Alva Devoy

As the debate over active vs passive continues to rage in Australia, differing views on the benefits of ETFs have often been confusing for investors trying to work out the best approach for their hard-earned savings.

With the launch of Active ETFs, a new dimension has been added to the debate – investors choosing an ETF now have the choice between active and passive strategies.

To help improve investor understanding of these different choices, Fidelity International has made an e-book available to all investors.  Entitled: ‘Introducing Active ETFs’, it can be accessed through Fidelity International’s online learning hub.

Alva Devoy, managing director of Fidelity International in Australia, says the e-book shows how ETFs provide the characteristics investors are often seeking – access to active management, diversification and liquidity.

“Facilitating access to actively managed strategies on exchange, through the Active ETF vehicle, allows investors to build diverse portfolios in a straight forward and transparent way,” says Ms Devoy.

“Investors can decide which strategies suit their objectives best, be they active or passive, and combine these options easily to help them achieve the outcomes they are seeking, such as the opportunity to outperform the index and also to defend their portfolio against downside risk in periods of volatility.”

Active ETFs are relatively new in Australia having first launched in 2015.  Since then, they have become part of the debate whether active or passive is the right approach for investors.

“This can be confusing for investors and their advisers when it comes to choosing ETFs,” she says.

“At Fidelity, we don’t believe it’s a case of active or passive. Active plus passive can be a great combination for clients, especially if keeping fees as low as possible is a priority for investors. At different points in the investment cycle, such as during increased volatility, a higher allocation to active may be more appropriate, while when all markets have fallen precipitously, a higher allocation to passive should achieve good returns for a lower cost.

“Already, Australians are seeking to increase the diversification of their portfolios. Active ETFs offer an easy way to do this, as many clients will already trade and hold individual stocks and shares. With an increasing number of Active ETFs now available, buying units in an actively managed fund can be done in exactly same way and the holdings can be shown side by side in one portfolio.

“We are committed to providing education to Australian investors on the benefits of this vehicle, especially in enhancing diversification of investments and also in providing risk adjusted returns.

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Alex Duffy

Fidelity Active ETF Global Emerging Markets Fund (ASX: FEMX) is managed by experienced portfolio manager Alex Duffy and provides investors with access to a concentrated portfolio of 30-50 quality emerging market companies.

Alex aims to identify companies that are well positioned to generate returns through market cycles and have also demonstrated a strong corporate governance record.  He is supported by Fidelity International’s global network of 140 research analysts and 400 investment professionals.

Alva Devoy, Managing Director of Fidelity International in Australia, said emerging markets were the ideal asset class for Fidelity to launch its first active ETF. “As the global economy slows, our clients are increasingly looking to us to help them diversify their sources of returns.  Developing economies offer a fantastic opportunity due to a range of factors such as favourable demographics, the development of the middle classes and increased spending power.

“However, it’s important to understand that they are not without risk and in this uncertain market environment, active management is crucial. That’s why we’re excited to be able to offer investors access to our emerging markets fund through the convenience of an Active ETF.”

Alex Duffy, Portfolio Manager of Fidelity Active ETF Global Emerging Markets Fund, comments:  “Emerging markets have always been important to the global economy due to their size.  Over the last 20-30 years, we’ve seen emerging market GDP go from 30-40% of global output to almost 60%. In my view, this makes them too big to ignore.

“While some of these markets have faced tough times in recent months, we continue to find opportunities to invest in good quality businesses exposed to enduring themes such as the growth of consumption.  My focus is on those companies with strong corporate governance, strong balance sheet structures and good quality return profiles, all at a valuation that provides a margin of safety.”

Fidelity Active ETF Global Emerging Markets Fund (ASX: FEMX) is expected to open for investing on 29 October.

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Ian Samson

“The US has slapped a 10 per cent tariff on US$200 billion of Chinese goods, threatening to increase this to 25 per cent in 2019 in the absence of a trade deal. Meanwhile, China retaliated with its own levies of up to 10 per cent on US$60 billion of US imports.

“We estimate the measures will lop 0.6 per cent off Chinese growth in 2019, assuming the US implements the higher 25 per cent tariff. This alone is not a significant cause for concern but it will add to China’s ingrained slowdown following the clampdown on the shadow banking sector and the loss of infrastructure stimulus as a growth driver.

