In the US, the Obama administration is ploughing a lonely furrow, the only major country in the world to be easing fiscal policy this year.

On the other side of the world, China faces a completely different set of problems. Its economy grew by 9.7% in the first three months of the year, only a fraction slower than the 9.8% in the last quarter of 2010. Chinese inflation, at 5.4%, is higher than it has been in nearly three years.

For the first time, the Chinese government has indicated that it will allow its currency to appreciate against the dollar in a bid to increase the country’s purchasing power in international markets and prevent prices from spiralling out of control. In the meantime, it has imposed price curbs from home appliances to food and pharmaceuticals.

Against these very different economic backcloths, it is unsurprising that investors remain undecided about whether to back the emerging or developed market horses this year.

In the short-term the conditions for US equities look more favourable than they do in the key developing markets with monetary policy deliberately behind the curve of an increasingly healthy economy.

Longer-term, investors in search of sustainable economic growth remain much more likely to find it east and south of Suez than in the debt-burdened old world. Even if, as expected, China’s growth rate pulls back to a less super-charged 5-6% a year in the medium term, the rest of us will look on enviously.
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Over the last 17 or so years since data has been compiled for the emerging markets and comparisons with the US’s S&P 500 have been possible, the two have marched to completely different drumbeats but ended up in the same place.
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During the 1990s when the US was developing an infatuation with technology, media and telecoms, the developing world was in crisis and its equity markets in aggregate did nothing for 10 years.  Then while the US endured its own “lost decade” emerging markets took off. During the financial crisis, the two have moved more or less in lock step.
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What lessons can be drawn from this and what does it mean for anyone trying to decide where to put their money today? The key point is that valuations matter. When emerging markets started their massive outperformance of the developed world in 2003 their shares were on average about half as expensive (in price to book value terms). At the top of the market in 2007 they stood at a 20% premium on the same basis. Developed market shares underperformed from 2000 because they started out at a silly price.
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Fast forward to today and there’s not a lot to choose between the two in terms of valuation. Emerging market shares are priced at about twice the value of their underlying assets while the world as a whole is at 1.9 times.
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If picking winners over a 20 year timeframe is impossible, and anyway might end up in a dead heat, the only sensible thing may be to make sure you have a bit of everything.

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Some of Europe and America’s most prestigious companies are shunning the well-established financial centres of London and New York and looking to Asia as a place to list and sell their shares, as well as their handbags.

Italian fashion house Prada has applied to list on the Hong Kong stock exchange in the next few weeks. US leather goods maker Coach may also list shares there, while luggage firm Samsonite and Italian motorcycle maker Ducati are also reported to be planning Hong Kong share listings.

They follow the footsteps of French skin care firm L’Occitane, which raised about A$700 million selling shares to investors in an initial public offering (IPO) in Hong Kong late last year, becoming the first French company to be listed in Hong Kong.

These foreign companies listing in the region are doing so because they expect a substantial part of their sales to come from the region. Selling shares in Hong Kong acts as a great marketing tool, as well as an effective way to raise funds for expansion.

Greater China now makes up around 15% of global luxury sales. With increasing incomes this figure is expected to grow to 44% by 2020. Over the next decade, China itself is expected to become the world’s single largest market for luxury goods, worth A$100 billion, up from $12 billion in 2010, according to a recent report by Asia-focused research firm CLSA. One reason is that luxury handbags, clothing, watches and jewellery are a favoured way for Chinese to display their increasing wealth – wealth that has risen due to their fast growing economy.

Prada already generates more than a third of its sales in Asia and has 14 stores in nine Chinese cities and a further eight outlets in Hong Kong; while Coach has 58 stores in China, Hong Kong and Macau.

Such high profile listings have transformed Hong Kong into the world’s biggest IPO market. It has been the world’s biggest market for IPOs for the past two years, eclipsing other major financial centres that have suffered in the aftermath of the global financial crisis.

Hong Kong has long been the place to list for Chinese firms seeking to raise funds from overseas, but it is only recently that companies from elsewhere have come to those with the money.
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While the number of IPOs in Asia is strong, the number of them has dropped off slightly from the record amount raised late last year. This is because Asian investors are quick learners and realise that not every stock continues to rise after its listing. Investors are, rightly so, becoming more selective.
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Higher wage growth over recent years, coupled with Asian governments increasing the social safety net, has resulted in the rise of the Asian investor. More investors are looking towards capital markets to park their money. For China in particular, we expect to see further developments in RMB-denominated IPOs.

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The recent softness in Asian equity markets stemmed mainly from worries about the impact of rising inflation and the monetary tightening needed to counter it.

“However, such concerns appear to be overdone,” says David Urquhart, Portfolio Manager of the Fidelity Asia Fund.

“The recent softness should not obscure the strong long-term case for Asian equities, which remain supported by favourable demographics, strong economic growth, the rising global prominence of China and good macro-fundamentals.”

