So when people say that a bond market bubble is inflating today – and quite a few are doing just that – my initial response is not to panic. Investment trends tend to last much longer than logic suggests they should. And as the famous economist John Maynard Keynes said, “The market can remain irrational longer than you can remain solvent”.

However, several stories in the past week or so have made me less confident.  First, I read that Britain’s pension funds now hold more of their assets in bonds than in shares. This has not been the case since the 1950s when the so-called “cult of the equity” began.

Investors have not been this gung-ho about fixed-income for 60 years.  Second, I saw that America had experienced its biggest ever week for inflows into bond funds, a total of US$9.4 billion. This was almost matched by the US$9.0 billion that flowed out of equity funds in the same week.

Finally, I noted that the yield on German government bonds had fallen to 1.3%, almost as low as it has ever been. At that level, investors are swapping a reduction in the real, inflation-adjusted value of their savings for the reassurance of knowing they will get their money back.

Something quite unusual is going on. Either the world has changed completely and investors will be content with derisory yields in perpetuity or they are setting themselves up for a disappointment. None of us who have lived through the lost decade for shares since 2000 want to repeat the trick with our bonds.

Figures from the Investment Management Association confirm that it is not just government bonds that are popular today. They show that in eleven out of the last 12 months more money has flowed into corporate bond funds than into any other sector.

The traditional homes for ordinary savers’ cash – UK and European shares – have been the least popular sectors over the same period.  In Australia, over the past three years, managed funds have seen some AU$14 billion in outflows from Australian equities, whereas Australian fixed interest has had net inflows of more than AU$2 billion over the same period.

It is not hard to see why investors are attracted to corporate bonds. In an environment of extremely low interest rates, it is almost impossible to achieve a decent income from a deposit account. To achieve an acceptable return on their money investors have to take some more risk. And bonds issued by the biggest and safest companies certainly look much better value than those issued by most governments.

The question for me is whether investors are right to have favoured bonds over equities. I think they have done so for a good reason – because they think bonds are intrinsically safer than shares – but  in doing so they may have under-played some important risks.  There are four principal dangers:

• The first is that the state of the economy could continue to deteriorate, pushing up the rate of company failures. If this happened investors might demand a higher yield to compensate them for the risk that they might not get their money back. For the yield on a bond to rise its price must fall. Existing holders would lose some of their capital in this case.
• The second risk is that the economy could pick up faster than expected. If this were to happen, central banks could raise base rates from their current 300-year low. Again, prices would fall.
• The third danger is that investors could all fall out of love with bonds at the same time. Fund managers might struggle to find sufficient buyers in such a situation, which could destabilise the market.
• Finally, there is the hidden risk of inflation, which many experts think might be the inevitable consequence of the quantitative easing or money printing of the past few years. Inflation is the enemy of bonds.

So what should investors do? First, I think they should look into whether their desire for income and security might not be just as well met by investing in high-dividend paying shares.

A balance of equity income and fixed income looks safer to me. Second, they should make sure that any bond funds they invest in have the flexibility to move between different parts of the fixed income universe. Not all bonds are created equal and a good manager will know where the value lies and, crucially, where it does not.

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Ironically, the state of the American economy and stock market could influence the election outcome. In the past, the lower the level of inflation and the higher the level of economic growth, the greater the incumbent’s share of the votes has been.

There is a common perception that the Republican Party is more pro-business, deregulatory and tends to support lower taxes and takes a more limited role in governance. The Democratic Party, on the other hand, is seen as more willing to regulate business, support higher taxes and play a more active role in government. The implication is that a Republican outcome should be better for stock markets.

However, the evidence does not bear this out. Over the past twelve elections spanning 48 years, the S&P 500 has delivered a higher average annual return under the Democrats.

At present, spread betting markets have offered relatively accurate predictions for the outcome of recent elections. The market odds for Barack Obama being re-elected continually fluctuate and these odds are very well correlated with the performance and level of the S&P 500. The latest (Intrade) odds of 57% (as at 4 September) suggest Obama will win. Any material fall in the US stock market would hurt Obama’s chances.