“Falling infrastructure investment growth is arguably more concerning than tariffs on exports to the US, which make up less than four percent of the economy. Investment in infrastructure had grown at around 20% annually between 2013 and 2017, before plummeting this year into contractionary territory.

“However, the tariffs could exacerbate China’s current account deficit. The country has been running a US$35 billion annualised deficit in the first half this year, following decades of surplus. A quick estimate would have this rising to US$135 billion (around one per cent of GDP) as a result of the new tariffs, although this could be less if China manages to redirect these ‘lost’ exports to countries other than the US.

“This would put more pressure on the renminbi, which we don’t think is priced in. That said, Beijing ultimately maintains a lot of control over the currency through capital controls, so we don’t expect any disorderly price moves. Overall we expect China to continue with its relatively minor easing measures seen of late, as much for domestic reasons as for tariff concerns.

“The impact of the tariffs on the US should be small, but the transmission channels may be unpredictable and could well surprise us. Still, the tariffs don’t do much to change our base case for how the US economy will progress. Another year of counter-cyclical fiscal stimulus will keep growth above trend until late 2019, when the fiscal impulse turns into a drag.

“We’ve seen estimates that the tariffs will provide a boost to US inflation of between eight and 30 basis points. This will be a one-off, which the US Federal Reserve would almost certainly look through and not adjust its rate path in response.”

US exports are less important to the Chinese economy than infrastructure investing

Source: CNBS, Haver Analytics, September 2018

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Oil prices have responded to political volatility in the Gulf.

In 1973, Egypt and Syria launched a surprise attack on Israel during the Jewish religious festival of Yom Kippur. The swift arrival of arms from the US helped Israel repel the assaults.

Opec nations, upset at US support for Israel, cut oil production and placed a sales embargo on the US and any European country that helped Washington funnel arms to Israel. Oil prices surged nearly 400% over the next 12 months in what became known as the first oil shock of 1973-74.  The result was the stagnation of the 1970s.[1]

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Michael Collins

In Europe, there’s a number that punctures immediate hopes for the region. It is the amount of bad debts that sit on eurozone bank balance sheets. Accounting firm PwC estimates that non-performing loans now exceed 1.2 trillion euros (A$1.8 trillion), a figure that has doubled in four years.[1] Until its banking system is steadied, Europe’s economy will be deprived of the lending it needs to recover, heightening the risk that only years of stupor lie ahead.

Forcing banks to confront their woes ranks among the most onerous tasks confronting policymakers in the eurozone, where non-performing loans will peak this year at 7.6% of gross lending, according to Ernst & Young.[2] The EU in October shifted a chunk of the responsibility for fixing banks to the European Central Bank. Late next year, the central bank will assume from national regulators sole responsibility for supervising large banks. The ECB will thus be in charge of ensuring that eurozone banks shed 3.2 trillion euros in assets (which means reduce their lending to trim their balance sheets by about 7%)[3] to comply with Basel III regulations by 2018, according to an estimate by the Royal Bank of Scotland.[4] While shifting supervisory powers to the ECB marks an achievement for Europe’s policymakers towards the banking union the area needs, they need to take even bigger steps to create the proper infrastructure needed to safely and swiftly restructure Europe’s banks. The challenge for lawmakers is that popular support is working against the formation of a union that is needed to ensure that the common currency survives.

A banking union entails having a uniform rulebook, one supervisor for all banks (rather than palming off smaller banks to national regulators as Europe has done at Germany’s insistence), a well-funded bank-resolution mechanism under central political control and a deposit-guarantee mechanism across an area. The key advantage of a banking union is that it spreads the costs of banking failures across the area under coverage, rather than allowing the pain to devastate the state (in Australia’s case) or country (in the case of the eurozone) where the bank is headquartered.

A banking union is not a cure-all, of course, and dollops of liquidity from the ECB and accounting and other tricks are propping up Europe’s banks anyway for now. A banking union won’t nullify the solvency threats from inadequate capital, a jobless crisis and the deflation taking hold in peripheral Europe. Its formation may prompt banks to over-prioritise boosting capital over lending. It won’t lower the equity and bond crossholdings among European banks that make the region’s banking system so vulnerable. But a banking union is the best way for Europe to cope with the excessive amount of soured loans to households and business that trouble bank balance sheets. It will help diffuse the threat posed to governments by oversized banks – due to excessive lending, eurozone banking assets amount to 3.5 times GDP compared with about two times in Australia, Canada and Japan and less than one times for the US. Perhaps far more significantly for Europe is the political symbolism involved with forming a banking union. Big leaps towards a banking union would verify that European policymakers are serious about creating the political, fiscal and financial integration Europe needs to surmount its crisis. For any banking union involves genuine political entwining and some fiscal sharing.

