Tipping points global perspectives on navigating the great divergence

Tipping Points
Global perspectives on navigating “The Great Divergence”

A survey and report created with


Printed January 2011

Table of Contents
Foreword
Executive Summary
Introduction
+ About the survey
The Great Divergence: Economic growth
The Great Divergence: Sovereign debt
The Great Divergence: Currencies
The Great Divergence: Fiscal policy
Sovereign wealth funds
Implications for investors
+ Emerging markets and their risks
+ New skill sets are required
+ Sharper pricing of risk
+ The impact of fiduciary frameworks
+ Assigning a value to liquidity
Conclusion

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About RBC Capital Markets
RBC Capital Markets is a Premier Investment Bank that provides a focused set of products and services to institutions,
corporations, governments and high net worth clients around the world. With over 3,300 professional and support staff,
we operate out of 75 offices in 15 countries and deliver our products and services through operations in Asia and
Australasia, the U.K. and Europe, and in every major North American city.
We work with clients in over 100 countries around the world to help them raise capital, access markets, mitigate risk, and
acquire or dispose of assets. According to Bloomberg, we are consistently ranked among the top 20 global investment banks.
RBC Capital Markets is part of a leading provider of financial services, Royal Bank of Canada (RBC). Operating since 1869,
RBC has more than USD711 billion in assets and one of the highest credit ratings of any financial institution – Moody’s Aa1
and Standard & Poor’s AA-.

About The Economist Intelligence Unit
The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of
The Economist. Through its global network of 650 analysts, it continuously assesses and forecasts political, economic
and business conditions in more than 200 countries. As the world’s leading provider of country intelligence, it helps
executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends
and business strategies.

Foreword
Our economic landscape has been evolving at a rapid pace over the last three years. As the global community becomes
more intertwined, institutional investors and corporate executives must address the increasingly complex implications
of local and regional challenges around the world. At RBC Capital Markets, we strive to provide our clients with the most
relevant information and insightful perspectives to help them navigate the markets and find opportunity.
With this goal in mind, we partnered with the Economist Intelligence Unit for our third survey of more than 400 capital markets
participants to gather sentiment as the industry moves away from the legacy mindset of the past 30 years. The purpose
of our poll was to gauge the consensus outlook, examine deviations from the consensus and discover how investors plan
to turn these expectations into action.
This white paper is the result of survey work conducted at the turn of the New Year. It reveals interesting insights into
a “Great Divergence” in our global economy, fundamentally driven by opposing scenarios in economic growth, sovereign debt,
currencies and fiscal policy. By capturing market sentiment via survey results and interviews, this report illuminates
the intricacies of these issues and their implications for investors.
We would like to thank the individuals who are quoted in this report for their valuable time and insights:
Michael Ben-Gad, Professor of Economics, City University London
Quentin Fitzsimmons, Executive Director and Head of Government Bonds and Foreign Exchange, Threadneedle
Lena Komileva, Head of G7 Market Economics, Tullet Prebon
Jonathan Lemco, Principal, Vanguard
Pippa Malmgren, President and Founder, Canonbury Group and Principalis Asset Management
Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management, Prudential Financial
Andrew Rozanov, Managing Director and Head of Sovereign Advisory, Permal
Robert Talbut, Chief Investment Officer, Royal London Asset Management
We hope you will find the report insightful.

Marc Harris
Co-Head of Global Research
RBC Capital Markets

Richard Talbot

Co-Head of Global Research
RBC Capital Markets

January 2011

TIPPING POINTS | 01


Executive Summary
It is a truism that the planet’s economy has become more connected
even as global imbalances have grown more severe. In today’s volatile
world – which combines abundant liquidity with extreme and potentially
long-lasting divergences across markets – investors are pondering both
the outlook for the coming year and the intermediate-term end-game.
They are specifically questioning:
•To what extent will the large gap in growth between emerging and
developed markets – with its attendant effects on capital flows and
asset prices – continue?
•Sovereign debt restructuring on the European periphery and elsewhere
appears inevitable. When will it occur and what market fallout will
it generate?
•Looking out five years or more, a large proportion of market participants
expect the dollar to relinquish its role as the primary global reserve
currency. Will the euro’s problems enable the dollar to retain its primacy
beyond this horizon?
•Can the U.S. continue to borrow and spend while almost all other developed
countries embrace austerity? If so, for how long? What would be the effect of
another economic downturn on deficits in developed countries?
All of these questions are unresolved, but one thing is certain: Building a
portfolio that generates excess returns requires stepping outside the legacy

mindset of the past 30 years. Two previous RBC Capital Markets white papers
examined the transition from the “great moderation” that began in the
1980s through the financial crisis to the post-crisis world of today.1
To discover how institutional investors, financial institutions and large
corporations are emerging from the old and adapting to the new, RBC Capital
Markets enlisted the Economist Intelligence Unit to interview a range of
investors and survey 461 financial market participants. The objective was
to gauge the consensus outlook, examine deviations from the consensus,
and discover how investors intend to turn these expectations into action.
Key findings are as follows:
1. Raising Capital in a New Era
(September 2009) and
The New “Normal”: Implications of
Sovereign Debt and the Competition
for Capital (June 2010).

