Global

Nick Price, Portfolio Manager Emerging Markets - January 2012

“Within the region of Emerging Europe, Middle East and Africa (EMEA), we are blessed with companies that can grow regardless of the economic landscape.“Without a doubt, the outlook for developed economies remains poor and the pains of the financial crisis in the eurozone are likely to be felt for some time. Consequently, we expect a degree of stock market volatility in our markets in the year ahead, but believe the long-term case for investing in the region remains as strong as ever.

“We are currently avoiding most Central European and Middle Eastern stocks as it will probably take some time before their overarching macro situations are resolved. Instead, we are buying into those businesses participating in the unappreciated African consumer and those miners involved in gold and silver production, as they should continue to do well.

“Global economic growth is expected to moderate in the new year as domestic activity in many countries eases and Western export markets weaken. However, emerging market valuations are attractive, especially in places like China and Russia. And while global markets may remain volatile in the near term, the growth potential for equities in the developing world significantly outweigh those offered by cash, debt and stocks in the more advanced economies.

“Despite the negative headwinds, we continue to find several interesting opportunities ranging from Asian smartphone component production to Russian oil and gas supply, to Nigerian beer consumption - all stories that have yet to be fully appreciated by the market. Therefore, we are positive over the long-term outlook, but remain fairly cautiously positioned until we see some sort of resolution to the current European crisis.”

Amit Lodha, Portfolio Manager of the Fidelity Global Equities Fund- January 2012

“I expect global economic growth to remain muted in 2012, with a continued and marked divergence between developed world and emerging market growth. The sovereign debt issues in the eurozone are far from resolved and the political intervention and consensus needed to stem the crisis will take time to materialise.

“Meanwhile, I expect the European economy to enter into recession on the back of constrained bank lending and austerity measures. The policy response from the European Central Bank (ECB) will dictate the length and depth of the recession, and its socio-economic implications.

“My outlook for the US is more positive. Housing starts have begun to rise from an all-time low as ultra-low interest rates are starting to incentivise buying rather than renting, and the backlog of foreclosed properties is starting to clear. Meanwhile, emerging markets continue to offer significant long-term growth potential. India, Indonesia and Thailand should benefit from inflation peaking in 2012. While a planned leadership change in China should be positive as the current government has undertaken sufficient policy tightening to create leeway for the new policymakers to settle-in.
“On the corporate front, balance sheets the world over are in excellent shape. This could support capital expenditure and merger and acquisition activity. This will benefit sectors such as technology, late cycle industrials and investment banks.

“During this low growth environment, my focus is on quality franchises with strong balance sheets, which do not rely on banks for funding. I look for companies that own assets where supply and demand is tight, sell products that all of us need on a daily basis, or are doing something truly innovative, which gives them pricing power.”

Fixed income

Andrew Wells, Chief Investment Officer of Fixed Income at Fidelity Worldwide Investment - December 2011

“We are now in a reflationary phase of the global economic cycle in developed economies that has, in fact, traditionally been associated with relatively strong bond performance. Economic growth is slowing and inflation is coming down, quite markedly in certain areas.

“The challenge for investors is to understand that bonds can be a good place to be if your bond manager is exposed to the right risks. A strategic approach is obviously paramount, particularly with regard to sovereign bonds.

“Aggregate bond indices and funds which are benchmarked against them now include significant concentration risks within sovereign bonds. Around half of the risk in the Bank of America Euro Aggregate Bond Index comes from sovereign bonds. More worryingly, the nature of that risk is highly correlated since if one peripheral nation leaves the eurozone, it increases the likelihood that others will follow.

“While aggregate benchmarks still make up the bulk of the bond market, I think we will see increasing consideration given to more equally weighted, high quality benchmarks, going forward. I think we will see greater interest in ‘strategic’ bond funds that balance risk and return, as investors move away from products that expose them to increasingly indebted governments and institutions.

“Portfolios based on ‘best issuers’ can differentiate between government bonds, investing in the most fiscally sound sovereigns, such as Canada and Australia, as well as the highest quality investment grade corporate bonds of multi-nationals, such as Proctor & Gamble and Johnson & Johnson. Such companies benefit from multi-national reach in relation to national regulatory risks, as well as strong cashflows and healthy balance sheets. They offer better credit risk characteristics than many sovereigns and allow investors to mitigate their overall sovereign concentration risk.

“Turning to the individual bond classes, there are threats and opportunities. In government bonds, we are seeing a reappraisal of what constitutes a ‘safe haven’. Investor demand for the government debt of countries deemed to be ultra-safe such as the US, the UK, Canada and Australia has risen. With the ability to print money in their own national currencies, these bonds are considered to have low default risks by investors. However, the low yields on offer make them less attractive for investors searching for yield.