The credibility test

While the EU-controlled European Banking Authority is working on a single set of rules for European banks, the challenge of securing all the steps needed for a banking union for the euro area became apparent when the ECB in October said it will prepare for its supervisory role by conducting a review of the eurozone’s 130 biggest banks. The aim of the exercise that will cover 85% of the eurozone banking system by assets is “to foster transparency, to repair and to build confidence”, the central bank said announcing the review that will include tests on how resilient balance sheets are to shocks.[5]

When asked on Bloomberg Television whether any exam that aims to build confidence sounds rigged, ECB President Mario Draghi was forced to respond that “banks do need to fail” to uphold the integrity of the review.[6] His attempt to protect the validity of the ECB’s bank assessment rang hollow to many used to eurozone fudges – as if the ECB is going to reignite the eurozone crisis by flunking a bunch of its largest banks. It reminded many of the stress tests in Europe in 2010 and 2011 that quickly lost credibility when banks that passed soon needed rescuing.

The announcement of the ECB’s review served to highlight the inadequacies of the steps Europe has taken towards a banking union. The big failure is to establish a jointly funded mechanism to handle bank failures under central political control. A major barrier to any agreement is agreeing on who bears the cost of managing bank failures and who decides that a bank should be allowed to collapse.

The only sizeable progress Europe has made towards a joint bank-rescue mechanism is to sanction off 60 billion euros within the 500-billion-euro European Stability Mechanism to help banks if a Europe-wide system is ever put in place to cope with bank failures. This is an underwhelming amount of money given the estimated numbers of bad loans to households and businesses on Europe’s bank balance sheets. A further restriction is that the money would only be deployed if national governments agree to as-yet unformulated conditions. Another complication is that the rescue fund is under the political control of the so-called troika, the European Commission, the ECB and the IMF, a setup ripe for squabbling. Until policymakers agree on a centrally controlled authority to handle bank failures, national regulators (governments) will stay the backstop for collapsing banks headquartered in their country. This only reinforces the potential all-fall-down embrace between weak banks and debt-laden governments.

While European leaders have set a deadline of 1 January 2015 to have a common resolution system in place, they are unlikely to meet that timetable if no legislation is passed before European parliamentary elections in May. A meeting of European finance ministers in November failed to make any progress towards a year-end deadline to agree on how to fund a joint banking backstop, in the hope of having a European resolution mechanism in place by the time the ECB takes over supervision.

Fudging

The core reason why a banking union is largely stalled in Europe is politics. Germany is the biggest impediment. Berlin says that treaties governing the EU need to be changed to create a single resolution mechanism, a view that stalls progress because changes to treaties usually mean undertaking the slow and uncertain process of gaining voter assent. Berlin opposes the EC having the power to decide whether to restructure or dissolve a troubled bank and wants to keep this decision with national governments. It is insisting that creditors get wiped out (bailed in) as a condition to bank access to EU rescue money, even though Draghi has warned that such bail-ins risk alienating private investors. It is thwarting a eurozone-wide deposit insurance scheme. It is resisting ECB and EU requests to hand its small banks over to ECB supervision.

Berlin’s motives are more than simply wanting to protect its taxpayers from bank failures in other eurozone countries. It thinks that keeping supervision at the national level is the best way to hide the inadequacies of Germany’s banking system that includes some dodgy multinational and some suspect smaller regional banks. The decision to make the ECB responsible for supervising large banks only was a sop to keeping Germany’s generally small banks under Berlin’s political protection.