02 | TIPPING POINTS

January 2011

Emerging markets and their risks. In both the survey and the interviews,
location predicts sentiment. Optimism abounds on prospects for emerging
and resource-rich economies, with the highest hopes focused on the non-BRIC


frontier markets. The consensus is so strong that it lends credence to the idea
of an emerging markets bubble, with a fire hose of capital aimed at a limited
pool of financial assets. If the emerging markets are flooded with more capital
than they can immediately use, valuations will outrun fundamentals and the
markets will eventually drop.

New skill sets are required. In contrast to the situation a year ago, much of
today’s portfolio risk is driven by sovereign risk. Prudential Financial Managing
Director Arvind Rajan points out that as sovereign risk rises, it tends to become
the common factor that drives all other portfolio risks. Therefore, the ability
to analyze sovereign risk is essential – and it requires a broader base of skills
than many portfolio management firms currently possess. The skill set includes
expertise in government financing strategies, multilateral lending agencies, the
banking sector, the CDS market and political scenarios. In addition, the loss of
credibility by rating agencies has contributed to a trend of bringing more credit
analysis in-house.

In today’s volatile
world – which combines
abundant liquidity
with extreme and
potentially long-lasting
divergences across
markets – investors
are pondering both
the outlook for
the coming year and
the intermediate-term
end-game.

Sharper pricing of risk. Risk has not been priced accurately in the past, to put
it mildly, and skepticism has grown around traditional methods of evaluating
risk, including snapshots of fundamentals, rating agency judgments, confidence
intervals and assumptions about government backstops. Capital preservation
requires a more conservative approach to the potential for extreme events.
The impact of fiduciary frameworks. Downgrades could limit the ability to

hold sovereign debt among large institutional investors facing investment
mandates. On the other hand, the new Basel III accord will require banks
to hold more capital and liquidity buffers, which will result in a mandate to
hold more asset classes that have historically presented low risks, such as
sovereign debt. This change would boost the demand for bank holdings of
government debt, even if the credit quality is below that of sovereigns.
Assigning a value to liquidity. The dollar may not be the best measure of value,
but it is undeniably the most liquid medium of exchange. This liquidity has
a higher value than it used to, which explains the reluctance of many sovereign
wealth funds to dramatically scale back their holdings of the dollar and
U.S. Treasuries. Portfolios are judged to be more volatile than they used to
be, with a wider range of scenarios on either side of the expected value.
The funds also face a wider range of potential calls on their liquidity – for
instance, to bail out local banks, companies or governments. Fund managers
are building in more diversification to stabilize values, and they are placing
more weight on liquidity.

January 2011

TIPPING POINTS | 03


Introduction
Although the economic crisis appears to have passed,
the nations of the world are diverging on multiple levels.
From the dynamic BRIC economies to the debt-burdened
nations of the European periphery, economies are diverging
in terms of economic growth, creditworthiness and fiscal
policies. And in this two-track global economy, it is the
slower-growing developed nations that are the most fiscally

constrained, have the greatest need for austerity and face the
most difficult prospects for regaining their economic health.
As a result, investors are breaking free of past orthodoxy
and viewing alternatives in light of new realities. One
manifestation is capital chasing higher yields, rising asset
values and appreciating currencies of emerging markets.

Another is the skepticism around notions such as confidence
intervals and mean reversion, which offer the promise of
mitigating risk but become difficult to apply in the face of
fundamental shifts in market conditions. Also under fire is the
notion of – in the words of a fixed-income executive at a large
London asset manager – “a world where friendly, big-brother
style bailouts always happen.”
The fuel for financial markets is confidence, an ingredient in
short supply when asset values are diverging. By assessing
the fundamental factors driving this Great Divergence,
and taking the pulse of the market via survey results and
interviews, this report aims to clarify the decisions faced by
global investors.

About the Survey
The Economist Intelligence Unit polled 461 capital markets participants on behalf of RBC Capital Markets in a survey
that closed in January of 2011. Of the respondents, 211 come from the financial services industry and 250 from
non-financial organizations.
•Within financial
services, 31% are
from commercial
banks, 26% from asset
management firms

or institutional
investors and
18% from investment
banks; the rest work
at hedge funds or
private equity funds.
The average asset
size is US$275bn.