Some academics have theorised a link between business cycles and election cycles. Since the 1960s, the US economy has experienced seven business cycles with an average length of 75 months, or a little over six years. Unfortunately, this theory is not borne out in reality. Similarly, history shows that unemployment is a relatively poor predictor of election results.

Whichever party wins the US election, they will have some hard economic work ahead of them.

Future challenges – the fiscal cliff
Tackling what has been labelled the fiscal cliff in a way that does not do further damage to an already weak US economy is the biggest challenge faced by the next administration.

They will have a choice; they could let sequestration kick in, which will indiscriminately see tax increases and spending cuts across the board. The Congressional Budget Office has estimated that this would see the US economy shrink by 4% in 2013, which makes this an unpopular option. At the other extreme, cancelling the automatic tax increases and spending cuts would stoke the US budget deficit and perhaps lead to a further sovereign rating downgrade.

The Republicans want to cut spending significantly and avoid raising taxes, while the Democrats want more limited spending cuts combined with tax increases.

An ideal outcome would be to phase in tax increases and spending cuts over time, and target cutbacks in areas where the economy is least sensitive, to minimise economic damage. While both parties want to avoid the ‘fiscal cliff’, finding an agreeable compromise on the issue will be difficult.

If Congress fails to find a solution to the fiscal cliff, spending cuts and tax hikes will be enacted indiscriminately across the board under sequestration.  And this could be extremely damaging if it adversely affects the most productive areas of the economy.

This becomes a higher risk if a clear election outcome is not achieved.

The market after the election – sector specific
How the US stock market performs after the election is also of interest to investors. History tells us that the stock market is likely to rally if the incumbent wins re-election. But, empirical evidence also suggests that the US stock market has historically delivered its strongest returns on the third year of an election term. This effect might be tied to the incidence of government spending within the presidential cycle, as most government expenditure occurs during the first and second years of an election term.

The biggest stock market effects this time, however, will probably be felt at a sector level – healthcare, financials and defence are sectors likely to be most affected by the election result.

Healthcare – the Affordable Care Act that was passed in 2010 (dubbed ‘Obamacare’) was designed to give 30 million of the poorest Americans access to healthcare. Opposed by the Republicans, it was criticised for being uncompetitive, inefficient, expensive and bad for the healthcare industry. They have challenged its legality as it makes buying healthcare insurance compulsory. The Act also expands the safety net of Medicaid, which provides healthcare for the poorest Americans. The election outcome is a key battleground that will have deep ramifications for the healthcare sector.

If Obama wins, companies that support Medicare and Medicaid should benefit, including pharmaceutical companies. It could also be supportive for jobs as additional hospital staff would be needed to cope with increasing patient numbers. Private health insurance companies would probably lose out.

If Romney wins, he may try to repeal the Act and replace it with an alternative. Companies from a variety of sectors that have lucrative contracts supplying Medicare (for the elderly) and Medicaid (for the poor), could be adversely affected. Pharmaceuticals would be negatively affected because there would be fewer medically insured people. Private health insurance companies on the other hand, would probably benefit – taxes, fees and regulation under the Affordable Care Act would probably be dismantled.

Financial reform – the Dodd-Frank Act passed in 2010 is the main financial service reform proposed by the Obama administration. However, it is complex and it has been difficult to implement. Romney has already vowed to repeal the Act if he is elected, criticising it for being overly burdensome. A repeal of the Act is unlikely, however. Wall Street firms have spent a huge amount of time and resources adhering to the new rules, so reform is still more likely than repeal under Romney.

Despite his threats, even the controversial ‘Volcker Rule’ that bans banks from proprietary trading probably is unlikely to change under Romney. Such a move would be politically unpopular following recent bank scandals. However, Romney would have influence over the Financial Stability Oversight Council, benefitting non-bank financial companies, such as asset managers and insurers. If Obama is elected, plans to shift OTC derivative contracts onto exchanges would benefit the clearinghouses.