Investment flows into Asia ex-Japan equities were negative in the first quarter of 2011, with investors tending to favour other markets, notably the US. However, a number of factors suggest that investor retreat due to rising inflation in the region may be overdone.

Mr Urquhart says “inflation in Asia reflects strong economic growth in the region and this is supportive of corporate earnings and thus sharemarket prices.

“It’s not a given that policy tightening always leads to market underperformance. For example, between 2003 and 2008 China raised interest rates with no major adverse effects on its growth.

“While strong demand is a contributory factor, the bigger driver of inflation in recent times has been higher commodity prices, including food prices. The generally accepted view is that these types of price rises tend to be temporary. In recent weeks we have seen a significant pullback in many commodity prices which, if sustained, should help to cool inflation.”
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Mr Urquhart added “moreover across all of the region’s main countries the longer-term trend is towards higher earnings, greater urbanisation and a rapidly expanding middle class. Importantly, these increasingly wealthy population segments also tend to be relatively young and highly aspirational, resulting in both a growing ability and willingness to consume more goods and services. This obviously points to a huge business growth opportunity for companies.
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“China perhaps represents the most striking regional example of a country which is on the verge of entering a golden age of consumption. To date, the country has been most well known for its manufacturing and exporting prowess and much less for its consumption capabilities. This is unsurprising perhaps when the country’s share of private consumption in GDP is only around 36%, roughly half the level in the US. According to some observers, China today resembles Japan in 1969 and South Korea in 1988: on the cusp of a more mature phase of economic development, where consumption intensity picks up significantly.
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“Another important consequence of China’s burgeoning domestic demand is that it’s grown to become a key source of export growth for the region’s other economies, reducing their traditional reliance on western demand. This is strongly evidenced by the rising share of China in the export profiles of many countries. For example, China (including Hong Kong) accounted for 41.4% of Taiwanese exports in 2010, up significantly from 24.4% in 2000.”
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Mr Urquhart pointed out, that while much of the world grapples with austerity measures aimed at reducing public debt burdens, most Asian economies are relatively unencumbered by such constraints. Budget deficits may have risen in many cases but, unlike in less fortunate regions, it will be fast economic growth rather than painful spending cuts that will do most of the work to redress the balance of Asian economies.
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“So while inflation worries and associated monetary tightening have been grabbing the attention of investors of late, helping to explain the recent run of comparatively weaker performance for Asian equities, closer inspection suggests that investor concerns in this area could well be overdone. The willingness of the region’s central banks to tighten policy can itself be seen as a good indicator of confidence in the strength of their economies. The near-term outlook for regional economic growth remains very good and this will be supportive of corporate earnings growth.”

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How much have commodities dropped? It depends.

Take silver, which has been one of the fastest-rising commodities this year, fell the most losing 25% of its value in a five-day slide in early May. Oil prices also slid, down almost 10%.

Several equity markets followed commodities lower and retreated from the post-crisis peaks they reached in April.

It was a change in global monetary policy that initially shifted sentiment and prompted investors to reassess their riskier positions in growth assets such as commodities and shares.

For several months, emerging markets, notably China and India, have been raising interest rates to stop their economies and inflation from running out of control. The sands are shifting in the developed world too and earlier in May, the Fed chairman confirmed his intention to stop US monetary expansion in June. Strong emerging market growth and loose US monetary policy have been central to the global recovery since 2009 and the feeling among investors is that the tide is turning on both.

If the fall in commodity prices continues, it will help countries that have been struggling with inflation and a drop in the price of oil will surely be welcomed by motorists around the world.

But the companies whose profits rely on buoyant commodity prices, such as the miners and oil majors, will be hoping this is a minor correction in prices rather than the beginning of a longer slump.

The concern over the pace of global growth was reinforced when disappointing US jobs data suggested the recovery in the world’s largest economy may be spluttering. Further denting confidence Wall Street and in Europe were several influential companies that announced lack-lustre results.

There are plenty of good fundamental reasons why commodities should have paused for breath. Higher input prices are self-correcting to a degree so it should be expected that the rise in energy, metals and foodstuffs in recent months would be reflected in falling US gasoline sales, lower than expected GDP in the first quarter on both sides of the Atlantic, worse than feared jobless figures and higher oil inventories.

In the emerging world, which is the principal driver of global growth today, rising inflation has triggered a monetary tightening cycle that will inevitably hold back the developing economies. And that is starting to show up at German factory gates, where orders were lower than expected.

A falling dollar makes commodity prices more expensive to non-Americans so it often triggers lower prices.

Despite the recent gyrations, the structural case for commodities remains strong. China’s share of world energy consumption is expected to rise from 10% a decade ago to 25% in 10 years time. We are in the middle of a fundamental shift in the balance between the supply of and demand for commodities which overshadows the more cyclical factors at play.

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Paul Taylor, Head of Australian Equities at Fidelity and Portfolio Manager of the Fidelity Australian Equities Fund, provides his outlook for the Australian stock market and why the market is presenting so many opportunities for stock pickers.

