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25 Aug 2013

Which 'house' is safe for investors?
The US looks like the best bet in the global investment village right now

Source: Sunday Times | Invest
By Alexander Friedman

All houses and buildings have one element in common: some kind of support that holds up the structure. Without strong pillars, even a house that looks great can be dangerous to inhabit.

Recently, business confidence in the United reached its highest level in many years, and US equities attracted record inflows last month.

The question now is whether conditions can generate the kind of confidence that could drive financial markets to even higher levels, and whether the virtuous circle of confidence in the US can develop in other regions of the world, including Asia.

Or, simply put, is the "house" safe enough for investors to move into? To answer this question, we need to assess the three pillars in which confidence is paramount - the economy, asset prices and the political environment - in the three biggest houses in the global investment village: the US, the euro zone and the emerging markets.

Emerging markets house: Deteriorating

The least stable house at present is the emerging markets, where structural support is deteriorating.

The "Fed taper" fears have resulted in an exodus of capital from these regions, exposing the fiscal and current account problems of some of the biggest countries - particularly India, Indonesia and Brazil - and leading to sharp declines in asset prices and higher funding costs for businesses.

In Indonesia, the rupiah has fallen to a four-year low and the cost of insurance against sovereign-debt default is at a two-year high.

In India, an attempt to address outflows - imposing restrictions on outbound investment - scared foreign investors and sent the rupee to a record low against the US dollar.

And in Brazil, even its substantial foreign exchange reserves could not stop the real from dropping 8per cent in a month.

Meanwhile, political uncertainty in these countries is high.

Next year, they all face elections that could further inhibit confidence and investment.

And, this time, the so-called engine that has led emerging market growth in recent years cannot be relied upon. The Chinese economy is slowing down, and its recent improvements have been driven by "low-quality" sources: exports, real estate development and traditional bank lending.

Thus, it is best not to knock and to stay neutral on emerging markets.

European house: Less stable than it looks

The European house is more stable but is still not sound.

True, the euro zone of the past month seems unrecognisable from the euro zone of the past two years, having exited recession and being seemingly on the cusp of breaking the negative spiral of tight funding and austerity that has undermined its recovery.

But its level of economic growth is too low to be self-sustaining.

Corporate earnings growth is muted and banks continue to unload assets, creating a headwind for asset prices.

Furthermore, the recent lull in political noise could come to an end following the German elections next month.

Thereafter, Germany may revert to being more strident in pressuring for new reforms in the European periphery, potentially unsettling already weak governments in the region, as it did through 2011 and the early part of last year.

Therefore, it may not be the right time to take on more risk in Europe.

That said, there is a bright corner in the house: In Britain, business confidence is at a new high, house prices are rising at the fastest pace since the crisis, and the political situation is stable.

Investors can take advantage of this through overweight positions in the British pound, funded by a relatively overvalued currency, such as the Swiss franc.

US house: Okay to move in

It is the United States which is the stable house that investors should look to move into. While speculation over the future of the Federal Reserve's quantitative easing programme has driven investors into a guessing game that sometimes roils markets, the reason behind it is a good one: The US economy is recovering.

Both the labour and housing markets are improving, with fewer people unemployed and fewer people whose home values are underwater.

Meanwhile, the S&P 500 has rallied 17 per cent in the past 12 months, ranking among the world's best-performing major indexes.

This improvement in asset prices has lifted overall business confidence, and signs of a genuine comeback in investment are emerging: Durable goods orders are up, and more companies are announcing plans to increase capital expenditure during the rest of the year.

This type of confidence boosts hiring and wealth, and creates even more confidence.

The biggest impediment to declaring that the US has fully achieved its virtuous circle is its politics.

The almost perpetual "debt ceiling" issue is back in the headlines, and risks remain that the political debate about it will be protracted.

But, rightly or wrongly, it no longer seems to be undercutting confidence the way it once did: The Economic Policy Uncertainty index last month fell to the lowest level since before the collapse of Lehman Brothers.

All considered, it is best to move into the US house and take overweight positions specifically within US equities, US high-yield credit and the US dollar.

The writer is the global chief investment officer of UBS Wealth Management, overseeing investment policy and strategy for US$1.7 trillion (S$2.2 trillion) in assets.