Defence – attempts to cut programs, such as missile defence under Obama, would require strong Democratic control of Congress and polls suggest this is unlikely. If the Republicans take control of Congress, defence cuts would be tempered, even under Obama. Many companies could benefit under both Obama and Romney, which is a reflection of the geopolitical tensions that still pressure US policy at present, not least in the shape of the Iran-Israeli nuclear crisis.

Firms that specialise in drone aircraft for military surveillance are likely to benefit regardless of the outcome. Funding the development of cyber security also enjoys bi-partisan support. Additionally, US defence companies will also benefit from equipping the depleted weapon inventories of close NATO allies.

If Romney wins, it is likely that he would support weapons exports to compensate those contractors adversely affected as wars in Iraq and Afghanistan wind down.

A contentious point, many analysts feel that a Romney victory would be more likely to bring about military conflict than an Obama one, presenting a potential boon for the defence industry.

In conclusion, the evidence suggests that the state of the US economy going into an election can influence the votes of swing voters and help to determine an election outcome.

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. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. 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.  2012 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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The latest headlines are not often the best indicator of the direction of the market, as investors look to the future while economic statistics focus on the rear view mirror. They can tell different stories at the same time.

Dominic Rossi, Fidelity’s Global Chief Investment Officer for Equities, has been bearish on equities for the past 18 months or so, believing correctly that shares were unlikely to go anywhere as long as there were large and unquantifiable obstacles to their progress in the form of the banking, economic and sovereign debt crises.

So I was intrigued when he recently told me that he now sees growing evidence for cautious optimism on the part of equity investors.

The thrust of his argument is that the key risks to equity markets – bank deleveraging, policy inaction and political risk with regard to Europe, and commodity prices – have all now been recognised by investors and so priced into the valuation of markets. It is not that they have disappeared – they haven’t – but their capacity to shock the markets has been dramatically reduced.

As investors have taken on board all the myriad problems facing the global economy they have positioned themselves accordingly.

As any contrarian investor knows, generalised distrust of a market like this is very often the trigger for a rally. Only when you get to this stage have all those wishing to exit the market already done so. When no-one wants to invest in equities any more there are no more sellers to drive prices lower.

Dominic points to a handful of reasons to be positive. He points to interest rates, which have been declining for some time, and more generally to expansionary monetary policies which have pushed the yields on longer-dated bonds to very low levels. This, in turn makes a compelling case for equities because, across the board, they now offer higher dividend yields than their respective bond markets.

Another reason is a technical one: markets have shown signs over the past few months of finding support at key levels. There is an unwillingness to push prices lower. This has reduced volatility.

Finally, and this is the most interesting point I think, the leadership of market rallies has changed. Markets are no longer being led upwards by sectors that traditionally do well when confidence returns – like commodities and banks – but by mainstream sectors like consumer discretionary, pharmaceuticals and technology, relatively dull sectors with steady dividend streams that offer investors a store of value.

In other words, investors are buying shares for the right reasons, because they offer income and security rather than the promise of a quick return.

When you look around the world, there is a huge amount of value available in these types of companies.

Does this mean we are out of the woods? Absolutely not.

There are still considerable risks – a slowing economy in China, the yawning budget deficit in America and the ongoing eurozone crisis to name just three very obvious ones.

But importantly the reasons to sell equities have become the conventional wisdom and that is very often a great time to start thinking of reasons to buy them instead. 

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. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. 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.  2012 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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How does the situation in Europe affect investments?
If you were to try to list reasons why stock markets have risen so much over the past three months, a reduction in worries about the eurozone crisis would be right up there. It is not that the sovereign debt crisis has gone away – far from it – but investors have stopped fearing the worst. To an increasing extent the likely outcomes have been priced into markets. Europe matters a great deal but it is not the only driver of investment markets as, at times, it has been.

