery, what we really want, beyond higher GdP and greater employment, is a return to that old, comfortable balance. When (we cant help but wonder) will we recover that old sense of equilibrium? the answer is becoming clearer every day: We wont. the rapid rise of China and other emerging nations has ushered in sweeping changes being felt from the bauxite mines of Asia to the gas pump on main street to the expensive office space in so Paulo. one of the great paradigm shifts in history appears to be upon us. such periods are always marked by enormous turbulenceand fear, as the markets recent wild swings may have already begun to express. As volatile as the past few years have felt, they are likely to be a mere prelude to a period of global disruption and uncertainty that will endure for years to come.
iAn BRemmeR
is the president of Eurasia Group, a leading consultancy on geopolitical risk, and is widely regarded as one of the most influential thinkers on global trends.
LisA sHALett
is the chief investment officer for Merrill Lynch Global Wealth Management and head of Investment Management & Guidance.
September 2010
Change has arrived so swiftly that our largest institutions, while still holding to the paternalistic model of the West as benefactor/protector, are being surpassed by the very countries they were set up to help. during the past two years, China offered more aid to developing nations than the World Bank did ($110 billion vs. $100.3 billion)even as China continued to receive billions of dollars in aid from the World Bank.1 if the World Bank has been thrust into such apparent contradictions, what are private investors to make of these developments? in disruptive times, even the most conservative strategies (buy-and-hold; stay close to home) may not be so conservative at all. navigating an age of risk requires meeting risk head-on, actively and dynamically, and
1
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Chinas Lending Hits New Heights, Financial Times, Jan. 17, 2011.
venturing into the strange landscape of a global economy. thats the tough way of looking at it. seen another way, disruption most always creates opportunities. to seize them, we must respond nimbly, adapt, adjust and, perhaps most important, come to terms with just how profoundly the world has changedand is changing.
in disRUPtive times, even tHe most ConseRvAtive stRAteGies (BUY-And-HoLd; stAY CLose to Home) mAY not Be so ConseRvAtive At ALL.
US Debt Clock, usdebtclock.org. See Debt Per Citizen. Washington Wire, Wall Street Journal, June 10, 2011.
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advanced
emerging
Source: International Monetary Fund, World Economic Outlook Database, April 2011
ts almost too easy to say that emerging nations are driving world growth. the international monetary fund projects that on a purchasing-power parity basis,4 emerging and developing markets will account for two-thirds of the growth in global GdP this year. still, that trend, striking as it is, masks extraordinary complexity. emerging markets dont make up a unified bloc, but rather are vastly different countries with competing goals, standards and agendasnot to mention enormous challenges of their own. thus far, the remarkable growth of developing countries has been tempered by their unwillingness to accept a proportional share of the responsibilities of global leadership. Whether its european-style environmental reforms, U.s.-style peace brokering in the middle east or coordinating antiterrorism policies, most of the comprehensive initiatives for solving the worlds problems continue to initiate in the West. While China may have developed into a banker and benefactor to Western and developing nations alike, it often tries to attach manifold strings to those trillions it sends overseas. this fall, Chinese Premier Wen Jiabao suggested his nation might be willing to step up its monthly lending and other investments in europe to help the eurozone out of its debt crisisif the europeans extended a way around the antidumping regulations that prevent Chinese companies from flooding the continent with low-priced goods.5 to be sure, the U.s. and europe often act with self-interest when pursuing their international policies, but China seems to be especially shameless about it.
The purchasing-power parity ratedefined as the number of units of a countrys currency that are required to buy the same amount of goods and services as one U.S. dollar would buy in the U.S.is intended to allow for apples-to-apples comparisons between average consumers in different nations. 5 World Economic Forums fifth Annual Meeting of the New Champions, Sept. 14, 2011.