04 | TIPPING POINTS

•The top industries
among non-financial
respondents are
manufacturing,
the public sector,
professional services,
energy and technology.
Average annual
revenues are US$3-4bn,
with a range of
US$750m to over
US$100bn.

January 2011

•The executives polled
are quite senior, with
36% coming from the
C-suite and another

58% at or above the
VP/Director level.

•Respondents came
primarily from
North America and
Western Europe,
with 38% from each
region. 14% reside
in the Asia/Pacific
region, and 9%
came from Eastern
Europe, Latin America,
the Middle East
and Africa.


The Great Divergence: Economic growth
The most obvious divergence is in economic growth rates. In its December 2010
Global Outlook, the Economist Intelligence Unit highlighted the varying pace of
the recovery. Although global growth is forecast at 3.8% in 2011, stark underlying
differences between developed and developing markets are expected to persist.
While the advanced (OECD)2 economies are forecast to expand by 1.8% in 2011,
growth outside the OECD is projected to be 6.3% in the same period.3
Among respondents to the survey, a greater proportion expects conditions to
improve rather than deteriorate in major regions of the world – with the exception
of Japan (see Chart 1). But it is clear that the recovery will proceed at multiple
speeds. While respondents are in strong agreement that the prospects for China,
India and developed Asia remain bright, there is much greater ambiguity about
the outlook for the rest of the world.

Survey respondents are less sanguine with respect to the developed world.
With the exception of Japan, pluralities – not majorities – expect better prospects
for 2011 in the developed world. In Japan, a plurality expects no change, and
more think that the economy will deteriorate than improve.

2. Organisation for Economic
Co-operation and Development
3. Economist Intelligence Unit
forecasts as of January 2011

Chart 1Over the next year, what change do you expect to the prospects for economic growth in the
following regions?
Chart shows the proportion of respondents who expect an improvement in prospects minus those who
expect a deterioration
Other developed Asia
(Hong Kong, Singapore, South Korea)

71%

India

70%

China

65%
32%

Russia

31%

Africa
Middle East

30%

North America

19%

Europe
Japan

10%

4%
–3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Proportion of respondents that expects an improvement in prospects minus respondents that expect a deterioration

January 2011

TIPPING POINTS | 05


Chart 2 From 1998 to 2008, the U.S. economy grew in real terms at an average rate of about
2.7% per year. Over the next decade, how do you expect this rate to change, if at all?

2%

Much higher
Higher

14%
18%

No change

53%

Lower

Much lower

12%

Don’t know

1%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Percentage of respondents

expectation of below-trend growth rates in the U.S., as well
as the European periphery and the rest of Western Europe.
The reverse is true for Asia-Pacific, Canada, the BRICs and
other emerging markets.

There is also a clear bifurcation between developed and
developing economies. Chart 2 shows that most market
participants think that U.S. growth in the coming decade
will be below that of the last decade. Chart 3 confirms the

Chart 3 How do you expect the real growth rate in your country over the next decade to
compare with the rate from 1998 to 2008?
Chart shows the proportion of respondents who expect a higher than average rate minus those who expect
a lower than average rate
Lower growth

Higher growth

Asia/Pacific excluding India and China

41%

BRICs

27%

Other (MEA, Latin America, Eastern Europe)

16%

Canada

7%
European periphery

16%
35%

Europe ex-periphery

37%

U.S.

53%

U.K.

60%

40%

20%

0%

20%

40%

Proportion of respondents that expects a higher than average rate minus respondents that expect a lower than average rate

06 | TIPPING POINTS

January 2011

60%


The Great Divergence: Sovereign debt
The imposition of fiscal austerity measures, of the scale required to service debt
in Greece and Ireland, means that it will be difficult for those countries to grow
their way out of the crisis. The concern is a persistent downward spiral of higher
levels of debt leading to slower growth and a further withdrawal of assets,
resulting in more losses on bank balance sheets.
“What these EU and IMF bail-outs are essentially asking those countries to do
is to put their economies into permafrost for a very long period of time,” says
Robert Talbut, Chief Investment Officer at Royal London Asset Management.
“What’s more, there is no guarantee that, in three years’ time, those economies
will be in a position whereby their citizens will be able to say that it was worth
taking the pain. Ultimately it’s inevitable that some form of debt forgiveness will
have to occur.”
Even in countries less severely affected by debt problems, the poor state
of public finances means that the role of government is changing. “The social
contract between the public and government is being renegotiated,” says
Pippa Malmgren, President and Founder of the Canonbury Group and Principalis
Asset Management. “The scale of the problem means that many people will be
forced to retire later than they expected for a lower standard of living than they

ever anticipated. Public services and benefits that people have come to expect
will no longer be available.” The confrontations involving trade union and public
sector workers in Greece, Portugal, Spain and Ireland may be just the beginning.