It could be a good time to buy Australian equities, according to one of the country’s best performing fund managers.
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Where do you see the Australian market heading for the rest of 2011?

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“While we are positive on the outlook for the Australian market in 2011, there are some black macro clouds hanging about. One is the European sovereign debt crisis, which began as concerns around Greece, spread to Ireland and could engulf Portugal and Spain. Another is the instability or geopolitical risk in the Middle East and north Africa that is boosting oil prices. A third is that the Chinese government is trying to slow the country’s economic growth to control inflation. Then there are the repercussions from Japan’s earthquake. Lastly, there is still a question mark over the US economy even though many economic indicators, from retail sales to production, are improving.
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“But when we look through these clouds we see a lot of positive signs within the Australia stock market. The market is trading cheaply on a 12-times price-to-earnings ratio, which is below the historical average of over 16-times. It is offering a dividend yield of about 4% to 5%, which is historically attractive. Australian companies are in good shape. They have repaired their balance sheets; in fact, some have built up such large cash reserves you could say they have lazy balance sheets. The Australian economy is in relatively good shape.
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“At a stock level, we are seeing some exciting opportunities – some great companies are trading at cheap prices.”
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What do you see as the main themes that will surface in the market in the next 12 months?
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“Over the next 12 months we are likely to see the continuing theme of a two-speed economy; a strong resources sector but also a strong Australian dollar and higher interest rates with their negative consequences for other segments of the economy. We could also see further merger and acquisition activity as companies with strong cash flows and balance sheets identify value in the market and potentially look for more growth opportunities. This could be both onshore and offshore activity.
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“The significant growth in smart phones, tablets, mobile telecommunications, online retailing and online media distribution is also likely to be a growing theme in the market over the next year and beyond with implications across multiple sectors.”
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What are your top overweight holdings and why?
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“Key sector overweights for the portfolio are the industrials, healthcare, materials and energy sector but these outcomes are built from the bottom up. So what we’re seeing in those different sectors are good companies at bargain prices. We think in this environment you want to be focused on pricing power; you want to be focused on the growth of the company.

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“What we’ve seen generally is that the valuation of the whole market has gone down based on these big macro fears, but the market is not discriminating between companies. That’s why we are seeing great stock-selection opportunities. When the whole market is priced at a lower level, there’s a great opportunity to pick up high-quality, high-growth companies on cheap valuations. And that’s what we have been doing across sectors.
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“In terms of sectors, mining services and engineering firms should benefit from the significant investment planned in major resource and infrastructure projects. This strong demand should lead to an improvement in contract terms like a move to a cost-plus basis and higher charge-out rates. Healthcare should see strong structural growth and should be relatively unaffected by the rising interest-rate environment. Within healthcare, I like the industry leaders and those stocks benefiting from structural growth themes.
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“If I look at some of the key overweight stocks positions in the Fund – Rio Tinto, Wesfarmers, MAp, Commonwealth Bank, ANZ and Oil Search – they are there because we think they are good companies with solid balance sheets and strong growth opportunities that are attractively valued.”
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What are your views on material stocks?
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“Within the mining sector, we prefer the big-cap miners over the smaller miners. We see the big miners as great investment opportunities at the moment.
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“Right now all the miners – big and small – are trading on similar multiples, which is unusual. History tells us that the big miners such as Rio Tinto and BHP Billiton should trade at significant premiums to the small-cap miners because they have diversified earnings streams and quality management, are proven operators and own the tier-one assets – the low-cost, long-life mines.
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They should trade at a premium to the small-cap miners. But when commodity prices are rising, the market generally gets excited about small-cap miners.
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“The fact that all miners are trading on similar valuations opens up a fantastic opportunity to invest in the big miners because that’s where the value is. To us, the great opportunity is Rio Tinto. On top of having the low-cost, long-life mines, Rio Tinto is trading at a valuation discount to BHP Billiton. So within the mining sector, Rio Tinto to us is the standout investment.”
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What are your views on the banks?
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“Australian banks are reasonably valued at the moment. They are offering a good dividend yield. While their lending growth is slowing, their margins are improving. So from a sector point of view, I think banks are reasonable investments at the moment.
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“Within the banking sector, our preferences are for Commonwealth Bank and ANZ. We think these two banks are the best positioned because they have the best growth opportunities and have the lowest-cost funding.”
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What do you think are the key risks for the next 12 months?
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“There are probably a few key risks for the Australian market over the next 12 months, the first of which is interest rates. The market still expects the Reserve Bank to boost interest rates in the second half of 2011. A cash rate at 5.25% from 4.75% now could add to pressure in the consumer-discretionary, in the household-spending, sector.
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“The second key risk is China. Chinese authorities are trying to slow economic growth to about 7% to 8% a year, which is still high by world standards. The question if they succeed is: are the Chinese still going to buy commodities at the same rate?
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“Another risk is whether a destabilising macro issue eventuates. In Europe, people are nervous about Portugal and they’re saying if there’s an issue with Portugal it could spread to Spain. These risks are likely to hang over the market at least for 2011.”

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