“Fortunately, the fixed income asset class is both wide and deep, so there are still very good opportunities for investors to achieve an attractive income, while avoiding threatened sovereigns. Higher-yielding parts of the bond market will retain support from investors searching for yield in an extended period of low nominal rates and negative real rates in Western economies. Coupled with aging demographics, the search for yield is a powerful force supporting the demand for high income generating assets.

“High-quality investment grade corporate bonds can offer many of the characteristics once associated with sovereigns. Generalised macro concerns have served to push up yields in corporate bonds across the whole credit spectrum, but crucially this has occurred while company fundamentals have remained basically sound. In reality, many companies are now in a better position than their governments.

“While they entail more risk, a case can also be made for high yield corporate bonds for investors prepared to take a longer-term view than myopic markets. Credit spreads now imply a significant rise in default rates, but as most seasoned bond investors know, the market rarely offers a pure assessment of fundamentals. Dislocation in financial markets periodically pushes the prices of high yield bonds to ‘distressed levels‘, which do not reflect company fundamentals. Bank deleveraging will impact the high yield market as it is a recessionary influence on the economy that squeezes the availability of credit for firms. On the other hand, this bank deleveraging phenomenon virtually assures a strong pipeline of new issuers for some time.

“In reality, most companies enter 2012 in much better shape than they did 2008/9. They have kept their cost bases under control; they continue to have access to bank lending, even if terms have become tighter, and they have actively managed their own refinancing needs in the past two years to protect themselves from this kind of volatility. These factors should contain default rates at lower levels than the market appears to be discounting. The total return of the high yield asset class is now supported by a very strong income stream - this income goes a long way to protecting total returns from this point. However, stock selection is critical to avoid the worst issues in the high yield space - these can have a disproportionate impact on returns.

“Given that quantitative easing and an increase in the money supply are possible policy outcomes in the continuation of this crisis, then inflation must be considered a significant tail risk. Inflation-linked bonds look cheap; inflation is not on investors’ radars as we have not yet turned the corner on QE. The problem is if investors wait for the corner to be turned, they will be too late as inflation will be the word on everyone lips and the markets will react quickly to build in those new expectations. I would certainly encourage investors to think about introducing inflation protection to their portfolios at the start of 2012, while it is still attractively priced.

“2012 will also see bond investors give much more weight to the idea of emerging market bonds being a structural, rather than a tactical, allocation in their portfolios. These economies are forecast to deliver the strongest growth rates, which gives sound underpinnings to their sovereign credentials. Indeed, the debt and budgetary positions of many emerging market countries is now far superior than many developed countries. Sharp drops in risk sentiment that lead to rises in the government bond yields of well managed, fiscally responsible emerging market countries could present opportunities for income-seeking investors. Similarly, emerging market inflation-linked bonds offer attractive real yields; inflation is higher than in the West but this likely to be more than compensated by robust growth.”

Asset allocation

Trevor Greetham, director of Asset Allocation – 2011

 “A bullish case can be made for 2012. It rests on a US-led economic upswing strong enough to offset anticipated weakness in the European economy and it assumes the worst-case scenario of a messy euro break-up can be avoided. US data has been resilient, but as things stand I am doubtful financial contagion from Europe can be avoided.

“Global growth is slowing and a peak in inflation will enable central banks to ease policy with force. However, it will be hard to offset a synchronised slowdown in the European Union, an economic area in aggregate larger than either the US or Chinese economies. Meanwhile, the ability of the US to underpin global activity is constrained by political deadlock over fiscal policy and China is unlikely to fill the gap. Its exports to the developed world are slowing and monetary easing is likely to be incremental with inflation still uncomfortably high.

“We enter 2012 with our portfolios as defensively positioned as we were throughout 2008. One of the key reasons for my caution is I believe policy responses are making the European debt crisis worse. US investors have become used to a sequence of events that sees a market panic elicit a policy response that rapidly triggers a reversal in the business cycle and in stock prices. In earlier times, people called this the Greenspan put. But what if the policy response is the wrong policy response?

