Over the past decade, developed economies across the globe have relied on the accumulation of unsustainable levels of private and public sector debt to maintain a high rate economic growth. Debts of companies and households rocketed, taking advantage of exceptionally low interest rates brought by the deflationary period of globalisation.  The downturn when it came was the worst in a century and government debt expanded dramatically to offset the huge forces of degearing in the private sector. Countries like the US, Spain and Ireland experienced similar private sector credit booms, while others, like Greece are now in debt traps caused instead by profligate government spending. Collectively, the developed world is now mired in a monumental fiscal deficit and a soaring public debt. 

This was no normal global recession.  Much of the developed world is now experiencing a balance sheet recession, where the banking system and households are busily reducing debts.  In such recessions, the effectiveness of monetary policy reduces because there is limited demand for investment capital.  Banking systems focus on rebuilding their capital base and shrinking assets.  They limit lending to bolster their balance sheets and enable them to meet commitments.  Balance sheet recessions take a long time to work their way out.  We are probably only half way through this slow process of deleveraging, and it will be several more years until robust growth can return to developed economies, with Britain among the worst hit. 

But recessions have a way of clearing out a path for new growth to emerge. They bring creative destruction, separating the wheat from the chaff and leaving only the strongest companies in the market.  Those with poor competitive positions, weak products, and high hurdle rates of return are eliminated, while those that survive have been forced to become stronger – indeed many are now very cash rich as a bolster against a renewed credit crunch.  But with demand weak, they are not investing this cash, and so not contributing to a recovery. Earnings are likely to be under renewed pressure now too.  The question everyone is asking is, where next for the global economy? 

To answer this question, you have to look at the world’s most influential economies.  Take China for example - this global powerhouse is slowing down as its customers in the developed world struggle.  Statistics from China should be taken with a pinch of salt, but even so, growth rates were revised down by the government, to a predicted 7.7% for 2012. China’s long term challenge is to refocus demand from serving the world to fostering a home-grown consumer that will insulate it increasingly from the rest of the globe. In the short term China faces considerable imbalances such as its massive current account surplus, and its housing bubble. So, should investors be worried about a hard landing in China? It’s incontestable that it would influence the rest of the world, especially given its population of 1.3 billion, but remember the Chinese government has deep pockets. It has the capability to execute policies effectively and rapidly. And, let’s not forget that China is not the only driver, as many other emerging economies are contributing to global growth.  Putting speculation aside, if investors want exposure to emerging economies such as China, they should focus on the consumer sector.  As the middle classes grow, the economic growth model changes from investment led to consumer led. 

Outside of emerging markets, The Bank of England’s, the ECB and the US Federal Bank’s bond-buying schemes have been a welcome shot of adrenaline to the markets in 2012.  The announcement of Quantitative Easing from the Fed was a clear sign that Bernanke was prepared to stop at nothing to boost the US economy in 2012.  This was the most aggressive move yet and the size of the package could pave the way for an equity bull market.  2012 saw the equally bold move from the ECB in the teeth of fierce opposition from Germany.  But while helping keep countries afloat, QE caused a bubble in the bond market, and boosted commodity prices, a cost ultimately passed onto consumers. Equities by contrast have suffered outflows in recent years, leaving valuations low. The dividend yields from equities are now higher than domestic bonds in most markets.  This is a clear anomaly and therefore investors seeking income should be targeting equities to meet their investment needs in 2013.

Summary
Despite economic growth being lower than we’re used to over the last 20 years, the best companies are increasingly global and therefore better able to take advantage of the opportunities available from around the world. We no longer need to think so much in terms of our own asset allocation to various markets, but trust the best companies to do it for us.