Citi: No global recession next year

TEFD: What is your take on the situation in Europe, the US and Asia? Where are the opportunities?
Rosgen: We believe Europe will go into recession next year with an outright contraction in GDP growth. The reason for that is obviously the weak economies: Greece, Portugal, and even Italy. France, for instance, will have zero growth and Germany will only grow by about 1%. So, in aggregate you have a negative growth number of about minus 0.3.

The risk clearly is … if it becomes lower than that. So it could easily be minus 0.5% to minus 1% GDP growth (in Europe).

Europe has plenty of issues to deal with, but what people fail to understand is that it is a very rich continent. So they have financial resources to mobilise should they so wish. The problem is there is no desire to do so for the moment, but I believe the desire to do so will increase as the severity of the situation increases. For now, it’s still very hard to convince, let’s say for instance, Germany to pay more to save someone.

The US will not go into a recession but will have sub-par growth, very much in keeping with the aftermath of a financial crisis where you just have sub-par growth. I don’t think it is any different from what we have seen in previous financial crises. Our GDP forecast for the US is 1.5% to 2% for next year.

Rosgen: Our global strategist is overweight
on emerging markets, because obviously
they have stronger growth and better
economic fundamentals.

In Asia, our forecast for China next year is a 7% to 8% real GDP growth, with about 4% inflation. That has taken into account the impact of a slowdown in US and Europe. For Japan we think it will be a little over 2% GDP growth next year, because they were in a recession this year after the earthquake.

On our investment viewpoint, our global strategist is overweight on emerging markets, because obviously they have stronger growth and better economic fundamentals. We are underweight on Europe, overweight on Japan and the UK and neutral on the US.

Japan’s absolute valuations do make it the cheapest equity market in this part of the world and expectations are very low because of the earthquake and the recovery.

The UK looks interesting; its equity market has many multinational companies, for instance, Royal Dutch Shell, Unilever and British American Tobacco. You’re buying into a global growth environment instead of the UK per se.

Having said that, most of our overweight countries are in Asia. Within an Asian portfolio, our overweights are Hong Kong, South Korea and Taiwan. We are neutral on China, our biggest underweight is Australia followed by India.

Why do we like north Asia? Our house view is that there [will be] no global recession next year. If there is no global recession, then some of the cyclical markets (in Asia) will continue to perform quite well. South Korea and Taiwan are cyclical markets, and Hong Kong will benefit from China’s continuous growth.

Given the debt problems in Europe and US, what would be your advice to Asian investors with regards to market timing and portfolio allocation? Should they keep more cash and wait for the right moment?
Let me put it this way, over a quarter of the last 36 years, two-thirds of the time you have made money in Asia on a 12-month view. One third of the time you’ve lost money. So you’ve made twice as much as you have lost. Your risk-reward in Asia is certainly positive. However, there are clearly still risks with Europe.

Europe, the way it functions as an entity, seems to always need to go the brink before it will come up with more measures or additional measures. And so I wouldn’t suggest that people put 100% of all of their net worth into the equity market.

But equally if you look at the alternatives that people have, you can leave it in the bank, where real interest rates are negative. So, in Malaysia real interest rates on savings accounts is about minus 220 basis points (bps). A hundred ringgit put in the bank in January will have a purchasing power about RM97.80 by the end of the year. So you’re surely but slowly losing money if you leave it in the bank.

So you can leave it in the bank for a short time but in the longer term I don’t think that is the way to make money. So put some of your money in the market and keep some money on the side. When the markets go lower, put a little more in. That’s the way I suggest people look at their investments.

For the moment in Asia there is no country where the savings deposit interest rate is higher than inflation. If you are in Hong Kong it is almost minus 700bps. No where does it look good for savers.

If you look at the equity portion of your investment, your risk reward looks interesting. Let’s say it took three years for the world to get back to normal.
Your highest compound total return would be Hong Kong, where you would make about 14% per year. In Singapore you would make about 10% and in China, 8.5%.

In Malaysia you would only make about 4.5% per year, if you assume that in three years market valuations will be back to their historic average. That is because current valuations in Malaysia are closer to their historic average than they are in the other markets of the region.

You tend to find that equity returns, be it in China, Hong Kong, or Singapore, are higher than the deposit rates, local bond yields and property yields. So equities don’t look too bad in that regard.