“Europe’s problems stem from a chronic lack of competitiveness in the peripheral economies resulting in large trade deficits with the core that markets are no longer willing to finance. Policy makers are addressing the crisis by insisting on ever deeper austerity, by threatening banks with injections of public capital and by hinting that countries that don’t follow the rules can leave the euro. These policies may do more harm than good.
Austerity is exacerbating the economic slowdown in peripheral economies, causing their fiscal dynamics to deteriorate in a vicious and unstable circle. The peripheral European sovereign bond markets behave like corporate bonds. These states cannot print money to repay debts and they cannot devalue their exchange rates to restore competitiveness. When economic growth slows, bond yields rise as investors factor in a higher likelihood they won’t get all of their money back. This rise in the cost of government finance itself makes fiscal sustainability more difficult. A move into recession will certainly test the commitment to cut spending and it will test the resolve of Germany to supply further funding to what it sees as errant member states.

“Offering banks additional capital sounds sensible but it is causing a credit crunch. Banks do not want to dilute their shareholders so they are making every effort to improve their capital position by calling in loans. Meanwhile, talk of Greece or other countries leaving the euro creates uncertainty about the integrity of the entire single currency area and causes investors to factor in a risk premium for possible foreign exchange losses even to bonds in the eurozone core.

“A solution to the problem could come from a policy to rebalance the European economies with the European Central Bank (ECB) intervening to maintain market discipline in the meantime. Trying to restore competitiveness by deflating wages and asset prices in the periphery is doomed to failure when debt levels are so high. It is far better to inflate the core. If policy makers are unwilling to do this, for example by easing fiscal policy in Germany, then a much weaker euro exchange rate could do the trick by boosting German exports to the rest of the world.
The ECB could help such a transition by providing unlimited support to cap yield spreads in eurozone sovereign bond markets. Much depends on Germany’s preparedness to agree to a policy that could involve a large transfer of wealth from the core to the periphery. The German Bundesbank claims that buying bonds in an unlimited manner would be illegal, amounting to central bank funding of member states. The greater impediment may be fear of moral hazard: that the signal ECB intervention would send to political leaders in the periphery is that fiscal irresponsibility will not be punished.

“For Germany’s opposition to this policy to become exhausted, we may need to see contagion spread to its financial sector and real economy. At present, this still seems some way off. The German unemployment rate is at a post-unification low of less than 7%; compare this to 23% unemployment in Spain and it is clear the German economy is simply not feeling the pain of its neighbours. Indeed, for now, Germany seems quite happy to live with or even engender a sense of crisis, as it allows them to push for structural reforms among their eurozone partners.

“Once the crisis reaches Germany, the choices could become binary. A eurozone break-up is something that Europe’s premier manufacturing export base wants to avoid at almost all costs. There would be huge damage to Germany’s export and banking sectors from the appreciation of new Deutschmark. Quantitative and fiscal easing to inflate the German economy and make it less competitive relative to the periphery may, ultimately, be a solution that Germany is prepared to stomach. The alternative would be full political union, perhaps with a smaller group of states, allowing for large fiscal transfers and coordinated economic policy. If and when we get bold policies like this, it could be time to become more positive on risk assets.

“A recession in Europe will have an impact on emerging markets through trade and financial channels. European banks are the dominant lenders into Asia where credit growth has been a key driver of economic activity. Emerging markets will probably not be spared from volatility but a weak global economy in 2012 could provide a good long-term buying opportunity in much the same way as it did in 2008/9. When global growth starts to recover, emerging markets are likely to outperform developed markets by some margin.

“Moving into 2012, we continue to favour bonds over equities. We remain underweight in commodities, albeit overweight in gold. Within equity markets, we favour the US; the market has relatively defensive attributes and, despite the fiscal deadlock, it is still the most likely to stimulate its economy to protect economic growth and jobs. Economic policy is more pro-growth than in other developed markets, with the Fed willing to take aggressive action when required and the Democratic administration likely to table fiscal stimulus and housing support programs. Swiss equities are also attractive for their defensive qualities, with the currency hedged. We expect a period of euro and Swiss franc weakness and dollar appreciation.

“In summary, investment conditions remain difficult. We expect short violent economic cycles driven by bouts of unprecedented fiscal and monetary stimulus. Diversification across a range of asset classes will remain an attractive proposition and there will be lots of opportunities to add value through a sensible tactical asset allocation policy.”
Dominic Rossi, Fidelity’s Global Chief Investment Officer of Equities – December 2011

“We believe that emerging markets will ultimately deliver better economic and stock market performance in 2012 than their overly indebted developed counterparts. The long-term case for emerging markets is intact and the fact we are in a ‘two-speed world’ in economic growth terms will only become more obvious.

“In episodes of heightened volatility, emerging markets will not offer near-term respite as equity correlations converge, but investors should begin to reward their superior economic fundamentals and their better ability to recover from the slowdown in global growth over the course of 2012. The headwinds in emerging markets are cyclical in nature rather than structural, so the case for investment is robust on a medium- to long-term view.