4
Because of its size and spectacular growth, discussions of emerging markets inevitably start with the Peoples Republic. the Chinese today arent just producing every kind of goods, and doing it with precision; as tens of millions of Chinese move into the middle class, theyve also begun consuming vast quantities, last year purchasing more cars than did Americans,6 and recently overtaking the U.s. as the biggest PC consumer in the world.7 Why, then, are the Chinese so worried? With the Wests buying power shrinking and their own citizens demanding a greater share of the wealth, Chinas top-down economic planners are struggling with whether they must fundamentally restructure their nations economy from what is still principally a state-driven, export-oriented system to a more consumption-driven one. Chinas state Council has made the growth of the consumer sector a theme of the countrys latest five-year plan. At the same time, it has shown zero willingness to dismantle the network of state-run giants (and some private ventures) that have benefited from the special financing and regulatory shields that the central government has long bestowed on them. this system of privilege was meant to fuel the countrys old export-driven growth, and clearly it succeeded. But while the furious development has lifted millions of Chinese out of poverty, it has nonetheless come at a significant cost. With the arrival of a new class of state-sponsored entrepreneurs and bureaucrats, the gap between rich and poor has widened, and the resulting imbalances have spurred what could become a massive power struggle between reformists and entrenched interests that reaches into every strata of Chinese society. As if to illustrate the challenges, the countrys exports as a percentage of GdP have ballooned back to pre-financial-crisis levels, at around 39%, the highest ever.8 China may indeed move toward a more self-focused economy, but we would do well to remember that every Chinese five-year plan is designed as just one step in a 25-year plan. Beyond China, india and indonesia deserve more serious attention than they get. Both countries have compelling demographics and commodity wealth, plus political and economic systems that arent in need of a wholesale overhaul. Here again, though, attempts to classify countries en masse fall short. Umbrella acronyms such as BRiC (for Brazil, Russia, india and China) have a handy ring but convey a level of uniformity that doesnt exist. Russia, for example, while rich in commodities, is actually losing population and labors under a sluggish bureaucracy and opaque corporate governance. some other, less likely names, meanwhile, may present investors with opportunities at least as BRiC-like. despite a recent uptick in religious conservatism and a disconcerting crackdown on free speech, turkey saw its economy surge 10.2% in the first six months of this year.9 even nigeria, with 155 million people and a burgeoning entrepreneurial spirit, deserves a serious look. still, none of these nations is jumping at the chance to fill the vacuum that will be left by the inward turn of the traditional Western powers. many observers see a new era characterized by uncoordinated policies from both developed nations and emerging markets. We will experience a world that is multispeed and multidirectional, with varied responses from lawmakers in every spot on the globe, like loose molecules. this has already had an obvious effect, with massive dislocations in commodities, currencies, credit spreads and asset prices. the takeaway is to expect
China Ends U.S.s Reign as Largest Auto Market, Bloomberg, Jan. 11, 2010. China Tops U.S. as Worlds Largest PC Market, Forbes, Aug. 23, 2011. 8 tradingeconomics.com/china/exports. 9 BofA Merrill Lynch Global Research, Sept. 13, 2011.
6 7
desPite A ReCent UPtiCk in ReLiGioUs ConseRvAtism, tURkeY sAW its eConomY sURGe 10.2% in tHe fiRst HALf of 2011.
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twenty years ago, it was the fiscal crises in south america and the asian tiger Cub economies that riveted investors. today its more of the developed nations that are rattling global markets with their high levels of debt and deficits.