While politicians are hamstrung, Europe is experiencing a credit crunch – loans to the private sector fell 2.1% in the year to October.[7] At the same time, European banks are financing wobbly firms to avoid capital losses and are allowing troubled borrowers to technically default in a way that prevents write-offs hitting the balance sheets. (The simplest way to do this is to extend troubled loans and pretend they are sound, a drill that bankers call “forbearance”.) Such practices can’t go on endlessly. Maybe concerns that the eurozone crisis will reignite sooner or later will energise Europe’s politicians into taking leaps towards a leaner, better-capitalised and unified banking system that is capable of providing the financial lifeblood that businesses across Europe needs to thrive. The flawed structure of the euro, Europe’s unemployed and all those bad debts demand nothing less.

by Michael Collins, Investment Commentator at Fidelity

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© 2013. FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

Financial information comes from Bloomberg unless stated otherwise.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment.

Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.

The post Bad debts hobble any European recovery appeared first on AdviserVoice.

Richard Lewis, Head of Global Equities, Fidelity Worldwide Investment, gives his thoughts on whether the worst is over for Europe and the challenge the euro poses for policymakers.

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In this article, Fidelity’s Nick Peters discusses the art of selecting the right manager, why monitoring performance is critical, and why it could make a difference to your overall returns.

Why is choosing the right manager important ?

Indeed, in recent years, the level of dispersion between top and bottom quartile managers has risen from around 10% to nearer 20%. The chart below shows, over five years, that the differential between the best and worst manager in the UK is extremely significant.  Theoretically, it is entirely possible for an investor to be completely correct in their asset allocation decision, only for them to lose money as a result of picking the wrong investment vehicle. Picking the right managers is critical.

No particular style of investing works over all time periods, so combining managers with different styles and processes can help investors to reduce their risk and smooth their investing journey. But finding the right manager is just the start; managers need to be monitored on an ongoing basis, with changes made in a timely and efficient manner when required.

The bedrock of successful manager selection is a rigorous research process.  In terms of technology and resources, a broad global capability is important to ensure that good managers are not overlooked.  It takes considerable time and effort to gain a deep understanding of each manager’s investment process and the drivers of their likely performance. The most effective approaches to manager selection will invariably combine both qualitative and quantitative analysis.

Running the Numbers

This is a vital part of the process and involves looking at both historic performance and fund holding data. The volatile markets of recent years have provided investors with a rich source of data for analysing fund manager behaviour. While past performance is no guarantee of future returns, it seems reasonable to approach a large universe of funds by screening out those which, for example, have never added significant alpha. It is important to assess performance during different market environments. For instance, for a manager with a more defensive philosophy, it is reasonable to expect them to preserve capital in difficult markets and to perhaps lag in strongly rising markets.

Meeting the Manager

The importance of detailed qualitative analysis of managers through regular face to face meetings conducted by professional investors should not be underestimated and forms the cornerstone of any manager selection process. Qualitative analysis usually targets three main factors – people, philosophy and process, and portfolio construction, as well as trying to assess softer factors such as passion, focus and organisational fit.

Investment management is a people business and assessing the fund manager, his team and wider resources is essential in understanding whether past returns can continue. Because every manager has a different investment process, there is no right size of team or organisational structure. What is important is that the organisation provides the necessary level of support for the fund manager. An alignment of interests between the fund managers, their teams and clients is also a positive sign as well as succession planning to mitigate the reliance on one key individual. Another important aspect is length of tenure within the team; a rapid turnover of analysts raises questions.

Identifying a manager’s edge versus similar funds is an important part of the discussion on philosophy and process. In other words, what is it about the process that is likely to lead to consistent performance in the future?

Alongside obvious factors that should be considered such as research process and portfolio construction, there are other intangible factors that need to be looked at in order to understand how a manager makes their investment decisions. A skilled manager has a differentiated perspective and hence tends to act differently on the same information.  Crispin Odey is a good example of a manager with such skill. His interpretation of the various cross-winds impacting global stock markets since the Financial Crisis has boosted his fund’s overall performance.

Another important indicator is a culture of continued innovation to maintain the performance edge.  The UK equity boutique Heronbridge  has an annual meeting specifically to discuss what went wrong in the previous year and what improvements can be made to the process to reduce the chances of errors (and underperformance) in the future.

Other indicators of success include signs of commitment, high internal standards and involvement in the investment process.  Alken, another boutique investment manager has an innovative approach to analysis: they literally let research analysts do what they want. Their team of six analysts are well aware that they are remunerated on ideas getting into the final portfolio. However they are given as much time as they require to analyse an idea before presenting it to the portfolio manager. This leads to well researched and thorough stock due diligence.  Most Alken analysts have a batting average (number of outperforming recommendations/total number of recommendations) of well over 50%.  Many active managers have a success rate of below 50%.