The only markets in Asia where bond yields are higher than your equity returns will be Indonesia, the Philippines and India. But elsewhere, you would be making much more in equities than in bonds. The extreme example would be Japan, where the dividend yield is 2.5% and the bond yield is 1%.

So, when valuations are below mean, expectations also have to be below mean. And so from that perspective I would rather buy in this environment, where equity markets are cheap relative to their own history. Your risk reward is just better. Ultimately in investing, if you buy cheap you make money and if you buy expensive you lose money.

Given the current market volatility, would people rather stick with good dividend stocks?
One of the interesting aspects of investing in Asia, not only in the last five years but 10 years or 20 years, is actually how well dividend yield as a strategy has done.

If you had bought the highest dividend yielding stocks in Asia 10 years ago, your US$100 will now become almost US$1,000. Dividend yield investing works and it works in Asia particularly well.

In Asia, you tend to find good yields in telecoms, financials, and for instance the tech space in Taiwan, then some of the tobacco companies across the region. The higher dividend yield countries in Asia are Australia, Taiwan, Thailand and Hong Kong.

You mentioned potentially good returns from the Hong Kong market, which sectors do you prefer?
In Hong Kong, some of the property stocks are interesting. Not necessarily purely the developers but also the landlords (those with a huge portfolio of investment properties).

The landlords in Hong Kong still see a very high number of tourist arrivals, most of whom are mainland Chinese and they like to go shopping and they spend a lot of money when they go shopping. The landlords that own the retail malls are currently doing very well on the back of rising sales and therefore rising rents.

Some of the banks (listed in Hong Kong), in particular the international banks that have very little exposure to issues in Europe would be of interest to us as well.

Some of the conglomerates also look attractive.

China’s growth rate is expected to slow down over the next few years. Is that good or bad for investors who wish to have a long-term exposure to China?
If you look at China’s five-year plan, it wants to see a slowdown in growth and rebalancing of that growth to more domestic consumption and away from net exports as the main driver of growth.

Yes, there will be slower economic growth, but slower growth isn’t necessarily a disaster. Many academic studies have shown that lower GDP growth countries have better equity market returns than high GDP growth countries.

The main reason behind it is when you have high GDP growth, to capture that growth as a company you have to issue lots of shares because you can’t keep borrowing from the banks. The only other way to get fresh capital is to issue shares and you tend to dilute investors every time you do that. So on an earnings per share (EPS) basis, the growth would look rather pedestrian.

Let me share an example. In the 1990s, EPS growth in China has been about 2.2%, EPS growth in Europe was at 6.5% and the European stock markets performed better than the Chinese stock markets.

The other reason why slightly lower growth is a good thing is because during high growth, as much as companies need to issue new equity to raise more capital, they retain most of their cash flows for business expansion, hence they pay very low dividends.

Over time, dividends account for 30% to 50% of your total returns when investing in equities. If you don’t get any dividends, you’re missing out on a level of return already.

A moderation of growth in China will take some of the pressure off the real estate sector because property prices are already falling. If they’re taking pressure off real estate then real estate companies will start to look interesting, as they’re trading at very cheap valuations with big discounts to book and net asset value.
Also, looking at the current valuations of the Chinese banks, their seven to eight times PER is a little bit too cheap. So these are some of the sectors we will focus on in China/Hong Kong.

A protestor smokes in front of riot policemen
during a rally of metal industry workers in Athens
last week. The Greeks have been demonstrating
for weeks against tough economic measures.

In view of the tougher outlook in the West, there has been much speculation that China will loosen up on monetary policy. Your view?
Yes. The official rate won’t be moved but the reserve requirement ratio (RRR) will be loosened. This will provide more capital for the banks to lend and that will ease some of the credit issues that are befalling the Chinese economy.

Again, with regards to the eurozone crisis, how fragile is the situation? How close to the tipping point are we?
I’ll answer this way. One thing people fail to fully understand, especially when they say the euro is going to break up, is it’s not just about going back to the old currency. It’s not that simple. Were it that simple I can assure you they would probably have gone down that route already.

For the eurozone countries, all their current liabilities are now in euros, and with euros their currency to debt ratio is one-to-one. But if you decided to leave the euro, and if your currency devalues to two-to-one, suddenly your liabilities would double. If you can’t pay back the current amount you won’t be able to pay back twice as much.

What then happens is that your banking sector will basically implode. For anyone who has savings in the banking sector, the banks aren’t going to pay them back in euros, but pay them the new currency and suddenly you have halved the value of your savings.