“Investors should focus on high-quality, defensive companies with stable and reliable earnings streams, which pay high and sustainable dividends. The dividend income offers a measure of protection to investors against further market volatility. These companies are typically large, robust household names, which may well prove to be a relatively safe place for investors to park some of their cash, when consideration is given to the mounting stresses in the banking system.”

Dominic Rossi – Global Chief Investment Officer Equities - Dicusses the Eurozone Crisis - November 2011

A lot of issues are now coming to the boil in the eurozone. It’s now evident that the problems in the periphery are increasingly beginning to impact the core. The fact that sovereign bond yields have moved up in Belgium, Austria and France is a worrying development that will ultimately put more pressure on the European Central Bank’s (ECB) bond purchase program.

We have already seen considerable purchases to support the peripheral nations; these purchases are draining reserves from the wholesale inter-bank lending market. This, in turn, has deleterious consequences for the wider real economy via reductions in bank lending and introduces the prospect of a second credit crunch.

So far, the ECB has been buying bonds on a sterilised basis using its balance sheet to fund purchases, meaning there is no increase in the money supply. With the need to support an enlarged group of sovereigns, the ECB may be forced to consider increasing the money supply to allow it to make unsterilised purchases of bonds. This policy change to quantitative easing has significant political barriers to overcome, however, principally in the form of German opposition.

The theme that has been driving bond markets in 2011 has been the reappraisal and re-pricing of peripheral sovereign bond debt. As we move into 2012, I think investors need to keep a close eye on the bond yields of Belgium, Austria and France

In 2012, the theme driving markets may well be the reappraisal of core, AAA-rated sovereign debt. We have started to see the beginnings of this process and the markets are ahead of the rating agencies once again.

Are we entering into a final phase of the crisis?

Given we are talking about AAA sovereign nations now becoming involved, this has to be the final phase of the crisis, simply because there is nowhere else for contagion to spread.

The wave of deleveraging, and the reassessment of risk that accompanies it, will have washed right through our financial economy. While 2012 is likely to be a troubled year, the attendant volatility that we see in financial markets should also mark the last down-leg of this crisis.

The speed at which the crisis has moved from Italy to Spain and now core Europe has been alarming, but it also suggests a crescendo. The evolution of the crisis path now suggests a tipping point at which quantitative easing by the ECB becomes palatable to Germany as the only option that avoids a eurozone break up. The path between the inconceivable and the inevitable has now become very short.

How should investors be positioning themselves?

Within equities, investors should focus on high-quality, defensive companies with stable and reliable earnings streams, which pay high and sustainable dividends. In Europe, dividend yields are considerably in excess of their 15-year average and there are a number of equity funds which are targeted towards this particular income-yielding section of the market; the income offers a measure of protection to investors against further market volatility. These companies are typically large, robust household names like Unilever, which may well prove to be a relatively safe place for many investors to park some of their cash, when you consider the stresses that the banking system remains under. I also think investors will certainly want to be exposed to emerging markets as we emerge from this crisis.

Dominic Rossi – Global Chief Investment Officer Equities - Discusses Italy – November 2011

The situation in Italy and the fact that their borrowing costs hit unsustainable levels means that markets have quickly breached the line that was drawn in the sand at the recent European Union (EU) Summit. This is characteristic of the pattern that has become typical so far in this crisis: markets are forcing investors and policymakers to confront “the unthinkable” as events once regarded as unlikely become realistic possibilities.

I think the situation has become more challenging now, because the window of opportunity for the EFSF (European Financial Stability Facility) Bailout fund to rescue Italy has passed. We now appear to be on an inevitable path towards bolder ECB involvement in the shape of quantitative easing, however, there is likely to be more volatility before we reach that juncture.

What next? Could we see some other countries exit the eurozone?

Ultimately, I see two potential outcomes. First, the crisis continues to deteriorate and begins to impact more seriously the core countries of Germany and France. German banks and insurers become embroiled to a point where the German government is persuaded that quantitative easing is the only option. The second outcome is that the Germans do not accept that solution at any cost – under this scenario, I think we would have to give significant weight to the possibility of a break-up of the eurozone.

How has the nature of risk changed?

I think we will need to re-write the rule book on risk as a result of this crisis. The concept of “risk free” in terms of developed market sovereign bonds has clearly been shaken to the core. Within equities, the crisis has implications for how we assess stocks. We must consider the financial health of a company even before we analyse its fundamental business model. We must assess its balance sheet, its debt position and whether it has sufficient to cash to run and invest in its business.

Where do you think investors should be looking for opportunities in this environment?