The Devil is in the Detail

Looking at the historic exposures within a fund over time allows an investor to conduct the “Ronseal test” on a manager – does the fund do what it says on the tin? It is important to identify those managers who not only have a solid process, but who apply that process consistently over time and do not change their style. It is important to verify the performance is consistent with the manager’s process and style.

For example, warning bells should sound when looking at a manager with a value style has a portfolio  full of expensive stocks. Managers who invest outside their core area of expertise may be lucky and pick the stock that does work, but it is skilled managers who will provide consistent performance over time.

Of equal importance as finding the right manager is the ongoing monitoring.  The aim is to make sure the process continues to be consistently applied over time and to identify inconsistencies between the process and what is subsequently happening within the portfolio.  Understanding the key drivers of underlying stock holdings is an advantage when assessing the manager as this makes it easier to understand the rationale for buying a stock and to make sure this is consistent with the fund manager’s approach.

For example, a small cap manager who has always focused on finding growth companies with robust balance sheets could be tempted to sacrifice the “quality” requirement as the growth stocks become expensive. This could have negative implications for performance, but more worryingly from an investor’s perspective is the fact that it represents a move away from the manager’s successful historic investment process, making it more difficult to have comfort that the pattern of strong past performance can continue.

It is difficult to overplay the importance of the qualitative aspects of manager selection and the advantages of building a long term relationship with fund managers. This is especially true of managers with short track records or those who work at boutiques. Investing in the right vehicle, as we are all aware, can have significant implications so finding the right manager and monitoring them is critical.

By Nick Peters, Portfolio Manager within Fidelity’s Investment Solutions Group

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  © 2013 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Federal Reserve building, Washington DC.

Stan Druckenmiller, a star US hedge-fund manager, slams the Federal Reserve for “running the most inappropriate monetary policy in history”. But what seems to scare investors more is the prospect that the Fed’s quantitative easing will end soon.

Financial markets wobbled after Fed Chairman Ben Bernanke on May 22 said the Fed could wind down the unorthodox monetary tool, whereby a central bank, having already slashed its cash rate to close to zero, conjures liabilities on its balance sheet to buy financial assets. The aim of the policy is to lower long-term interest rates to encourage consumers to spend and businesses to invest.

The policy, first tried in Japan in 2001, has helped the world avoid the deflation and depression that dogged the 1930s. While the ability of quantitative easing to spur economic growth is more debatable, for it has failed to stir a lasting recovery, it’s clear the practice carries side effects, including beneficial ones for financial assets.

Druckenmiller and others say the Fed’s asset-buying misallocates resources (hard to prove) and will unbuckle inflation expectations (no sign of that happening). Other alleged spin-offs are so-called currency wars (inadvertent) and inequality because the practice favours asset owners (as the Bank of England admits). The asset-buying has certainly propelled bonds to record low yields, even Netherland bonds that were first issued in 1517, and boosted stocks to fresh peaks.

A definitive assessment of quantitative easing must wait until the practice ends. Many worry it will finish badly. They fret that the great monetary experiment of our time is yet to be halted seamlessly in any country as its economy reignites. Japan has conducted bursts of quantitative easing over the past 12 years (thus temporarily ending it), but without revitalising its economy. But there are no reasons why quantitative easing can’t end smoothly enough for the US as its economy rebounds. It may, however, prove more troublesome for other parts of the world.

The intentions

The declared Fed policy is that it will reduce its asset purchases worth US$85 billion (A$90 billion) a month in steps any time now, if economic, especially jobless, readings justify a less-promiscuous policy. The Fed expects that by mid-2014 it will have stopped the asset-buying that has swelled its balance sheet to US$3.7 trillion from US$894 billion at the start of 2008. By then, the Fed expects the jobless rate to be under 7%, from a four-year low of 7.3% in August.

The Fed can alter, even reverse, its actions at any time if the economy changes beat. Bernanke, aware that policymakers wrecked recoveries in the 1930s by braking too soon, says he won’t allow “a premature tightening”. But such comments to Congress have failed to soothe investors and speculators. Since the end of May, these “feral hogs”, as Richard Fisher, the President of the Dallas Fed described them to the Financial Times, have walloped bonds (thus boosted interest rates) and driven up the US dollar while undermining stocks, especially emerging ones, and commodities.