What do you think happens to society if you do that? ‘People will have a few riots’, is probably a nice way to put it.

The European Central bank (ECB), the Bank of Japan (BoJ), the Bank of England (BoE), the US Federal Reserve, they all understand this.

If it comes to a tipping point, governments around the world and policymakers around the world will move heaven on earth to prevent that from happening. If it means bringing in capital controls, or a huge global synchronised monetary central bank policy injection, it will happen.

The way the European system works, you need to take things to the brink in order for more money to be made available.

The reason for that is not because policymakers need to be forced to, but because they need to be re-elected.

In order to convince their electorate that they need to give more money to someone else, you have to tell people that if they don’t, it’s the end of the world because none of us like to give out our money to people who seem to be doing OK.

Sadly that is how the system works, that is how democracy works. But it’s the best system among all the other availabilities. Things in Europe are risky.
Clearly bond yields are telling me that, credit default swap spreads are telling me that. No one believes that things are looking good.

Europe will slowly improve. The gauge to determine if things are improving is to see if the new governments in Spain, Greece and Italy come up with a fiscal retrenchment plan as well as supply side reforms.

The one thing we do know is we can’t cut our way back to growth. You can’t go cutting off limbs because at some stage it will affect your ability to earn.

If the market believes that, ‘maybe not this year but in the longer term things will look up’, then the market will give it the benefit of the doubt.

I would be very cautious in going out and saying Europe is going to blow up. The consequences of that are truly horrendous.

So it’s a one way street where Europe can only move forward, and it kind of playing with fire, having to go so close to the edge to get any political momentum because it is standing in the way of itself?
Yes, they can only move forward. The five stages of dealing with bad news are: denial, anger, bargaining, depression and acceptance.

The same thought processes are going through the minds of the people who are being asked to pay. In this case it would be the Germans, being asked to transfer more money to the Italians.

‘I’m working hard while this guy is taking retirement at age 55?’ They get angry. Many people get depressed and eventually they accept it.

When you see the Greeks rioting, they’ve gone from denial to anger. That’s where they were at. Bargaining happened a few weeks ago when George Papandreou thought Europeans would be kind to him.

He thought he could get a bigger haircut but the Europeans told him, if you’re out, you’re out. No more money and he went in to a depression and gave up and a new government was formed.

This process happens in many parts of life. It’s not just terminal illness or a break-up and all this takes time. The market however, isn’t known for being patient.

When do you see a resolution to the Euro crisis?
Less than years. The acuteness of it is not going to be years but the patient is going to be in physio for awhile. By the middle of next year there is going to be a heavy borrowing schedule for Italy when it kicks off in March. Some debt is going to be rolled over and some new debt will be taken on.

However if the bond market is still asking for 7% yield on Italian debt, that will not be sustainable.

Is there a possibility of a default?
For Italy, no. The reason is if Italy defaults, others will begin to default and savings in France, Greece, Spain, Portugal, Ireland will be wiped out.

There is a book called Leviathan written by a political philosopher in the 1650s. He believed there needs to be a leviathan, a big person in charge, otherwise life would become short and brutish. That’s what life would be like if people found out all their savings were gone.

The leviathan would be the ECB, the Fed and everyone else working together. The ECB lacks power because ... the unemployment rate in Germany has been the lowest in decades.

Germany for the moment is the paymaster, the rich uncle. But if the rich uncle has low unemployment, they think ‘well what’s the problem?’

They think everything is going well. Therefore the German populace at large doesn’t believe in printing money. Only when they start to realise that they’re not working overtime because there’s no demand they may turn around and ask ‘what’s the problem?’
Then it’s the job of the politicians to explain that if this whole thing fails unemployment will increase. Life will be short and brutish.

What is the most powerful driving force in your life? Survival. It’s the most powerful thing in our minds, it’s the same for any political motivation. If push comes to shove, the ECB will be allowed to print money.

The BoE the BoJ will come to help out. It is not in their interest to watch a large portion of the global economy to go down the drain.

Doesn’t this create a moral hazard situation where Europe knows the world will come to its rescue?
Yes, it has moral hazard written all over it, but you’ll have to give up something. If you have to bring in moral hazard to save the world economy that’s a trade a lot of people will do.

It is not just the European wellbeing that is at stake but many other parts of the world are at stake. We are living in a very global world, and what affects one part also affects another part.

There’s no point going around saying, ‘If this had not happened’. It’s irrelevant. What’s important is how you then move on from there.