China-US turbulence threatens smooth sailing

Investors need to build some hedges into their portfolios as uncertainties about the speed and shape of the western world’s economic recovery remain, according to Mercer Investments.

Andrew Kirton (pictured), Mercer’s global CIO, says the prospect of inflation and the possibility of a major European default – either of a country or a big bank – are two of the major concerns on the minds of pension fund trustees.

However, he believes the biggest concern facing the world is how the US-China economic and political relationship develops over the next few years.

“China has reached the late stage of ‘emerging’ and it’s at that stage that countries have to join the adult world of floating exchange rates and market discipline,” he says. “My betting is that it will happen in the next five years… There are loads of consequences to come from it. To get through it will require political leadership.”

China grew on the back of its exports, largely to the US, and then recycled its dollars with a controlled exchange rate back into the US. The money found its way into tax decreases and mortgages. This was one of the causes of the global financial crisis, Kirton says.

“The US has come out of the recession very indebted. In fact, it doesn’t feel like it’s out of recession. It’s in an unsustainable position and can’t go on as it is. This will have a knock-on effect too.”

Kirton was speaking during one of the firm’s global investment forums, in Melbourne, attended this week by about 365 pension fund executives and managers.

He says there is also a fear that the US may embark on more protectionism because of its persistently high unemployment: “the US is not in a great position”.

Mercer has been encouraging funds to diversify further by rebalancing global portfolios towards the emerging markets, alternatives and ‘real assets’ as well as introducing hedges, such as inflation hedges.

“There’s a good chance this will be a good decade for investments,” Kirton says, notwithstanding the uncertainties.

“Our themes for 2011 are not very different from 2010. It’s a bit more micro this year. We’re wary of developed-market bonds, which look expensive. We’re looking at emerging-market debt and various active strategies in bonds. Clients are looking for flexibility and the ability to behave dynamically.”