“While [Greek] debt
restructuring may
be more painful
initially for existing
bondholders, it is
perhaps an outcome
that, combined
with the budget
consolidation in
progress, provides
a more definitive
solution to the
long-term problem.”
Arvind Rajan,
Prudential Financial

Flat growth, or a tumble back into recession, will dramatically accelerate the
prospects of debt restructuring in these economies. “Many people consider
a potential restructuring in the coming years to be inevitable, simply because
they don’t believe that Greece can grow its way out of such a large debt,
particularly with the fiscal austerity measures that have been forced upon it,”
says Arvind Rajan, Managing Director and Head of Quantitative Research and
Risk Management for the U.S.-based fixed income business of insurance and
investment management giant, Prudential Financial. “While debt restructuring
may be more painful initially for existing bondholders, it is perhaps an outcome
that, combined with the budget consolidation in progress, provides a more

definitive solution to the long-term problem.”
So if debt restructuring is the inevitable outcome of crisis in the Eurozone, why
not embark on the process now, given that we don’t have a sustainable position?
The problem essentially comes down to an unwillingness to accept the inevitable
and the consequences that debt restructuring is likely to entail in terms of
further recapitalisation of the European banking system. And the reluctance of
policymakers to adopt long-term measures aggravates the loss of confidence
in developed-world sovereign debt. A funding crisis looks increasingly likely for
some sovereigns, particularly when the scale of debt that is maturing over the
next year is taken into account (see Chart 4).

“If you think it has been tough to secure funding in Europe this
year, it will be even tougher next year,” says Mr Talbut.

January 2011

TIPPING POINTS | 07


Chart 4 Sovereign gross funding needs as percentage of projected 2011 GDP
70%
Debt Maturing Oct 2010 to Dec 2011 (% of projected 2011 GDP)
60%
General Government Fiscal Deficit 2011 (% of GDP)
50%
40%
30%
20%
10%

n

es

pa
Ja

at

ce
ite

d

St

ly
Ita

Gr

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m
iu

ce

lg
Be

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ga

an
Fr

n
Po

rtu

ai

s
la
er

th

Un

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Sp

nd

nd

da

la
Ire

m
do

Ca

ng
Ki
d

Un

ite

h
ec
Cz

na

ic
bl

an

pu

Re

rm

bl
Ge

pu
Re
ak

Sl

-20%

y

ic

k

d

ar
nm
ov

al

an

De

nd
la
Ne

w

Ze

st

ia

ria

Fin

Au

en

en

ov
Sl

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Sw

ra

lia

a

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Au

re

rw
No

-10%

Ko

ay

0%

Source: IMF Global Financial Stability Report

European periphery will face difficulties in funding their
shortfalls. A similar proportion expects the U.K. to face the
same challenges (see Chart 5).

Although almost all respondents believe that governments

will be able to finance themselves over the next one to three
budget cycles, they do not expect the fundraising process
to be easy. More than half expect that the nations of the

Chart 5In your country, will the national government experience a funding shortfall
over the next one to three budget cycles? If yes, how severe will it be?
U.K.

55%

11%
59%

European periphery
33%

Canada
Other (MEA, Latin America, Eastern Europe)

17%

37%
34%

U.S.
25%

Asia/Pacific excluding India, China

23%

BRICs
16%

European ex-periphery
0%

January 2011

Yes, and the government
will fund the shortfall,
but with difficulty

12%

Yes, and the government
will be unable to fund
the shortfall

14%

7%
9%

9%
20%

40%
Percentage of respondents

08 | TIPPING POINTS

6%

60%

80%


The Great Divergence: Currencies
Survey respondents and interviewees agree that the euro will
survive these uncertain times. Over half put the chances at
20% or less that the union will lose members in the next
three years, while 80% estimate the same low odds – 20%
or less – for the collapse of the single currency during the
same period (see Chart 6). And Europeans – particularly those
in the most troubled countries – say that the probability is
even lower.

“The assumption that the euro, for all its
flaws, is vulnerable to collapse is not true.
There is no direct link that says just because
one sovereign country in the Eurozone defaults
on its debt that the euro therefore becomes
worthless or the European Central Bank ceases
to function.”
Michael Ben-Gad,
Professor of Economics, City University London
But even if the euro survives the current crisis, its long-term
role in the global economy will have been compromised.

