Portfolio manager outlooks for 2012

Australian equities

Paul Taylor, Head of Australian Equities at Fidelity Worldwide Investment and Portfolio Manager of the Fidelity Australian Equities Fund - December 2011

“Banking crises are generally followed by sovereign debt crises and these tend to be followed by increasing inflation.

“The events in Europe are part of this bigger cycle. It’s not the end of the world, but you have to be aware of what it means - for the local market, local companies and local investors. One thing that the latest gyrations in Europe will definitely lead to is slower global growth and a prolonged recovery period. This will impact our currency, exporters, consumer demand and more.

“Despite this, there are still pockets of good growth in the local economy and market, with several companies remaining in good shape and growing well – and not valued as such.

“We’re in a very different environment to that of the original global financial crisis (GFC), which was all about debt on corporate balance sheets. Through the GFC Australian companies repaired their balance sheets and are now in a much better position. Though some strengthened more than others. Investors need to take a back to basics approach and seek good companies with good cash flow. Investors need to find the structural growth opportunities, find which companies are growing faster, which companies have really good industry positions and the best growth opportunities.

“Besides looking for companies that are continuing to grow I am also looking for those that are providing income. Stocks that can provide both growth and yield will be bid up by the market. There are several listed companies that are paying dividend yields that are well above that of bank term deposit rates and these will increasingly be in demand from investors seeking consistent income from the market.

“What investors should try to do, what I am trying to do, is to withdraw the macro influences from a portfolio as much as possible. You can only do this by taking a bottom-up stock picking approach.”

Kate Howitt, Portfolio Manager Australian Equities – December 2011

“There are four issues that will drive markets in 2012. One of the main factors to include markets in 2012 is that it will become clear that ‘halfway house’ solutions for the Euro won’t work, so 2012 will either see a push towards European fiscal integration, or the dismantling of the single currency in its current state. Germany must decide on the fate of the eurozone – and this will have significant impacts for the rest of the global economy.

“A second factor is that markets will grapple with the ability of the US to maintain its current slight positive economic momentum. US election-year inertia means fiscal policy is unlikely to be a factor, either in stimulating the economy or in implementing the cuts required to by the extension of the debt ceiling. If the US economy needs further stimulus it will again have to come from the Fed, most likely this time in the guise of asset purchases of residential mortgage backed securities in an attempt to provide relief to homeowners via lower mortgage rates.

“A third factor will be the outcome of the current policy debate in China between reformers who would like to see a faster rebalancing of the Chinese economy towards consumption by continuing the squeeze on investment, and the provincial authorities who are supportive of reflationary policy moves.

“The outcome here has obvious implications for China’s demand for raw materials and hence Australia’s terms of trade, commodity stocks as well as domestic interest rates. We know that the Reserve Bank of Australia (RBA) will be responsive to any weakening in the economic outlook for Australia, but it also seems clear that it doesn’t want to see house prices grow to any meaningful extent in the interest of restraining household debt levels and so it will remain vigilant to any signs of housing market exuberance.

“Fourth, the net outcome of these situations will be seen in the currency markets. A stronger US$, ongoing restrictive Chinese policies and lower RBA cash rates would weaken the A$; while reflationary moves by either the Fed or the Chinese authorities could easily see the A$ sustained back above parity for much of the year.”
These factors would have different impacts on different asset classes over 2012.

“The RBA appears to remain comfortable with flat nominal house prices. So property is unlikely to be the stand-out asset class.

“Given the macro uncertainties it is also hard to see cash returns trend up in the next 12 months, with bank deposit rates already dropping recently. Accordingly, cash may no longer be king and its attraction is likely to weaken.

“That leaves us with equities. But, why would you possibly want to buy equities when the world is so grim? Stepping back from the headlines, we know that the local equity market is offering close to a 5% dividend yield - with even higher yields from selected blue chip stocks such as the banks, Telstra and REITs. We know that our banks are some of the strongest in the world, corporate gearing is at 30 year lows and earnings are generally below cycle-peaks, with the market offering reasonable valuations, yield support, solid fundamentals and the potential for reflationary policy moves.

“These factors suggest it may not be too long until we are back to 2009 where there was a greater risk to not holding equities. Markets tend to ‘climb the wall of worry’. So even though Europe is unlikely to be ‘solved’ in any quick way, an end to the uncertainty would likely give rise to a relief rally.”

Asian equities

David Urquhart, Portfolio Manager Fidelity Asia Fund - December 2011

“The Organization for Economic Co-operation (OECD) forecasts the Asian region to grow around 7% in 2012 and 5.6% for South East Asian economies. That’s below the 8.5% forecast for China, but above the 4% projection for Australia.

“Although Asia is not immune to a slowdown in the West, growth rates in Asia are also slowing, but it’s proving more resilient to a global economic downturn than in the past. One reason is that the region is significantly less reliant on the West than previously. For example, today it’s less reliant on the West as a market for its exports, with over half of Asia’s exports now being traded within the region.

“The region’s steadily rising labour force will provide a source of higher growth. The labour force is forecast to grow at 1.5% a year for the next 10 years, compared to Europe and the US which are growing at just 0.3%. As people enter the labour market they become economically productive, rather than being a drain on an economy. More people will be able to earn and therefore spend, buying goods and services that companies provide.

“The rising labour force is also adding to the growing middle class in Asia, which is expected to almost double to over a billion people in the next five years. China is expected to report the biggest absolute increase, while India and Indonesia will have stronger percentage growth.