48.1
even more of the same, at least for the time being. that includes trade wars, industrial piracy and the hoarding of resources la Chinas recent stockpiling of vital rare-earth metals. so while investors rightly move to emerging markets for growth opportunities, the search for stability and equilibrium goes on.
in the debt World, as you can see above, there are the U.s. and europe. While all of the major players in europe are committed to the eurozone, the continent has a long, hard slog ahead. for the immediate future, markets are likely to punish the europeans, even as they begin to turn things around through austerity programs and tentative steps toward greater fiscal unity. the U.s. position, despite the sting of its own downgrade by standard & Poors, has the built-in advantages of a single government (however fractious) rather than many, and a single muscular central bank in the federal Reserve. that said, Americas fiscal problems are real, and the resolve it has shown in facing and overcoming the challenges has so far seemed modest at best. moreover, as in europe, the struggle to ease the public debt burden is complicated by private debt. in simple terms, the U.s. workforce and economic base were built to be sustained by consumer borrowing and rising home values. the model helped to fuel U.s. GdP by roughly 3%
ne crucial group of actors in this volatile global shift is the central banks, as nations and markets naturally divide more and more along new fault lines. instead of a world marked by developed and emerging, we may be entering the age of debt vs. no debt.
missionand lower fees, plus the ability to target more specific objectives. For example, to hedge against the impact a rise in oil prices could have on the rest of your portfolio, you might purchase shares in an oil-linked etF. One potential drawback is the underlying methods these funds use to generate their returns. although etFs generally seek to match the spot, or current price for immediate delivery of their commodity, most actually do so by trading longer-dated futures contracts. Periodically, when the price of futures outpaces the spot price, as during the big run-up in oil prices in the first half of 2011, the cost of buying new contracts after the old ones expire can eat deeply into the performance of the fund, even if the commodity itself is doing very well. 2. Actively Managed Funds actively managed commodity funds rely on managers skill in pursuing more complex objectives, such as outperforming commodities indexes or countering the effects of volatility. historically the leading purveyors of active management strategies were hedge funds (see even More targeted solutions for Qualified investors, page 16), which limited the approach to a relatively select group of clients. but in recent years more mutual funds have been getting into the arena. though these nontraditional mutual funds
typically dont offer the same alpha, or added upside potential of hedge funds, their fees are generally quite a bit lower and investors face far fewer restrictions on eligibility and liquidity. 3. Market-Linked Investments While all forms of commodity exposure can be effective at adding diversification and reducing overall portfolio risk, these investments provide a way to explicitly manage the risk of a commodity allocation itself. theyre essentially market-linked bonds (issued by banks and other companies) whose returns can be linked to another asset. using one type of Market-linked investment, for example, you might buy a five-year note tied to the spot price of gold. if the metal continues its rise of recent years, youd receive a payout at maturity reflecting all or a portion of those returns. but if the price of gold goes down, youd still get back your original investment. Purchasers of Market-linked investments take on other riskschiefly the credit risk of the issuerand because payouts are usually subject to a cap, returns may be less than with a direct investment in the underlying asset. nonetheless, for many investors, they remain another way of buying commodities today that can help meet their specific objectives. no vault or grain elevator required.
1. Index and Exchange-Traded Funds the simplest and least expensive way of gaining commodity exposure, index funds seek to match the performance of the major commodity composite indexes, such as the dow Jonesubs or standard & Poors GsCi. because the funds are passively managed to hew to their indexes, management fees tend to be lower than for most mutual funds. and daily trading makes the investments highly liquid. exchange-traded funds (etFs) offer similar ease of investmenttheyre bought and sold on stock exchanges for a com-
a year from 1996 to 2008.10 But the levels of demand projected going forward are waningBofA merrill Lynch Global Research recently lowered its U.s. GdP forecast to 1.6% for 2012 and 1.4% for 2013.11 that missing 1.5% is at the core of the tragically high structural unemployment that is itself a major drag on growth weighing on the efforts to bring government spending in line with revenues. in the meantime, look for more years of low economic growth, constrained fiscal policy responses and a central bank forced into ever more extreme monetary fixes that, from an investors perspective, all amount to the same outcome: lower interest rates.
10 11
International Monetary Fund; Merrill Lynch GWM Investment Management & Guidance. BofA Merrill Lynch Global Research, Global Economic Weekly, Sept. 23, 2011.