Within equities, equity income trumps equity growth. Investors must consider equities on a total return basis at a time when the yields available on many stocks are almost double what the safest government bond markets offer. From a geographic perspective, I think investors need to seek out the parts of the world with solid fundamentals – economies with current account and fiscal surpluses. This typically means the emerging markets. We are very much in a two-speed world now in economic growth terms. The weaker global growth environment (stemming from slowing developed world growth) actually allows many emerging markets more room for policy manoeuvre than they had. Economies like Brazil and China can take the necessary steps to bring inflation under control. These markets have been indiscriminately sold off, largely as a result of deteriorating equity risk sentiment, yet I believe their markedly better fundamentals will see them perform reasonably well, going forward. 

Andrew Wells – Global Chief Investment Officer Fixed Income - Discusses Italy – November 2011

Berlsuconi’s announcement that he would stand down was initially greeted positively, but it was quickly replaced by acute uncertainty over what comes next in the minds of bond investors. In most key regards, this is a crisis of confidence in the Italian government and the political framework. There were simply no buyers of Italian bonds at the start of this week, except the European Central Bank (ECB) via its Securities Market Program (SMP).

On the positive side, the ECB is now buying Italian bonds more aggressively and the government managed to sell its full €5 billion (A$3.7bn) allocation at auction - one-year bills were sold at a lofty average of 6.09%, but that is considerably lower than the peaks seen in the last few days when yields breached 7% across the board.

Given the size of, and rate of increase in, Italian debt, combined with the deteriorating growth outlook for the Italian economy and tightening fiscal conditions, a ‘soft’ restructuring may now be inevitable. Markets appear to recognise this fact and recent market action can be seen as an attempt to force the European authorities to act with greater magnitude.

What next? Could we see some other countries exit the eurozone?

The probability of a member state leaving the eurozone has risen in recent weeks. We first saw this possibility take shape with Greece, which was recently being described as a ‘unique situation’. However, it seems conceivable that two or three countries could consider an exit, particularly if a precedent is established. This is certainly not a possibility that investors should be complacent about.

Where do you think investors should be looking for opportunities in this environment?

Investors should be favouring corporate bonds over government bonds in portfolios given the ongoing reappraisal of sovereign risks. The characteristics once sought in government bonds are now better found in high-quality, investment grade corporate issues. High yield bonds also offer significant value if investors are prepared to take on a little more risk. In my view, the current dislocation in financial markets has made many of these bonds attractively priced at their current ‘distressed levels’.

Yet, the fundamentals of many companies in the corporate sector remain healthy – a fact which is disconnected from the low valuations now available. Most companies have kept their cost bases under strict control. They continue to have access to bank lending, even if terms have become tighter, and they have actively managed their own refinancing needs in the past two years to protect themselves from this kind of volatility. These factors should contain default rates at lower levels than the market appears to be discounting. The total return of the high yield asset class is now supported by a very strong income stream, with some of our high yield funds currently yielding over 15%, this income goes a long way to protecting total returns from this point.

I also think that investors need to consider the tail risk of resurgent inflation in developed markets. It is not on people’s radar screens right now, but if we are moving towards a situation where quantitative easing by the ECB becomes more likely, then it will become a major talking point again. Breakevens (the difference between yields on nominal government bonds and inflation-linked government bonds – an indication of the inflation bond markets are discounting) are phenomenally cheap right now on a historical basis and, in time, this could later prove to be an opportune time to get exposure to index-linked bonds. 

“The European Union leaders surprised positively after the squabbling of recent days but were low on detail on the critical point of leverage for the bail out fund to backstop Spain and Italy. We may have to wait until November for specifics of possible BRIC/IMF (Brazil, Russia, China, India / International Monetary Fund) involvement alongside a partial insurance scheme for primary issuance.

The critical test will be what happens to the eurozone economy. Provision of liquidity goes hand in hand with further austerity in the periphery with Italy now the focus. Meanwhile, if the United Kingdom experience is any guide it will be hard for national regulators to prevent banks deleveraging their balance sheets now forced public capital injections are threatened.”

Dominic Rossi, Global Chief Investment Officer Equities at Fidelity Worldwide Investment - October 2011

“It looks like we have an agreement on three key elements:
- a new €130 billion Greek bailout
- €106 billion bank recap, and
- a voluntary 50% write-down on Greek government bonds for private bond-holders.

Markets have reacted positively to the intent shown by policymakers, yet my overall view is that the deal is not the game changer investors are looking for. Italy's 120% debt-to-GDP (gross domestic product) doesn't look any more sustainable t