The financial reaction surprised Bernanke. Perhaps he failed to realise how addicted market players have become to their central-bank fix – so much so that promising reports on the US economy now trigger turbulence for they reinforce that the Fed’s asset purchases will slow soon. Another problem, though, is that some people see so-called tapering as a squeeze on credit, the scourge of the Great Depression. But tapering is not a tightening of monetary policy. If the Fed spends one dollar buying assets, it is easing monetary policy. Once the Fed stops buying assets, then monetary policy is in neutral.

The reason why the ending of quantitative easing is unlikely to be threatening to the US is that the central bank doesn’t need to sell the assets purchased under the program (outside of its normal trading of securities on the money market to control the cash rate). The central bank can hold the bonds to maturity, for, under a system of fiat money (when notes and coins are backed by nothing), the size of a central bank’s balance sheet is peripheral. The dimensions of the monetary base (notes and coins in circulation and bank reserves held at the central bank) have no influence on the Fed’s ability to control the cash rate and thus inflation. When central banks in the 1990s moved to a system of announcing cash-rate targets, they snapped the link between the money supply and the cash rate.

The political reality, though, (and Fed officials are attuned to that) is that the puffing up of the Fed’s balance sheet has sparked warnings of inflation, asset bubbles and economic imbalances. Bernanke admitted to such risks on May 22 when he told Congress the Fed’s loose policies could “undermine financial stability”. Fed officials want to shrink the balance sheet for they anticipate blame for any financial mishaps while it stays bloated. The Fed can be expected to sell assets to trim its balance sheet, and if it does, it’s tightening monetary policy. The Fed will only do this if the economy is humming enough to stoke inflation beyond its 2% limit. By selling assets, the Fed wouldn’t need to raise the cash rate as much as otherwise to keep inflation benign. This will help the recovery for it will receive fewer Fed-raises-rates jolts.

A bond surprise

Amid the tapering talk, US 10-year Treasury yields have risen about 130 basis points from 1.67% on May 1. (They peaked 2.99% on September 5.) The ending of quantitative easing may have a less-dramatic effect on US yields over the rest of the year, though. Investors have priced in the Fed’s intentions and the economic data is modest. (The US economy expanded at an annual rate of 2.5% in the second quarter). Investors are reassured that the Fed will be flexible about curtailing its asset-buying if circumstances demand and they think the central bank is determined to keep the cash rate low. Analysts only expect one 25-basis-point rise in the US cash rate in the next 12 to 18 months.

The biggest risk with ending quantitative easing is that even small increases in borrowing rates could torpedo the US recovery. The US economy’s rebound is wobbly as it is battling reduced fiscal stimulus, stricter bank-lending practices, a feeble eurozone recovery and a slowdown in China. Another risk to the Fed in shrinking its balance sheet is that it will realise losses on bond sold, if interest rates are climbing. That will force a de facto tightening of US fiscal policy. These concerns can be offset by the fact that any dip in economic growth could lead to a renewed loosening of monetary policy.

Investors can expect endless speculation about how and when the Fed will act. The jobless rate will be the best guide but the official rate fails to capture the intricacies of the labour market. The better official employment numbers shroud that many of the jobs created are low-paid and part-time and that many people have dropped out of the workforce. The gains in jobs may not empower the economy that much. The Fed could remain a bond buyer until the official jobless rate is well under 7 per cent\.

The reactions on financial markets to every economic release or Fed utterance can be considered a cost of slowing or reversing quantitative easing. The Fed should worry about bond yields for higher interest rates threaten the recovery. The Fed’s job is to control US inflation and promote US economic growth. It can ignore gyrations on currency, commodity, property and stock markets that have no obvious consequences for the US economy.

It’s hard to see how the ending of quantitative easing can ignite inflation when it will only boost interest rates, which would subdue inflationary pressures. The threat of deflation dispels notions of a bond bubble so it’s not likely that Bernanke will trigger a 1994-style bond crash. The big surprise of the ceasing of quantitative easing could well be how little disruption this causes in the US.