“Another positive for the region is that while most Western economies have a negative current account balance, most Asian nations have a positive one (with the notable exception of India). This provides another reason for optimism about Asia, as the West slows, is that policymakers in the region still have more growth-supportive options at their disposal than their developed market peers. Asian economies still have the ability to use both monetary and fiscal policy to help stimulate domestic demand, while in the West high levels of government debt have made Fiscal policy tools unavailable. Most Asian central banks have been tightening their monetary policies in the past few quarters so they now have flexibility to relax interest rates and credit policy in case of a severe economic slowdown outside their borders.

“It is similar, with foreign exchange (FX) reserves. Asia accounts for 63% of global FX reserves, with China accounting for half of these at the end of 2010. “Asia still has the capacity to lend and borrow. This will help corporates in the region.

“Corporate debt levels are the lowest they have been since 1981 at 25.8% debt/equity. They have been building increasingly large reserves of cash and significantly de-leveraging their balance sheets following the Asian Financial Crisis in 1997 and the Global Financial Crisis in 2008. Strong balance sheets, cash flow and rates of return have put Asian companies in great shape. Though some companies will do better than others in this kind of environment.

“There are several other factors that will further contribute to Asia’s growth next year - and beyond - including increasing participation rates in tertiary education, rising labour skills, increasing urbanisation, developing credit markets and so on. All these should further underpin the growth opportunities of companies and their share prices in the region.

“Overall, Asia’s healthy financial system, robust domestic demand, low debt levels, high savings rates and the emergence of China as an anchor of growth for the region will continue to be supportive of multi-year growth in the region.

“This is one region why the Asia (ex-Japan) region has already tripled its representation in the MSCI World All Country Index from 3% in 2003 to 9.9% by mid 2011.

“By being in better economic shape we expect Asian equity markets - which are currently following the lead of US markets – have greater upside when global markets do improve.

“I have returned to a slight overweight to China, as the government in Beijing should start to loosen monetary and fiscal policy there as inflation concerns reduce and growth slows in response to the slowing global economy. This should help the growth of local companies. I also like Indonesia and Thailand, as we have identified some great businesses there with great growth potential.

“This is key, as while the region as a whole is one of the strongest in the world it is important to identify, from the bottom-up, those companies that are going to deliver earnings per share growth stronger than the market anticipates and currently at very attractive valuations. These stocks should perform well over the next few years even in the challenging macro environment.”

Chinese equities

Martha Wang, Portfolio Manager Fidelity China Fund – December 2011

“China’s economic growth is expected to moderate as external demand from Europe and the US slows and domestic economic activity falls.

“This means, that after tightening for the last two years, the policy environment will be more benign going forward. The recent fall in inflation pressure has given the government some room to ease its monetary policy. Headline gross domestic product (GDP) growth will depend on the balance between looser policies and weaker external demand.
“I am positive on the outlook for the next 12 months. There have only been a few periods in China’s stock market history when valuation levels have been as attractive as they are currently. Most of the macro risks have been largely priced in and the risk/reward outlook is very favourable.

“In terms of stock ideas, I favour the consumption space where I am finding many opportunities with attractive valuations.”

David Urquhart, Portfolio Manager Fidelity Asia Fund - December 2011

“Slower global growth and the resultant lower commodity prices will help to reduce some of the inflationary pressures in the Chinese economy. This will provide policy makers a reprieve on what was expected to be further tightening measures.

“I have moved China from underweight to an overweight. Currently, China is trading at a forward P/E ratio of 9.5x, which is at a significant discount to its 5-year average of 13.5x.

“I am also definitely seeing more attractive buying ideas in China. In an environment of slowing global growth, the focus has shifted away from growth opportunities – where risks of disappointment are increasing, and more on the value opportunities that exist in the market. Typically when you see the P/E of a stock that is the same as the sustainable dividend yield you are getting a great buying opportunity. This is especially so when these companies still have good prospects for growth. Recently there have been an increasing number of attractive opportunities that have emerged.”

Anthony Bolton, Chinese Equities Portfolio Manager - December 2011

“The next 12 months should be a defining moment for Chinese investment when investors realise the economy is not about to collapse and the tightening period is over. We have been through an extraordinarily volatile year but I believe that when the dust settles and things calm down, investors will focus on relative growth rates they can get in different parts of the world.

“I feel very strongly that this will result in money flowing out of developed markets that have sovereign debt problems and very mediocre prospects over the next few years into the faster growing emerging markets like China.

“I am not saying that China is not immune to a slowdown in the developed markets. The country’s growth rate will slow down but it will still expand by about 7.5% to 8%, which will be very attractive compared to the rest of the world.
“Inflation has been a key issue in 2011 but it has already started to come down. A slowdown in inflation has allowed the Chinese authorities to stop tightening monetary policy. This should be positive for the markets. The speed and format of further loosening will depend partially on how the domestic situation develops from here and whether the developed world returns to recession.

“Some of the other issues that investors in China have been focusing on are bank bad debts and falling residential property prices. There are some real challenges regarding potential future bad debts, but the government has the financial resources to address these. The outlook for residential property in 2012 is poor. I am more concerned about the uncertainty due to the important political changes that are due over the next 18 months and whether they will lead to a change in policy direction.

“I continue to be positive on the consumption and services sectors and remain underweight in exporters, commodities, infrastructure companies, banks and property companies. Consumption and services are not immune to any slowdown in China, but I believe these are the areas with the best longer term outlook where structural trends favour them. Even with a slowdown in GDP growth, I expect these areas to outperform the general economy. If I am wrong about the world outlook, and a new recession were to commence leading to China embarking on another stimulus programme, these areas would likely be direct beneficiaries.”

Global equities

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.”

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 – December 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.”