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124
Number of full-time workers (in millions)
30
Number of part-time workers (in millions)
122 120 118 116 114 112 110 108 106 104
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
29 28 27 26 25 24 23 22 21 20
Full-time
Part-time
Source: Bureau of Labor Statistics and Merrill Lynch GWM Investment Management & Guidance. Data as of Aug. 31, 2011.
tHe CHALLenGe is to deveLoP A stRAteGY tHAt CAn BotH WitHstAnd tHe CRises And Ride tHe tide tHAt is LikeLY to dominAte tHe next CentURY.
the question now is: What replaces the 1.5%? even as America pays down its debts, public and private, it must begin to tackle the even more fundamental issues glossed over during the housing boom: An enormous baby boomer generation whose entitlements must in large part be borne by younger people facing a less-than-certain financial future. Wealth inequality that hasnt been this severe since the 1920s. A similarly intensifying disparity between skilled and unskilled workers, with the latter group both growing in size and falling further behind. A social compact that increasingly treats labor as just another variable cost to be shed whenever demand is low. Underpinning all of those specific issues is something less easy to define but no less real: a lingering crisis of confidence. According to the University of michigan Consumer sentiment index, as of August 2011, attitudes in the U.s. about the business climate and their personal finances were at near a 30year low.12 these findings, bolstered by similar numbers from the Conference Board,13 came at a time when the country was not even technically in a recession. the matter of which must happen firsta return of confidence, or progress on the hard work aheadis a classic chicken-or-egg question. either way, theres no denying that reinvigorated capital markets require a bit of swagger, a return of the animal spirits that drive capitalism. no doubt that can happen. the worlds biggest economy has too much creativity, too much resilience to stay down forever. Yet the rebound could still be a ways off, and investors must realize that when the American economic giant reawakens, it will be to a global economy governed by new rules and populated by new highly motivated and highly competitive players. By contrast, China and (bizarrely enough, considering the trillions they have defaulted on in the past) much of the rest of Asia and south America have already begun to exercise the flexibility that comes with membership in the no-debt World. Gradually, fitfully weaning themselves from
12 13
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Surveys of Consumers, Thomson Reuters, University of Michigan, Aug. 26, 2011. Consumer Confidence Survey, The Conference Board, Aug. 30, 2011.
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dependence on the West, these economies will continue to grow, giving their central bankers increasing sway over the worlds markets. And as their inflation picture sharpens, they may continue on a path much different from that of Western countries.
investinG in Bonds of tHe foRmeR AsiAn tiGeR CUB eConomies dURinG times of CHRoniC UnCeRtAintY CAn seem Like PURe foLLY. BUt it isnt.
t h e e l O b a l as h ia d th GrOad he Ft
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mAnAGinG Risks in tHis enviRonment ReqUiRes WHAt miGHt onCe HAve seemed BetteR sUited to mARket sPeCULAtoRs.
ones actual income needs, todays low treasury yields and the relatively strong balance sheets of the Asian countries, the opposite may be true.
1991 Recession
1.0 0.9 0.8
Correlation coefficient
12
managing risks in this environment requires what once might have seemed better suited to market speculators: an approach more dynamic than old-style investing, more tactical, more flexible and quicker to respond. its not enough, for instance, to diversify along traditional lines: risky growth stocks on one hand and stable dividend-paying blue chips on the other. it means knowing how to diversify between countries and regions: between southeast Asian chip manufacturers and south American miners. it means seeking out mutual funds that have broader mandates, with an ability to hedge positions or to range across borders and asset classes. it means taking a look at alternative assets in general, including commodities and, for qualified investors, hedge funds and private equity to determine whether theyre appropriate for your portfolio. traditional asset classes, too, must be seen through a more global, dynamic prism. diversification matters more than ever, but it can no longer be achieved by dutifully filling neatly defined slots with 60% stocks, 30% bonds and 10% cash and then holding on for dear life. Are those stocks positioned to capture global growth, to help protect against currency fluctuations, to provide yield potential? Are you prepared to change directions as new opportunities arise?
it meAns knoWinG HoW to diveRsifY BetWeen CoUntRies And ReGions: BetWeen soUtHeAst AsiAn CHiP mAnUfACtUReRs And soUtH AmeRiCAn mineRs.