Trouble elsewhere

The ending of quantitative easing, however, may be more complicated elsewhere. The widespread use of the US dollar in trade and in pricing assets and the fact that many currencies are linked to the greenback ensure that US monetary-policy shifts are transmitted around the world. The problem is that while the US economy is recovering many other countries are struggling. Those with currencies tied to the US dollar are losing their export competitiveness as higher US interest rates are boosting the greenback.

The region most at risk is Europe, even with a free-floating euro. The ending of the Fed’s asset-buying may trigger a rise in global bond yields that, however gentle, hampers Europe’s economy, while exposing the limits of the European Central Bank’s bond-buying promise to save the euro. Investors may discover that the ECB can’t keep bond yields of troubled sovereigns at low-enough levels to keep governments solvent, just as a slowdown shoves more pressure on public finances.

Emerging markets are vulnerable in a different way. When quantitative easing started in 2009, US money fled to emerging markets to seek higher returns. The US-sourced capital may gush home if US yields rise. Investors fret that more emerging countries might need to raise interest rates, and thus curb growth, to attract capital to offset current-account deficits and protect their currencies from a slump that triggers inflation via higher import costs. Central banks in Brazil, India, Indonesia and Turkey lifted key rates and took other steps in recent months to prop up their currencies and balance their balances of payments. (India’s moves included capital controls).

The Fed’s actions, however, might be less of a concern than the other causes of economic slowdowns already underway in much of the emerging world. Brazil confronts falling commodity prices, sluggish growth and inflation. China is battling excessive lending. Inflation-prone India is heading to its biggest balance-of-payments crisis since 1991 because politics have stymied reform. Central European countries such as the Czech Republic, Hungary and Poland are largely untouched because their economies are better balanced. Heightened US economic activity sucking in imports may offset some of the short-term damage of the tapering, which will probably prove a hiccup for emerging countries rather than trigger a crisis. Most of the capital directed at the emerging world in recent years was for long-term investment and many countries have low foreign-debt-to-income levels and enough reserves to cope with the whims of speculators. The emerging world’s favourable demographics, abundant raw materials, rising middle class, pro-business policies, large savings pool and low labour costs will nurture its industrialisation for years to come.

Australia is better placed to cope than most countries from any Fed-induced buffetting. Australian bond yields will tick up to some extent with US yields but not fully as China’s slowdown is crimping growth and containing inflation. While rising local yields will slow the economy and steeper global interest rates will add to foreign-debt repayments, the Australian dollar will probably slide to more competitive levels and help our economy overcome the sag in the resources boom.

Over in Washington, the US-taxpayer-funded Fed should just focus on managing the US economy. It should ignore the global repercussions of its policies unless they will hurt the US. Authorities elsewhere should just better brace their economies for a less-lax US monetary policy.

Financial information comes from Bloomberg unless stated otherwise.

By Michael Collins, Investment Commentator, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise.  © 2013 FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Dominic Rossi, Global Chief Investment Officer Equities at Fidelity Worldwide Investment – “At times like these, it can be difficult for investors to know what to do.  Markets have reacted badly to the US Federal Reserve Bank’s (Fed) policy statement and European sovereign debt issues continue to rumble on.

“We should expect news over the next few weeks to deteriorate further.  As we go into the earnings season shortly, there will be more missed forecasts and guidance
from companies will be uncertain and gloomy.

“For investors, valuations will come in to play at some stage. Yields will be well covered because balance sheets are strong.

“It is clear now that the Fed cannot bail equity markets out any more and any interest rate cuts by the European Central Bank (ECB) may not have much of an impact
on markets.

“The solution on the fiscal front will be either Greek default or Germany accepting that it has to fund debt restructuring and so reduce the quantity of debt in Greece.
This will be a prototype for other European countries.

“At times like these, investors should remember the strong get stronger. We will see M&A pick up in Europe. There is little capital around and so the threat for
companies from new competition is disappearing. Markets will have to consolidate so that oligopolies or duopolies are created and the remaining companies have strong
cash flow and don’t have to rely on the debt markets.

“This is a carbon copy of what happened in emerging markets 15 years ago. Equity will shrink as well-financed companies grow by acquiring others and buy back their
own equity. In time, this will stabilise equities.”

Amit Lodha, Portfolio Manager Fidelity Global Equities Fund – “I think equity valuations are cheap.  A number of stocks can be bought at cheaper valuations than in 2008, but with stronger balance sheets.