What will happen if Greece falls out of the euro?
Despite what I have just said about the eurozone crisis, if Greece does fall out of the euro markets will most likely react badly in the short-term and the event itself will be a significant shock to investor sentiment. Greece is undoubtedly struggling to find the spending cuts that it has signed up to and it has asked for more time to get its books balanced. That might make an exit from the euro sound more likely, but I think the fact that a grown-up conversation is being had about exactly how Greece can get back on an even keel makes it more likely that it will actually stay inside the single currency.

How can I reduce the risk in my portfolio while still achieving my goals?
There’s a simple answer to this one – diversification. None of us can know what lies around the corner and that means that putting all of our eggs in one basket, geographically or between assets classes, is never a good idea. Having a multi-asset portfolio spread between all regions of the world means you may never shoot the lights out performance-wise but you will avoid catastrophe. And that, coupled with a realistic program of regular saving, is the best way of hitting your goals.

Should I stay in cash, and how much money should I keep there?
A little bit of cash in a portfolio is always a good idea because it gives you the opportunity to take advantage of market falls. But, that said, too cautious an approach will doom you to watching the real purchasing power of your money eroded by even quite modest rates of inflation. In the long run, equities and bonds have outperformed cash and I would be amazed if in future they did not continue to do so. 

What is the right mix of growth and defensive assets in this environment?
Just as a decent mix of assets and geographical exposures makes sense, so too does a combination of growth and value investments, cyclical and defensive assets. Markets can change mood very quickly as we have seen in the past three months. Being on the sidelines because you felt nervous about the outlook would have been a very expensive mistake in recent weeks. With so many headwinds for the global economy, an overly aggressive stance would also be risky in my opinion.

Should I stay in shares?
Yes, I would definitely stay in shares for the reasons I’ve already given. But not exclusively so and the proportion you should hold in the various asset classes will depend on a number of factors, not least your age. The longer you have to invest, the greater should be your exposure to shares, which offer greater potential returns but also the greater likelihood of short-term fluctuations. And don’t forget that retirement age is not the end of the line either – with many people these days facing the prospect of a long retirement having some exposure to income producing shares even after you stop work can make sense.

Should I reduce my holdings of growth investments?
The past 30 years or so have been a period in which investors have tended to focus on growth investments where returns have been largely driven by capital appreciation. In the great bull market from 1982 to 2000 investors were pretty indifferent to the income offered by most investments but I think that has changed for the foreseeable future. In the long-run income has actually provided the lion’s share of the total return from most investments and I expect that to continue to be the case. Income-generating investments have many things to commend them over pure growth-oriented investments.

Can shares play a role in providing me with income?
Absolutely. Investors are switching on to the fact that dividend-paying shares can make a big contribution to the total performance of a portfolio of investments if the income is re-invested. But if your principal concern is generating an income then shares can do this as well. The good news is that at today’s market prices many well-known blue-chip shares are offering high and sustainable incomes, well above the income on offer from government bonds and cash deposits in many cases. For investors who are able to handle the unavoidable volatility of equity investment, the income from shares can be very attractive today.

How can I get more income from my investment portfolio?
If you want to generate a bigger income then, all other things being equal, you have to take greater risks with your capital. That is why a corporate bond tends to offer a higher yield than a government bond and why a less financially robust company will offer a higher yield than a rock solid business.

Will the market recover to its 2007 levels?
Depending on the market you are talking about, we are getting back to those levels already. In time, I am sure the answer is yes because companies are in pretty good shape and valuations are relatively cheap compared to history. Recoveries from bear markets can take a long time but the long-term trend of the market throughout all the turmoil of the 20th century was upwards. No-one can predict the future but it would be a very bold call indeed to say that the current century would be any different.

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. Past performance is nota reliable indicator of future performance.  Prior to making an investment decision, retail investors should seek advice from their financial advisers. Investors should also obtain and consider the Product Disclosure Statements (“PDS”) for any Fidelity fund mentioned in this document. 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. ©  2012 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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The eurozone accounts for around 10% of the value of world stock markets and European companies derive less than half of their profits from within the euro-area. What is going on in Europe has no bearing on housing starts in the US (which are picking up) or electricity output in China (which is not). Greece is neither here nor there in the context of a $14 trillion European economy. But markets hate uncertainty and that is what we must accept for the next few months.