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BEForE KEy
at a glance, fixed income doesnt seem to change much. but in the before model, its almost entirely allocated to u.s. bonds, with 14% of all assets dedicated to treasuries and municipalsand just 1.75% to bonds from overseas. 8% 2%
U.S. Equities International Equities Emerging-Market Equities Fixed Income Cash Global Hedge Funds Global Private Equity Global Real Assets
50% 35%
5%
AFTEr
in the after models, no distinction is made between u.s. and foreign bonds theyre all classified as global. though theres no specific allocation to commodities for average affluent clients, exposure still comes through etFs listed on u.s. stock exchanges. through global managers, even the most mainstream clients can access companies based in south america, asia and eastern europe. For qualified clients, real assets could include the standard commodity vehicles plus direct investments in farm and timberland. Private equity lets qualified clients invest in companies (and countries) at an earlier stage in their development. hedge funds offer especially dynamic strategies for managing risk and seeking higher-than-market returns. in the after models, exposure also grows to include foreign companies based in developed nations like Canada and Japan.
2% 7% 38% 28% 2% 9%
4% 21%
Affluent Client
24% 8%
But how? Just because nigeria may be booming, individual investors arent likely to leap into the nigerian stock exchange or to parse the intricacies of investing in indonesia or in a toll road project in China. What they can do, however, is with the help of their financial advisor locate the money managers that invest in emerging-market tech companies. or select one that takes long and short positions on the vicissitudes of the Asian business cycle. of course, the success of active management19 depends on making wise decisions, so due diligence is key.
All of the sample allocations are based on Merrill Lynchs model portfolios. The before scenario is based on the U.S. RIC Tier 0 Moderate Strategic Allocation; and in the after scenarios, the affluent client is based on the Global RIC Tier 0 Moderate Strategic Allocation, while the more affluent client is based on the Global RIC Tier 2 Moderate Strategic Allocation. The more affluent client portfolio includes alternative investments, which are defined as hedge funds, private equity and real assets. Additionally, up to 20% of the Global RIC Tier 2 Moderate Strategic portfolio might be illiquid for three to five years. We define liquidity as the percentage of assets, by invested value, within a portfolio that can be reasonably expected to be liquidated within a given time duration under typical market conditions. Most alternative investment products are sold on a private placement basis, and eligible clients must typically be Qualified Purchasers ($5 million net investments). 19 The active manager will deviate from various benchmark weights to produce a return that exceeds the passive return with minimal risk.
18
14
(see know Your managers, below.) there are other ways to tap into specific, otherwise hard-toreach global investments. market-Linked investments, for example, are bonds with returns that can be linked to the performance of any of a wide range of assets, including the stock-exchange indexes of developing countriesBrazil, say, or China or Russia.
investoRs ARent LikeLY to LeAP into tHe niGeRiAn stoCk exCHAnGe. BUt tHeY caN LoCAte tHe fUnd mAnAGeRs tHAt invest in emeRGinGmARket teCH.