“Although I remain convinced that monetary union will
survive, the notion that the euro will be one of the
world’s dominant reserve currencies is now debatable,”
says Jonathan Lemco, a Principal at Vanguard. “To me,
it makes the U.S. position as global reserve currency
of choice even more assured than before, despite
its problems.”
Survey respondents agree: 80% expect the dollar to
retain its position as the dominant global reserve currency
over the next three years, while 52% expect it to retain
this role five years from now. An Economist Intelligence
Unit survey conducted in June 2010, also on behalf of
RBC Capital Markets, found similar sentiment, suggesting
that market perceptions of the dollar and euro have
not changed significantly as a result of the more recent
strains in the Eurozone.
The dollar’s role allows the U.S. to tolerate higher levels
of debt than other sovereigns without having its solvency
called into question. “The U.S. can run massive current
account deficits and get away with it and can benefit from
much greater economic stability than it would otherwise
have,” says Dr Lemco.

40%

45%

35%

40%
Percentage of Respondents

Percentage of Respondents

Chart 6 What probability would you assign to the following events taking place over the
next three years?

30%
25%
20%
15%
10%
5%

35%
30%
25%
20%
15%
10%
5%

0%
0%

1-20%

21-40% 41-60% 61-80% 81-99%

Probability of one or more Eurozone countries
leaving the monetary union in the next three years

100%

0%

1-20%

21-40% 41-60% 61-80% 81-99% 100%

Probability that the Eurozone will breakup
during the next three years

January 2011

TIPPING POINTS | 09


The Great Divergence: Fiscal policy
These are uncharted waters for policymakers as well as
investors. Stepping outside the legacy mindset requires
central banks and other policymakers to enact heterodox and
unprecedented methods to deal with the new reality. There
is no textbook policy prescription for the current situation.
As a result, approaches differ.
Compared with the approach being taken by heavily indebted
sovereigns in the Eurozone, the U.S. government has so
far been reluctant to embrace fiscal consolidation and
continues to pin its hopes on monetary policy to jump-start

the economy (and thereby ameliorate fiscal dynamics). “From
the administration’s perspective, the implementation of the
stimulus package is the priority and if it means that this will
lead in the short term to a wider deficit, then that seems to
be considered an acceptable cost,” says Dr Lemco.

According to the Congressional Budget Office, the U.S. debtto-GDP ratio was 62% in the 2010 fiscal year, and could
rise to 90% by 2020. A bipartisan commission formed by
President Obama has proposed US$4tn in savings, which
would bring down the budget deficit to 2.2% of GDP by
2015, but few believe that its proposals will be implemented
in a political environment that appears to be in permanent
gridlock, especially as the 2012 elections draw closer.
Nevertheless, there is a growing consensus around the need
to tackle the fiscal deficit. “There is a sense in certain parts
of the U.S. that they are not going to be able to get out of
their current situation relying on the Fed to pump money into
the system and that they will need to address other aspects
that make it unattractive to invest and employ in the U.S.,”
says Mr Talbut.

More than 60% of U.S. respondents think that the level of
their country’s external debt is growing at an unsustainable
level (see Chart 7). And government debt (as opposed to
total external debt, both public and private) is a concern as
well. “Many investors worry about the ability and the political
will of the U.S. government to put the public finances on a
sustainable long-term path,” says Andrew Rozanov, Managing
Director and Head of Sovereign Advisory at London-based
fund of hedge funds, Permal.

Chart 7Is your country’s external debt growing at a sustainable level?
No

Yes

Europe ex-periphery

24%

74%

BRICs

21%

74%

Asia/Pacific excluding India and China

28%

70%

Canada

23%

79%

Other (MEA, Latin America, Eastern Europe)

35%

63%

European periphery

38%

56%

U.S.

65%

32%

U.K.

64%

31%

80%

60%

40%

20%

0%

20%

40%

60%

80%

Percentage of respondents (excludes respondents who answered “Don’t know”)

10 | TIPPING POINTS

January 2011

100%


Sovereign wealth funds:
A souring love affair with sovereign debt?

W

ith sovereign issuance
forecast to increase
significantly over
the next few years, government

debt managers will be on a charm
offensive to attract and retain their
key investors. Top of the list for
many will be the world’s sovereign
wealth funds (SWFs), which
collectively wield about US$4.1tn of
assets. The largest, the Abu Dhabi
Investment Authority, is estimated
to hold in excess of US$600bn.
SWFs have traditionally been big
buyers of sovereign debt. In the
run-up to the financial crisis, many
began to look further afield into
higher-yielding assets. But the crisis
has forced a reappraisal of these
investment strategies, particularly
for newer funds that have a mandate
for economic stabilization.
“Some funds realized that they had
severely underestimated the amount
of prudential liquidity that they
ought to have in their portfolios,
either to refinance their budgets,
bail out domestic banking systems
or support the local economy,”
says Andrew Rozanov, Managing
Director and Head of Sovereign
Advisory at Permal. “The nature
and range of potential calls from
the government on their capital