Volatility of markets is something that we are going to have to get used to. Indeed, the dramatic ups and downs that have characterised the Japanese market over the 20 years of its post-bubble deleveraging could be the template for Europe as the painful process of mending the region’s balance sheets is endured for years to come.

This is an extremely difficult environment for investors, especially if your main experience of investing was during the aberrational years between 1982 and 2000, when everything went up and the investment industry’s idea of risk was moving too far from a rising benchmark.

Now the risk is the real one that you lose money and investors are quite rightly switching on to the importance of capital preservation. If you lose a third of your money you have to grow what you have left by 50% to get back to where you started.

A year ago the market fell sharply to a new trading range at the bottom of which investors looked at valuations (especially as indicated by the hard reality of dividend yields) and thought the rewards on offer made the risks worth taking. I expect something similar will happen this time around. European shares are cheap.

They trade on around 10 times expected earnings (just nine in the UK), dividend yields are often higher than those on corporate bonds and government debt, cash flow is strong and companies have lower levels of borrowings than for 20 years or so.

The corporate sector is quite strong. Investors have to make a decision in today’s volatile markets. They can attempt to catch the increasingly frequent waves and protect their portfolios during the commensurately frequent downturns or they can accept that this type of market timing is impossible. In that case they must focus on quality – companies with pricing power, good managements, recurring revenues, a spread of clients and robust balance sheets.

They must buy these companies at a sensible price and they must hold them through the inevitable sentiment-driven ups and downs. They must, in other words, follow the likes of Warren Buffett and think like business owners.

European politics and macro-economics are a mess but the region is home to many excellent businesses with fantastic prospects in places such as the US and the Far East, where life is going on even while Europe makes a hash of it. Shares in those companies won’t bounce back immediately, but in 10 years you may well look back and think that the summer of 2012 was a pretty good time to be investing in these long-term winners.

Five ways to handle volatility – FidelityWhile many investors are choosing to take risk off the table, this might not be the best strategy, particularly for those with long-term goals.

1. Keep calm – “The worst thing investors can do is to over-react to market volatility. They will usually respond more slowly than the markets as a whole. This means they will be late to the party when markets rise and also risk bailing out after markets have already corrected, crystallising their losses.”
2. Don’t blow things out of proportion – “The eurozone accounts for only around 10% of the overall market value of global stock markets.  Europe is not the only story for investors today. “Even in Europe, many of the largest companies continue to do well, protected from problems on their doorstep by successful operations around the world and especially in the faster-growing emerging markets.”
3. Diversify – “Investors should ensure that their investments are well-spread between different asset classes, such as equities, bonds, commodities and cash. Government bonds in Germany, the UK and US have all performed well during the latest bout of equity volatility as investors have sought safe havens for their money, providing investors with an important source of performance.”
4. Consider the price you pay – “Longer-term what matters is the market’s valuation, so investors should look at the price they are being asked to pay today. The average multiple of a company’s earnings that a share price represents is actually cheaper than at any point since the late 1980s. Only at the bottom of the market in March 2009 were shares much cheaper on this basis than they are today.”
5. Stick with it – “The beauty of regular saving, say monthly, is that it forces you to invest at times like these when the market has fallen and you instinctively prefer to walk away. That makes sense from a survival point of view (which is why we are hard-wired to do it), but it does not usually make sense from an investment point of view. Volatile markets create opportunities and a mechanical investment approach obliges you to take advantage of them.”

13 July 2012

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. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. 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 also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 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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In an age of instant communication in which investors have become drawn into the daily contortions of financial markets, it pays to stand to back and consider some of the longer-term themes.

Many of the most rewarding investment returns in the last two decades have been the product of the most compelling and intuitive narratives.