o paraphrase Hunter s. thompson, when the going gets weird, the opportunistic investor turns pro. Consider this peculiar sequence of events: the U.s.s wobbly debt sparks a near panic in global markets, causing investors to seek protection in the debt of the U.S., a surge in demand that in turn pulls Americas interest obligations to historic lows. How should investors respond to this bizarre turn? they can either chase yield down the credit ladder, seeking out riskier bonds here at home, or they can adopt a bond strategy as diversified as their approach to other asset classes, with appropriate allocations to higher-yielding municipals, corporates and bonds in other parts of the world. its worth noting, for example, that even as the yield on 10-year treasuries dipped to an unprecedented 1.72% in september, 20 the yield on comparable
have made it easier to discern the lucky from the good, and to see which managers have performed during the toughest times. as every investor knows, past returns are not indicative of future results, but they can be indicative of the disciplines and controls that a fund has in place. Merrill lynch expends considerable energy each year seeking to reduce due diligence risk by confirming that the approaches advertised by the funds on its platform are backed by consistent patterns of rational decision-making. Are they truly global? When a fund manager who has made a name in u.s. small-cap stocks starts a multi-asset fund with exposure to emerging markets, theres no guarantee the transition will go smoothly. Just as the global economy favors large, multinational stocks, it also favors fund managers with proven global reach. For example,
typically only the largest, most experienced global funds hold a Qualified Foreign institutional investors (QFii) status, crucial for gaining access to Chinese investment markets.21 What do they spend on research? in the same way an innovative manufacturer keeps improving its products through research and development, leading global funds maintain staffs dedicated to tracking events as they unfold and finding opportunities others may miss. the resources a fund commits to indepth, local and original research into the areas in which it invests can tell you a lot about whether it is truly generating original, exciting ideas or simply following popular trends. talk with your financial advisor about how the funds under consideration for your portfolio rate on this, and other, key benchmarks as you seek to refine your global investment strategy.
Are they tested in good times and bad? Going back to the technology crash that began in 2000, a decade of extraordinary volatility has yielded a large population of managers seasoned in all phases of the business cycle. long track records
20 21
U.S. Department of the Treasury, Sept. 22, 2011. Defined by the China Securities Regulatory Commission, a Qualified Foreign Institutional Investor (QFII) is an approved overseas fund management institution, insurance company, securities company or other assets management institution that invests in Chinas securities market.
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days of highly leveraged, exorbitantly priced buyouts. in addition to going more global, the deals getting done now tend to be smaller, with a greater emphasis on cash and less on borrowing. While the formula may make for fewer splashy headlines, its a climate that actually favors affluent individual investors. Many private equity companies also have been enticing investors by distributing regular interest or dividend payments. because private equity requires investors to commit capital for extended periods, getting some income while you wait can ease those illiquidity concerns. Global Hedge Funds in a volatile global economy, policy makers and government agencies in Washington, brussels or beijing can jolt international markets with a single speech or regulation. to keep pace, affluent investors may need to rely more on global hedge funds, which can have the flexibility to offset risks and exploit opportunities as they arise. Global macro funds, for example, base their investment models on forecasts and analyses of international politics and policies, relations among countries, interest rates and other factors. event-driven funds, meanwhile, seek to take advantage of temporary market inefficiencies caused by political
developments, natural disasters or other events that may affect companies operations. Ultra-Structured Solutions at a time of rapidly shifting global risks and opportunities, growth with safety is a priority for many investors. ultra-structured solutions, an exclusive subset of Marketlinked investments (see Commodities by any Other name, page 9), give qualified investors the ability to customize exposure to a wide variety of global themes across the risk asset classes, all the while building in protective features more characteristic of bonds. an ultrastructured note might be designed, for example, to track the performance of the turkish lira, protecting against the first 10% of any losses if the currency ends up weakening over the next several years. Or a note might allow an investor to benefit from the widening spreads between u.s. and asian bonds while buffering against the first 30% of losses if those spreads start to narrow. ultra-structured notes do carry credit riskthe company issuing them could default. still, they provide another way of diversifying a complex portfolio and reducing the impact of a volatile investment world while taking advantage of its distinct growth potential.
