Economic evidence is starting to show the US is emerging from recession, but the really good news, according to Jim McCaughan the chief executive of Principal Global Investors, is that credit is flowing again, which means a sustained recovery. Amanda White spoke to him about the implications for institutional investors.
Government stimulus packages are a bit like giving a kid a glass of red cordial; it produces a short-term (hyper) activity which in the long-term is not sustainable.
Jim McCaughan, chief executive of Principal Global Investors, believes the global economy needs a more hearty meal and returning credit can act as that stimulus.
“One dollar of government spending, on say infrastructure, produces only one other dollar of economic activity. A stimulus creates a short term flurry, but what is more dynamic is to get the credit flowing,” he says.
“or a recovery to be sustained it is so important to get the private sector going again. Small to medium enterprises are the most resilient through downturns and are good at job creation. If credit gets flowing it leverages through the economy.”
The good news, according to McCaughan, is that both are happening now.
“The US has been in recession for 18 months, and it was the withdrawal of credit that made it a sharp recession. What it is so important is it is back.”
However the recovery will not be at the rates seen in the past few years, and investors will have less tolerance for the more devilish characteristics of credit, which has important implications for asset allocation.
While McCaughan believes equities will be robust for the next five to 10 years, returns will not be as aggressive, and investors won’t have to pay such a premium for equity assets.
“The crisis, particularly since September, has led to the withdrawal of liquidity which has meant forced selling in equities. Stocks didn’t move according to fundamentals but to the owners needing cash, it has been a very bad time to be an active fundamentally-driven investor. Markets were acting randomly,” he says.
“Typically as liquidity is restored then investors start to discriminate between stocks based on fundamentals again. Now is a good time to be investing actively even though it’s hard for some investors to see it.”
But more strategically, investors will have a much lower tolerance for high degrees of leverage.
“What we have seen in the past few years is a false sense of complacency. I think as clients go back to basics there will be a decline in derivatives use and a move towards simplification,” he says.
With this in mind the underlying economics of allocation is more important now, McCaughan believes, and how to fulfil long-term asset allocation decisions will be the focus for institutions globally.
Principal, which has funds under management of $189 billion at the end of March (down from $248 billion in 2007), has had positive cash flow throughout the volatility of the past couple of years.
“One of the big sources of cash flow in the past nine months has been large funds allocating to equities based on rebalancing, which has been a major phenomenon in some markets,” McCaughan says. “There has been a lot
of talk about rebalancing and my view is that few things upset a client or trustee board more than missing out on a rising market. There should be pressure on funds that are sitting on cash.”
McCaughan believes the crisis has thrown open opportunities for institutional investors to invest in assets that long term they wanted access to.
For example if funds are looking to diversify into real estate, tactically a good way to start may be with commercial backed mortgage securities.
“Tactically it is a good way of implementing a strategic allocation,” he says.
Part of Principal’s resilience and continued cash flows globally, according to its chief, has been due to its diversified product line-up across fixed income, equities and real estate as well as specialised overlay and advisory services including currency.
Where some banks and insurance companies have been selling their asset management businesses, and McCaughan believes merger and acquisition activity in this sector will continue, Principal has been expanding.
It recently completed a capital raising of more than $2 billion and is looking to expand its affiliate program, with a European global bond boutique on the radar.