“However, the probability of recession in Europe – and the world – continues to rise every day and we see no resolution to the sovereign debt crisis. Without bank
lending, growth will be slower. That risk results in loose monetary policy in the developed world which, in turn, equals higher inflation in emerging markets.  That
inflation is a tax on consumption growth and reduces the likelihood of significant monetary easing to drive growth.

“The property sector in China, in particular, continues to make me nervous. Resources companies say they see no slowdown in China. However, land developers have
started to make fewer purchases. The demand today for cement, steel and copper is for sites purchased 6-12 months ago. If no land is being purchased today, that sets
up a pretty negative scenario 6-12 months down the line from now, unless we see some significant easing of restrictions in China.

“Given the transition of power that will take place in China in 2012, I think the Communist Party will focus on controlling inflation rather than going for growth.
This means growth could be slower, hence me being cautious on materials investment, as well as the outlook for economies closely linked to the emerging markets, like
Australia, South Africa, Russia and Germany.

“My preference is to be invested in commodity-related equities that benefit from consumption rather than capex (capital expenditure) spending.

“While rising inflation is a worry, increased gross domestic product (GDP) per capita will drive the emerging economies more towards consumption-driven growth.
Copper, energy and potash fit this bill, while I find aluminium, steel and iron ore less interesting. Gold is now the other side of the financials trade. If the
sovereign debt crisis can be resolved, we will see lower gold prices.

“Unfortunately, I think resolution will come only through printing more money longer term. The end goal is therefore higher inflation longer-term. I remain bullish on
the opportunity this presents today. I think miners are cheap versus bullion prices and my focus is therefore on gold mining companies driving growth in production.

“I also like platinum as a commodity as it offers a link to gold, plus a link to the industrial economy through its use in automobiles.

“All in all, I remain a structural bull of emerging markets as in a growth starved world, longer term, companies that can profit from the growth in these markets
(irrespective of their domicile of listing) will trade at a premium. Emerging market central banks may be tightening now to fend off inflation but they have the
flexibility to cut again to drive growth, if need be, and especially if food inflation eases. They still have unused firepower. In contrast, developed world
central banks are running out of options that won’t just lead to further inflation. As a result, I continue to invest in those equities best placed to benefit from
this.”

Martha Wang, Portfolio Manager Fidelity China Fund – “The latest concern has been over signs of increasing leverage ratios of Chinese property companies which
enhances the likelihood of further fund tightening for property developers. In addition, China coal, oil and gas names also suffered due to fears of a potential
increase in tax on these companies. Despite these spots of negative signals, the outlook for China’s economy is positive given the recent indications of peaking of
the food component in the Chinese CPI data. Moreover, the weakness in manufacturing indicates that China’s policy tightening is taking effect.

“Although China is not insulated from the global slowdown, looking at its growth since the 2007 global financial crisis, the country appears to be in a stronger
position than the rest of the world. The fact that the Chinese government has been tightening aggressively while the rest of the developed markets are still in
doldrums, indicates that the pace of growth in these markets is diverging. Despite the current sequential slowness in manufacturing, China’s output is 50% above the
pre-2008 crisis level.

“The country has shown remarkable resilience during the last crisis provides comfort. Currently, China’s ‘A’ and ‘H’ share markets are very attractive compared
to regional peers and relative to history, trading below their historical average P/E level. Given that China is nearing the end of its tightening cycle we expect the
‘H’ share market to experience a strong rebound when the government starts to loosen its policy.”

Teera Chanpongsang, Portfolio Manager of the Fidelity India Fund – “The sharp fall in US and European equities has put downward pressure on Emerging Asian equities. The sell off was led by industrials, materials, oil and gas sectors that reflects growing investor concerns about an economic recovery in the West.

“Emerging Asian economies are not immune to a softer economic recovery in the West but I believe the region’s strong domestic fundamentals and structural growth
drivers will continue to lead to superior growth. In fact, the prospects of a slower recovery in the West should make Emerging Asian growth rates look even more
attractive to investors.

“In addition, the fall in commodity and oil prices should further ease inflationary pressures, and in particular improve India’s fiscal position due to reduction in
import costs. That said Emerging Asian equities continue to have a high correlation to global markets and might remain volatile in the near term. However, in the long
term we can expect the region’s strong fundamentals and superior growth profile to lead to better returns than developed markets.”

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