Private Equity in many emerging markets, particularly the frontier markets in africa and southeast asia that may represent some of todays biggest growth opportunities, public securities exchanges are rudimentary at best. so to gain access to these growth stories, affluent investors may need to look at funds that trade not in stocks or bonds, but which actually buy and sell whole companies. the private-equity market has changed considerably since the pre-credit-crisis
tax-free municipal bonds was tracking at 2.11%, 22 with prices holding steady as state governments got a jump on their federal counterparts in bringing their fiscal problems under control. the spread between U.s. and Chinese bonds is similarly striking. over the past 10 years, Chinese government and corporate bonds as a group have posted total annualized returns (the combined returns from price appreciation and interest coupons) of 8.9%, compared with 5.7% for U.s. bonds. 23 in light of this disparity, the leap into foreign bonds should feel less strange. But any decision to do so requires an investor to make yet another cognitive jogand start thinking about currencies. thats because foreign bonds bring exchange rates directly into play.
22 23
Bloomberg, BVAL Muni Benchmark 10-Year. Data as of Sept. 22, 2011. Chinese bond market returns are based on the S&P/CITIC Composite Bond Index, and U.S. returns are based on Barclays U.S. Aggregate Bond Index. All indexes in U.S. dollars. Data as of Sept. 30, 2011.
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this is not as true in the case of Chinese bonds (although they could have other issues) because Chinas currency is unlikely to lose ground to the dollar. But suppose you purchase a french bond with an attractive yield. if the euro drops while you own the bond certainly a possibility, given the eurozones debt problemsthe extra income from that higher yield could be wiped out when you convert back to dollars. some foreign countries and companies offer bonds transacted only in dollars, which can help mitigate currency risk. However, that approach limits the range of choices, as well as the possibility of gains if currency moves in your favor. so what do you do? Here again, investors should set aside conventional thinking and embrace the shiftfor instance, buying the bonds of emerging-market governments and companies in places like malaysia or indonesia or Peru. the logic is fairly simple. As capital continues flooding into those countries, their currencies will likely gradually keep appreciating as their central banks take advantage of the inflows to lift the purchasing power of their citizens. As with the new world order in equities, a smart, global approach to fixed-income investment comes down to working with your financial advisor to find the right bond funds led by managers experienced in foreign markets, whether theyre watching emerging markets anywhere in the world or dedicated to a specific regionlike those new models of fiscal health, the Pacific Rim and south America.
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to meet demAnd, fARms WiLL HAve to PRodUCe moRe food dURinG tHe next HALf CentURY tHAn dURinG tHe PRevioUs 10,000 YeARs.
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a more important source of yield as u.s. multinationals deploy the cash on their fast-improving balance sheets to lure investors in volatile markets. Seeking the safety of emerging-market bonds. With u.s. treasury yields at historic lows, global fixed income becomes more attractive, especially in markets that pair higher interest rates with currencies likely to be buoyed by influxes of foreign capital. (a stronger local currency makes for stronger real returns when bonds are converted back to dollars.) experienced global fixed-income managers can help source the right combinations of currency strength and yield. Buying direct exposure to overseas equities. While u.s.-based multinationals
give some access to emerging-market growth, its prudent to have assets that provide more direct exposure to some of the worlds fastest-growing economies (think: China, turkey, Malaysia, even nigeria). experienced global fund managers, again, are especially critical here, along with Market-linked investments that can be tied to stock indexes or baskets of stocks in less established markets. reducing risk with commodities. One of the worlds most volatile asset classes can also be one of its best diversifiers. although owning commodities poses its own risks,27 it can reduce overall portfolio risk by providing a hedge against scarcities in vital natural resources that can drive up production costs and hurt corporate earnings and consumer spending.
Because most commodities actually are raw materials, they also provide possibly the best natural counterbalance when inflation erodes the value of a bond portfolio or eats into corporate earnings by driving up the cost of manufacturing. investors sometimes overlook commodities during periods in which, as today, weak growth and high unemployment help contain overall U.s. inflation. if anything, though, the hedging power of commodities has historically reached its peak during such times, because inflation is tied more directly to the rising cost of materials on world markets than it is to higher wages or other consequences of a faster-growing U.s. economy. in a real sense, owning commodities can offer a hedge not just for your investment portfolio but also against higher consumer prices, be they of groceries or the gas for your car.
