Prior to the GFC there existed a divergence of growth rates between the advanced western economies and those of the emerging economies in favour of the emerging economies. However, prior to the GFC investors remained somewhat wary of simply chasing the higher growth rates of emerging economies as it did not offer the same level of security, transparency and "soundness" as perhaps the lower growing developed western nations. The GFC has changed the scales on that score with the reputation of the western economies now tainted, with sluggish growth albeit recovering economies, but carrying debt levels more reminiscent of the smaller emerging economies.

The risk profile of the advanced economies has changed as the debt profile has changed and the new school of thought is that the US and Europe will be weighed down heavily by debt whereas the more dynamic emerging economies will not have to carry the debt burden and the risk differential has narrowed somewhat.

Forecasts for Real GDP and CPI

Forecasts for world growth in 2010 is 4.6%, which is a respectable number. However the advanced economies are forecasts to grow at 2.3% compared with 7.8% for the emerging markets, with a similar profile in 2011.

Every economy in the Asian region is forecast to grow by more than 4.0% with China at around 11%. The Latin American economies are forecast to grow at 5.0% with the BRICs at 9.4%.

Inflation in the emerging and BRIC countries is higher with Latin America at 6.1%, and the BRIC's at 4.2%, but the difference that's been brought about by the GFC is the debt position which has changed the playing field.

Government Debt

The US, Japan and the UK all have General Government debt as a % of GDP at 10% or higher. The emerging markets level is running at 3.3%, one third of that of the US, Japan and UK. The tide has turned where you now have higher growth and lower debt in the emerging economies compared to lower growth and higher debt in many of the advanced economies.

It is also worth noting that the current account position of the emerging markets is positive compared to being negative in many of the advanced economies.

Patterns of consumption and saving in both the West and emerging markets are shifting. The West is starting to consume less and save more, which implies slower future economic growth. Meanwhile Asia, less affected by the global crisis and less encumbered by legacy debts, should grow at a faster rate in the foreseeable future.

It certainly raises the question as to whether the tide has turned in terms of regional economic performance.

This is no more evident then what is happening in China and India.

Two centuries ago, China accounted for 35% of the world's population and 30% of world GDP, while India accounted for 20% of the population and 16% of GDP. These figures fell by nearly 80% by 1950 but are now soaring back with China growing in recent years at about 10% annually and India by 7%.

China will have a bigger economy than the US well before 2040 and India will be as big as Germany, Britain and France combined.

Indeed, assets are likely to be deployed differently from the past, with a reduced emphasis on slower growing "mature' markets, and greater emphasis on the faster-growing economies of Asia. This is likely to have an impact going forward on profit drivers for companies and I suspect many of the global multi-nationals will be looking to the emerging markets to generate revenue growth.

The emerging economy theme however can be played through the advanced economies securities markets where the global companies are mostly listed and look to the emerging economies as a growth engine. The story is not so much about investing in advanced or emerging markets but how to best benefit from companies leveraged to the changing economic fortunes of the regions. For example, investing in Australia's listed markets is a proxy play on China given our ties and the direct benefits flowing through to the resources sector which is also flowing to other sectors.

These interrelationships and an understanding of where the risk and opportunities lies is deeper than simply looking at the asset allocation as it can be misleading. Just like during the debt boom the real risk was not in the asset class but the underlying securities in the asset class and the interrelationship with other securities.

Here China plays a greater influence than perhaps many of us realise or are even aware of.

China – How much of an Influence

China is now Australia's largest exporter taking 25% of our exports and our most important trading partner. Our exports however are narrowly focused around our resources base particularly iron ore. China's position in the world economy has also increased significantly from a 3.5% share in the early 1990's to a 12.7% in 2010. As China has resumed it's growth path on the 10%+ highway and our terms of trade improves, it places upward pressure on the exchange rate, increases domestic demand, provides stronger employment growth, and overall our national income grows.

We should of course not lose sight of the fact that the mining output represents only around 9% of Australia's GDP and just 1.5% of Australia's workforce but the multiplier effects are real and Australia's economic fortunes are tied in with that of China. This of course has significant implication on the investment front.
The obvious and direct one is the prospects and valuation of our mining companies, and the companies that service the mining companies.

The less direct includes the construction industry, our housing outlook through the rise in national income and the impact on our export industry given a higher Australian currency. Australia and its resource link to China also represent a "clean" way to play China given our strong financial system, regulation, transparency and accounting. But like all investments we should be wary of a one way bet and placing all our eggs into the one basket.

I worry that as more Australians buy the China story (and it is a real one) through the Australian listed market, employment, superannuation, and non-super investments. Are we simply multiplying our bets. What if there is a sharp reversal?

My concern would be that with success and prosperity overly tied to such a dominant factor then where is the diversification that will safeguard wealth if the story derails. By all means we should participate in the dynamics of a growth story that is pulling Australia along but we should not forget the risks and from an investment point of view investment management firms should be considering not only how to benefit and seek returns from the China growth story but also point out the risks and products that are likely to deliver and safeguard if the story reverses.