turned out to be much broader
and less predictable than they
had anticipated.”
For many SWFs, a retreat from
risk means a bigger allocation to
sovereign debt. “A number of funds
have scaled back some of the more

ambitious plans to move out of
the dollar and U.S. Treasuries,”
says Mr Rozanov. “In fact, all else
being equal, I would argue this in
principle bodes well for government
debt in developed countries,
especially the U.S. and Europe.”
But not all developed nations.
For example in November,
Russia’s sovereign wealth funds,
which control an estimated
US$142.5bn in assets, announced
that they would no longer buy
the sovereign debt of Ireland and
Spain. The announcement sparked
a large increase in borrowing
costs for the peripheral countries
of the Eurozone.
Of course, the true situation is more
nuanced. Mr Rozanov points out
that the Norwegian fund – the second
biggest in the world – has stepped

up purchases of Irish, Portuguese
and Greek government debt. “There
is an important difference between
‘pure’ stabilization funds, which
are focused on nominal returns and
are very conservative in their asset
allocation, and those like Norway,
that are essentially intergenerational
wealth transfer funds focusing on
real returns and operating more like
a diversified portfolio manager,”
he explains.
While these trends suggest a
potentially brighter-than-consensus
outlook for sovereign debt, there
are clouds on the horizon even for
highly rated issuers. A key concern
is QE2 and the potential for more

quantitative easing, on the value
of SWF dollar holdings.
“The whole idea of moving into
uncharted territory with quantitative
easing on that scale, from the issuer
of the main reserve currency in the
world, gets a lot of people nervous,
certainly among sovereign funds
with seriously large allocations to
these markets,” says Mr Rozanov.
Survey respondents acknowledged

this concern when 60% said that
foreign holders of U.S. Treasuries
would face losses over the next
three years.
High debt levels in developed
countries are also a key concern.
“SWFs worry about the ability
and political will of the U.S.
government to put public finances
on a sustainable long-term path,”
says Mr Rozanov. “They are also
concerned about the ability of
the European Union and its core
constituents, like Germany, to
resolve the debt problems on the
periphery of the Eurozone.”
So while SWFs are likely to remain
important investors in the world’s
sovereign debt, they are paying
close attention to the unfolding
economic picture. Indeed, as survey
respondents suggest, government
debt managers may eventually find
that their charm has worn off –
leaving significant shortfalls in their
finances and potentially affecting
the risks of other country-specific
assets as well.

January 2011

TIPPING POINTS | 11


Implications for institutional investors
The events of the past two years have seen long-held
assumptions about the creditworthiness of developed
and developing economies overturned. Prior to the crisis,
investors viewed Eurozone bonds and U.S. Treasuries as
essentially risk-free, and emerging market debt as needful
of much greater scrutiny and analysis. (Indeed, Basel III
still weights OECD sovereign debt at zero risk.) Now these
positions have been reversed. “There has been a challenge
to the orthodox way of dividing up the sovereign debt world
between developed and developing markets,” says Quentin
Fitzsimmons, Executive Director and Head of Government
Bonds and Foreign Exchange at Threadneedle.

Emerging markets and their risks
One obvious outcome of this reversal is the interest in
the emerging markets. Almost three-quarters of survey
respondents expect an increase in valuation in major
Asian equity markets over the next 12 months (see Chart
8). According to EPFR Global, a financial data provider, net
inflows to emerging market bond funds reached almost
US$40bn in the first nine months of 2010 – four times the
previous record for a complete year. “There is a broad
search among investors for hard assets offering real returns
and this is where the emerging markets come in,” says
Lena Komileva, Head of G7 Market Economics at Tullet

Prebon, an interdealer broker. “They offer the triple

attraction of higher real yields, rising domestic asset values
and appreciating currencies.”
The prospects for many emerging markets are almost
certainly highly positive over the long term. But some
investors worry that there is too much emphasis on shortterm returns. This could lead to investors over-paying for
assets, especially in countries with flexible exchange rates,
where large capital inflows have prompted sharp currency
appreciations. “While on the 20-year view I agree entirely
that emerging markets will become more economically
significant, my concern is that you need to be careful about
the price you pay when you decide to invest,” says
Mr Talbut. “People have been flooding into emerging
markets paying almost any price to get in there but there’s
a danger that they’re paying too much in the short term.”
Another concern is the formation of asset bubbles as
investors rush into these markets in search of yield.
“Investing in emerging markets is not a risk-free strategy,”
says Ms Komileva. “Because of that one-directional flow
of funds in the global economy, the sovereign crisis in
effect encourages global capital imbalances that threaten
bubbles in emerging market government bonds while
creating sharp liquidity outflows and added volatility
in developed markets.”