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or at least 40 years, growth has been the investors watchword. success meant crafting a portfolio of what appeared to be stable, mostly U.s.-based stocks and bonds that would grow predictablynot in a straight line but with relatively brief interruptions that would be more than counterbalanced by long stretches of economic expansion. the fundamental strength and resilience of the U.s. economy was the unquestioned foundation on which investors could always build.
See commodities disclosure on back page.
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now we need to balance that view of the worldand that style of investing. more shocks are doubtlessly coming: climate change, inflation in world food prices and continued movement out of the dollar into gold and other currencies. And there will be other, unexpected crisesnatural disasters such as the Japanese earthquake and tsunami as well as man-made upheavals like the Arab springthat further roil the global landscape. As humans, we will, as always, adapt and re-engineer. As investors, we must be prepared for risk, even in the unlikeliest places. As we saw during the financial crisis, even money market funds are not entirely safe when an outlier event like a freeze in the financial markets occurs (and, given their exposure to the very short-term debt of european banks, there is at least a possibility they could be impacted again). so, we must focus on sustainability, resilience, the ability to deal with the unforeseen and also the wherewithal to capitalize on often fleeting opportunities. flexibility gives nations the capacity for extraordinary strength and resilience. Japan has presented challenges to investors over the past two decades, but time and again it has been able to rely on its citizens to help pull itself out of crises. most recently, the government announced plans to spend $248 billion on disaster relief funded in part through higher taxes and disaster bonds.28 the country is banking on its citizens personal savings to find a way out of a crisis that could have crippled another nation. As for the U.s., for all the challenges it faces and the noise it sometimes creates, it remains one of the most flexible, stable and sought-after economies on the planet. With just 4.6% of the global population, the U.s. accounts for just as much output in a year as the next three largest economiesJapan, China and Germanycombined.29 Judging by reports in the popular media, you would think that the U.s. makes nothing and consumes everything. in truth, the country is still a global manufacturing powerhouse, the worlds second largest, having ceded the top spot to China only in 2008.30 the list goes on and on: When combining goods and services, the U.s. remains the worlds top exporter,31 a fact masked by headline trade-deficit figures. According to just about any consumer survey, the planets most recognizable brands are largely American.32 the U.s. has the worlds favorite economy for foreign investors, the largest market for it spending and the largest and highest-quality university system in the world.33 All of which is to emphasize the obvious resilience of the U.s. that has brought the nation back resoundingly from crisis after crisis in the past. As much as the U.s. and other traditional players in the global economy admire the growth of newcomers, the winners among the emerging nations will be those that learn from the developed countries and find ways to move beyond pure growth and adopt the flexibility to survive inevitable shocks of their own. much the same can be said of investors facing a world they never foresaw. the winners are likely to be those who maintain the flexibility, both in mind and in portfolio, to see and respond to the world as it has become.
The International Institute for Strategic Studies, Japan: Life After Kan, Sept. 2011. International Monetary Fund. 30 U.N. 31 World Trade Organization. 32 Brandz Top 100 Most Valuable Global Brands 2011. 33 U.N. Conference on Trade and Development; Economist Intelligence Unit estimates; Quacquarelli Symonds World University Rankings.
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As HUmAns, We WiLL ALWAYs AdAPt And Re-enGineeR. As investoRs, We mUst do tHe sAme.
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The article co-authored by Ian Bremmer was prepared under an agreement with Eurasia Group and is provided for informational and educational purposes only. His opinions, assumptions, estimates and views expressed are as of the date of this publication, subject to change and do not necessarily reflect the opinions and views of Bank of America Corporation or any of its affiliates. The information does not constitute advice for making any investment decision or its tax consequences and is not intended as a recommendation, offer or solicitation for the purchase or sale of any investment product or service. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice. This material is not intended to be relied upon as a forecast or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. 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