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Invest in offshore debt, not equities

As low inflation, GDP growth set in.

JOHANNESBURG – Diversification-seeking South Africans should put money into offshore treasuries and bonds rather than offshore equities, which are likely to face significant volatility and unimpressive returns for at least the next ten years, according to Annelise Peers, European economist for Investec Wealth and Investment.

“South Africans sit in equities and BBB [South African] government debt, which could become BB debt in the event of a downgrade. Your diversification is to diversify to something with less volatility,” Switzerland-based Peers told journalists on a recent trip to South Africa.

“It’s not about getting yield [offshore]. You can get yield and rand diversification in South Africa,” she said, adding that the volatility of BBB debt is in any event similar to equities.

According to Peers, the end of the “debt super cycle” implies lower GDP growth and inflation, which spells lower returns for risk assets, increased volatility and the end of “buy and hold” legitimacy.

Debt ceiling hit?

Research from global management consultants, McKinsey & Company reveals that global debt has grown by $57 trillion since 2007 to $199 trillion, or 286% of global GDP.

Government debt is up $25 trillion since 2007, with Japan’s debt to GDP at 517%; Spain at 401%; China at 282% and the US at 269%.

With such high debt levels, credit extension cannot go further, said Peers, in turn pushing inflation and GDP growth lower.

“High debt levels mean that deflation remains a problem, especially in the developing world,” Peers said. “Countries with strong currencies will import deflation.”

Meanwhile, GDP growth indicators – including money supply, business confidence, and manufacturing PMI – are weak, maintained Peers.

The best-case scenario is that the US generates just enough growth to keep the world above water. In the worst case, the US will experience “imported deflation”, said Peers, since US firms derive 45% of earnings from the rest of the world and continued currency strength will weigh on exports and growth.

“The US is still dependent on exports. Consumers haven’t taken over just yet,” said Peers.

Chinese consumers haven’t taken over either, something else the world is banking on, added Peers. “It could take between ten and 30 years for the nation to build a proper middle class.”

Equities not as attractive

“Structural inflation is over,” Peers argued, noting that 75% of OECD countries have inflation below the 1% mark.

The close-to-zero level will prove sticky among developed economies, as American consumers – scarred by the home repossessions of 2008 – shy away from high debt levels, while in Japan, a population of savers – many of who are ageing – does little to boost spending levels.

“We’re genetically programmed to think that high inflation is normal and fund managers invest as if this is the case,” Peers continued. “Structural inflation is over and inflation is likely to trend sideways, in which case return of capital is more important than return on capital,” she said.

“In a sideways environment with low growth, equity volatility is what we have [to look forward to] in the next ten years,” Peers cautioned. “A longer term disinflation trend is clear in risk asset returns.”

Without inflation, the only way to grow is through production. “Developed market productivity is the key to sustainability,” said Peers, who argued that low US unemployment numbers were a function of low productivity more than anything else.

“The fewest jobs have been created among 24- to 50-year olds, who are your spenders,” said Peers.

Despite having no reason to hike rates, the US Fed is committed to moving away from “zero bound,” she said

Peers warned that in the long-term, South Africa faces stagflation: a situation of low growth and high inflation. “The South African economy runs on commodity exports,” she said, noting it could take ten to 15 years before commodity prices rise again.

Peers said that developed market governments continue to hold a large of portion emerging market debt. “We haven’t really seen hot money move.” The so-called “emerging market selloff” has been primarily corporates (some paying off dollar debt) and individuals, who have taken money offshore to protect themselves.

“We haven’t seen large-scale selling of emerging market bonds,” Peers said.

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