Chart 8Over the next 12 months, what movement do you expect in the following?
Chart shows the percentage of respondents who said “stronger” minus those who said “weaker”
Weaker

Stronger
66%
58%

Oil price in dollars

58%

Chinese renminbi

39%

Inflation in your country
U.S. equity market

27%
21%

Major European equity markets

8%

Euro
U.S. Treasuries

20%
29%
40%

Major Asian equity markets

Dollar
20%

12 | TIPPING POINTS

0%
20%
40%
Percentage of respondents saying “stronger” minus those saying “weaker”

January 2011

60%

80%


Mr Rajan agrees, and says that the signs of potential asset
bubbles are already appearing. “You’ve got inflation in
basic commodities and property booms in many emerging
markets such as China, and these run-ups in prices are
being justified on the grounds of strong fundamentals,”
he says. “But the macro risk is that, by flooding these
countries with money they can’t efficiently use, investors
could ultimately create another global credit bubble, and
valuations could get well beyond the fundamentals before
they crack.”

New skill sets are required

Sovereign debt analysis now requires a much broader set of
skills, given the very different situations in which developed
and developing markets find themselves. Analysis of Greek
debt, for example, now requires the skills of emerging market
experts with an understanding of how IMF support affects
solvency and economic recovery. It also necessitates the
combined input of government portfolio managers, bank
analysts, credit default swap specialists, European fixed
income professionals and economists, all focusing on both
cyclical and structural trends in the markets.
Government indebtedness is just one variable among many
that needs to be assessed, including the exposure of the
banking sector, the political situation and the scale of a
country’s public sector liabilities. “Every country needs
to be considered and analyzed on its own merits because
the dynamics facing each country are different,” says
Mr Fitzsimmons. “There is no generalized template to say
that an economy running 10% deficits on a yearly basis
with a 100% debt-to-GDP ratio is more likely to run into
trouble than an economy with a smaller deficit and debt-toGDP ratio. This is all about confidence and it’s all about
the perception of medium to long-term viability of the
financial system and the nature of the guarantee that any
particular sovereign entity is providing to its banking and
private sector.”
For Dr Lemco, and many other asset managers, there is
now a need to be much more discriminating when selecting

investments, particularly sovereign debt. “We have to take
countries on a case-by-case basis far more than we did in the
past,” he says.

“As best we can, we need to try to avoid
generalizations, such as developed or emerging
markets, and really investigate spreads over
time. There’s obviously short-term volatility,
but the question for the medium or longer
term is whether the trends that we’re seeing
in the marketplace are consistent with what
we think of as the fundamentals.”
Jonathan Lemco, Vanguard
Inputs to credit analysis are also changing. Rather than
rely on rating agencies, which one interviewee described
as “entities that have made a business model out of
being behind the curve”, asset managers are increasingly
recruiting their own credit analysts or assessing other
indicators, such as the credit default swap market.
“The transparency of the CDS market does shine a fairly
bright light and provides an independent free market
appraisal of what’s going on,” says a London fixed-income
executive. “It tends to be sharper in terms of pricing in
problems a bit quicker as people hedge themselves.”

Sharper pricing of risk
For investors in sovereign debt, a fundamental lesson relates
to the need to price risk more accurately. The assumption
that risk can be measured by taking a snapshot assessment
of fundamentals, relying on past price history and confidence
intervals is now a thing of the past. “For those interested
in capital preservation and who want to know they have
protected tail risk, it will be worth looking beyond the current

snapshot of rating agencies, beyond the assumptions of past
mean reversion, and beyond the false comfort of confidence
intervals and a world with few consequences for profligacy,”
says the London executive.

January 2011

TIPPING POINTS | 13


“When sovereign risk
goes up, it can become
a contagious factor
that drives systemic
risk. And given that
developed government
guarantees form the
foundation of so-called
risk-free securities,
if governments are
risky, that shakes
this foundation,
forcing investors to
re-evaluate other types
of credit risk.”
Arvind Rajan,
Prudential Financial

Higher levels of risk in the sovereign debt market can have a profound effect
on risk in other asset classes, because of common factors running through the

banking system and other channels of contagion, and because of government’s
role as a guarantor of last resort. “Systematic risk is multi-dimensional, and
is best described by what we call principal components, which quantify the
correlation of security prices stemming from exposure to common risk factors,”
says Mr Rajan. “When sovereign risk goes up, it can become a contagious
factor that drives systemic risk. And given that developed government guarantees
form the foundation of so-called risk-free securities, if governments are risky, that
shakes this foundation, forcing investors to re-evaluate other types of
credit risk.”