It is very difficult, if not next to impossible to predict what factors will bring to end to a bull story, particularly when everyone is on one side of the trade but we should not ignore the lessons learnt from the GFC and the importance of understanding the risks and safeguarding against a possible reversal in the investment thesis. I want to make it clear that I am a believer in the future growth of China and its benefits to Australia as a key trading partner but so too we must be conscious of how much we want to bet on it. Let's not relive the lessons of the tech and credit boom.

Unfortunately, it's the fall out of these boom periods that leads to an ever increasing regime of regulation.

Which brings me to the topic of regulation. We have yet to face the full force of regulation and the next 2 yrs will be dominated by increased regulation.

US and other three dot points

In the US, there is a bill with the US Senate to create a new body the "Financial Stability Oversight Council" to provide oversight to systemic risk problems. An answer to the "too big to fail" hazard. There are also proposals to limit proprietary trading and closer regulation and control of derivatives and exotic financial instruments. The initiatives are not necessarily a bad thing if it is successful in managing undue risk that can result in catastrophic outcomes if not checked, because we have seen and experienced that self regulation does not always work. This is likely to limit the potential growth of some financial institutions.

The regulatory impact overseas is heavily focussed around the banking system and improving standards of "light touch" financial centres. Clients are now less tolerant of funds being set up in less regulated financial centres and asset managers will need to think more carefully about where they locate funds.

The perception that private equity, hedge funds involvement in prime brokerage, leveraged loans and derivatives can create systemic risks, has also created an imperative to regulate these sectors to a much higher degree.

Meanwhile, the European Union has already taken steps to impose regulation on alternative investment funds and managers, and this may be replicated elsewhere.

Regulatory efforts in the banking sector may also have a knock-on effect in the asset management sector since the increased capital that banks will have to hold will lead to a restructuring of many of their businesses. To raise capital, some will divest their asset management businesses. Not so much in Australia but this process has already begun in the US and Europe.

Australia

Ripoll, Cooper and Henry will all have an impact although in terms of the value chain the least impact is most likely to be on the manufacturers. Manufacturers will not be immune to the change but in terms of adjusting the business model it is the least impacted.

We should not underestimate the changes. We've seen from the Bowen announcement that the government is not taking a step backwards and if the Bowen proposed changes is any indication, we are in for further significant announcements. The Henry review, is I think primed for some material announcements on the tax front that will challenge everyone's thinking. I won't comment much on the Henry review given that it is only four days away but one area where I will comment on is the resource rent tax or dubbed the mining tax, and this will be interesting in terms of the government's position.

We should not be surprised to see governments target booming industries for a bigger tax grab. That's what governments do, they look for the biggest honey pot and take a cut. It may be that the government will not consider a mining tax but if it does the debate is more likely to be around what the right level of tax should be, but I would also like to see how the receipts from the tax take will be used.

If governments are going to tax the mining industry in this period of boom they must recognize that the mining sector is cyclical and there is not an unlimited supply of resources. The current boom and potential tax take should not be wasted and thought of more like to how the UAE nations think about managing their unlimited resources. If we are going to tax the mining industry over and above the corporate rate then how will this grab be shared with future generations of Australians when the endless resource of minerals is no longer endless.

Let's not waste the current boom and let's not simply spend it for today but think about investing for the long term and future generations. The government is already benefiting from the mining boom through higher corporate profits, and any additional tax should go towards the future when those mining corporate profits may not be there.

Politically this also makes sense as the public will be supportive of using the tax take to consider the future and well-being of future generations and not simply a tax grab for the government coffers of today.

On regulation more generally, we are supportive of measures that promote the principle of acting in the best of interests of investors, provides transparency and raises the professional standards of our industry. This should not be an aspiration but a goal that when achieved the industry will be able to truly earn the trust of the client and result in an even more attractive industry to be involved in.

Those organisations that can demonstrate a clear value proposition to their clients are most likely to benefit from the recent changes announced by Chris Bowen. The players in the value chain must believe that they do have a value proposition that clients will want. That value proposition may change depending on the nature and size of the client but nonetheless that must be the starting proposition.

If as a business or as an industry we don't believe in our ability to add value then we have to question our reason for providing a service.

The potential stripping of volume based payments between advisers, licenses, platform and product providers will both create transparency and reduce the conflicts of interest, but it will also come with some pain during the adjustment phase. New business models will be created but that's perfectly fine provided the principles around client interests, transparency and professional standards are not compromised.

We at BTIM like many other business will conduct a review on all our existing relationships and comply with all of the reforms by the application date in July 2012.

As investment managers we are already in an environment were our value add is judged daily, monthly, quarterly and yearly and understand that if we do not deliver then our clients will go elsewhere and that does provide for a good solid discipline. We await the government's response to the Henry tax review and the Cooper review to be able to take a holistic view of all the changes that together will keep the industry very very busy as it digest the implications of the recommendations.

In addition to trying to manage the regulatory front we all still have a business to run and clients monies to manage and advise. One of the areas that has created a lot of interest has been the flow of funds to term deposit rates.

Investments into term deposit rates has increased dramatically over the past five years particularly since the introduction of the government guarantee.