The impact of fiduciary frameworks
Many institutional investors have investment mandates that prevent them from
investing in debt below a certain credit rating or once yields or credit default
swaps reach a certain level. As the IMF notes in its Global Financial Stability
report: “Investors with strict ratings guidelines in their portfolio mandates
(notably central bank reserve managers) may also be less inclined to maintain
their current allocation to sovereigns where credit spreads imply deteriorating
credit rating prospects.”
If more sovereigns suffer ratings downgrades, this could have a profound impact
on the extent to which pension funds and other large institutional investors can
hold sovereign debt. “We operate in an economy where there is strict regulation
surrounding pension fund liability management, which has tended to favor
investing in government bond markets,” says Mr Fitzsimmons. “Now if there was
a significant question mark about the solvency of those assets, then it has very
nasty implications for the current, legislatively required asset mix. On the other
hand, if yields just rise because people are worried about things like inflation,
then perversely that can actually reduce liabilities in the short-term because
discount rates will be higher.”
Emerging regulation will also influence appetite for sovereign debt. The new
Basel III accord will require banks to hold larger capital and liquidity buffers

and force them into holding some proportion of their capital in supposedly lowrisk asset classes, such as sovereign debt. “Regulation will require banks to
concentrate their holdings into the higher layer of capital in the markets, which
is government debt,” says Ms Komileva. “This will increase the structural demand
for banks’ holding of government debt, even if many governments now have
poorer credit prospects than corporates.”
A cynical interpretation of this quirk of the Basel III rules would be that regulators
are pushing banks into holding sovereign debt at a time when demand for
the asset class is likely to fall among institutional investors. But just 12% of
survey respondents agree that the primary purpose of the higher capital
requirements to be imposed under Basel III is to compel the financial sector to
fund government deficits. Most think that this is a side effect of the proposals
or at most, a secondary objective.

14 | TIPPING POINTS

January 2011


“The crisis has refocused
attention on the
question of liquidity.
The majority of
sovereign funds realized
during the crisis that
they had severely
underestimated the
amount of prudential
liquidity that they
ought to have in
their portfolios...”

Assigning a value to liquidity
For sovereign wealth funds, and asset managers more generally, an important
lesson from the financial crisis has been to build their capital reserves and ensure
that they have a strong balance sheet that can weather unanticipated shocks.
“The crisis has refocused attention on the question of liquidity,” says Mr Rozanov.
“The majority of sovereign funds realized during the crisis that they had severely
underestimated the amount of prudential liquidity that they ought to have in
their portfolios, either to refinance their budgets because oil or other commodity
prices that they rely on collapsed, or to help bail out domestic banking systems
or support local companies. That led many funds to either scale back some of the
more ambitious plans to go out of the dollar and out of U.S. Treasuries.”
In addition to building up capital reserves, asset managers are re-assessing
their portfolios and subjecting them to a range of possible scenarios. The
watchwords are diversification and risk management, on the basis that the range
of potential outcomes on either side of a central view is so much broader than it
was before. “It is incredibly difficult to build a portfolio based on a single view,”
say Mr Talbut. “What you have to do is build a portfolio that has some insurance
to it against some things going badly wrong but also has the ability to take
advantage if things pan out better than they are being discounted at the moment
in the market. That’s not going to be the perfect portfolio for every possible
outcome but in terms of your risk/reward, it’s still likely to give you a better
return than if you bet the whole lot on one single outcome. We’re building in more
diversification into our multi-asset portfolios than we’ve ever done before.”

Andrew Rozanov,
Permal

Chart 9To what extent do you believe that the higher capital requirements to be imposed
under Basel III are designed to compel the financial sector to fund government deficits?

A side effect of Basel III,
but not an intended purpose

41%

Secondary purpose

25%

Primary purpose

11%

Basel III will have little or no effect
on demand for government debt

10%

Don’t know

14%

0%

10%

20%

30%

40%

50%

60%

70%

Percentage of respondents

January 2011

TIPPING POINTS | 15


Conclusion
For asset managers and other institutional investors, the
range of possible outcomes in a highly divergent and multifaceted global economy has rarely been greater. The role
of sovereign debt within a portfolio has been transformed,
while there has been an inversion of risk profiles between
developed and developing markets. These are profound,
long-term changes that are likely to force asset managers
to re-evaluate accepted wisdom around risk management,
asset allocation and portfolio construction.
A return to pre-crisis conditions around the world is
unlikely. For now, volatility will remain high as the global

16 | TIPPING POINTS

January 2011

economy goes through a painful period of adjustment.
But even when it subsides, the investment landscape will
have shifted significantly. Long-held assumptions about
the role of sovereign debt in investment portfolios may
no longer be tenable – or at the very least will be much
more complex and nuanced than in the past, while high
levels of indebtedness in many developed economies will
raise the prospect of funding shortfalls, restructurings and
even defaults. The period of Great Divergence will be one
that is fraught with risks, although the unfamiliarity of the
environment will mean that, for some, this will also be a
time of great opportunity.



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