The emerging markets became a bone fide asset class and the “BRICs” moved from marketing gimmick to a serious engine of economic growth.

The term “commodity super-cycle” was coined to reflect the resource hungry demand of industrialising emerging markets. Rallies in finite resource sectors such as oil and metals, or in internet stocks, or in gold in an age of money printing have all garnered investor attention based on persuasive premises. 

Investors have always been drawn to compelling narratives. Turning points in markets are often associated with the emergence of a new story or the widespread adoption of an existing one.

Change is afoot
The world today is barely recognisable from 1980. The developed world is likely to see slower growth rates for some time due to the multi-year deleveraging required to reduce the high debt burdens created by the financial crisis. The outlook for growth in emerging markets remains far in advance of the developed world and the gap has been exacerbated by the ongoing effects of the financial crisis.

The cornerstone concept of ‘risk free’ is being reassessed in the light of the Eurozone debt crisis and has significant implications for investors. Meanwhile, recent developments in the energy space are significant, with the commercial exploitation of shale gas & oil discoveries likely to make north America a net exporter of hydrocarbons. Investors must take stock of these shifts and consider whether they have adequate exposure to the fastest-growing parts of the world.

Long-term themes for investors to consider
Here are some of the most prominent multi-year themes that are likely to have a significant impact on investment returns.

A ‘two-speed’ world with a shifting balance of power: Emerging economies are benefiting from a multi-year shift in the global balance of economic power.  The investment universe is becoming increasingly polarised between low-growth, mostly developed world economies and higher-growth, mostly emerging economies. The fallout from the credit crunch is a multi-year hangover as developed economies face macroeconomic headwinds.

The US dollar’s position as dominant reserve currency will be challenged: The loss of the US sovereign’s triple A rating and the rebalancing of economic power will support calls for a new reserve currency system, particularly as the Chinese renmimbi (or Yuan) is increasingly internationalised.

Do not underestimate demographics: Demographics are perhaps the least understood, yet most significant of multi-year trends for economies and investment markets. Some countries have already consumed their demographic dividend; others are now reaping the benefit of young and productive working age populations.   

The reassessment of “risk-free”: The conceptual cornerstone of risk-free assets in the shape of triple-A rated government bonds has been shaken to the core, due to the sovereign debt crisis. Investors will be forced to reassess outmoded ideas about risk. In a developed world characterised by low bond yields, investors are likely to embrace income as a means of boosting total return. This will mean a move up the risk spectrum in order to get yield, with equity and property playing a greater role in providing income. 

The age of the emerging market consumer is here: Consumption in emerging markets is growing strongly and this theme has the power to support equity investment in companies based in emerging and developed markets who can take advantage of this growth.

Don’t write off the US just yet: The US may have lost some of its dominance but the obituaries are premature. Despite the rise of the BRICs, the US remains a dominant economic and consumer power, well ahead China and India in per capita growth terms, and with a long track record in creating in creating shareholder value.

Energy shake-up: The discovery and commercialisation of extensive shale-based hydrocarbons in North America are a game changer in the natural resource landscape that will have a significant impact on the balance of power in energy markets.

Watch out for the “disruptive” technologies: The impact of disruptive technology is one of the most powerful forces in the corporate sector, creating billion dollar companies like Apple, Google, and Facebook, while relegating other firms to obscurity. Distinct ages in technology are now apparent – 1990s was the decade of desktop internet; the 2000s moved into mobile internet; and the 2010s seem set to become the decade of cloud computing.

Time taken understanding the narratives driving current and future investment thinking is invariably time well spent.
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. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. 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 also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 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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His dramatic mood swings, from extreme optimism to deep pessimism, meant that the price he quoted fluctuated wildly from day to day.

Graham’s point was that the level of the market was unrelated to the intrinsic value of the companies quoted on it. Depending on Mr Market’s mood, it could be well above or well below fair value.

The wise investor would sell when Mr Market was bubbling over with enthusiasm and offering a high price, and would take the opportunity to buy when Mr Market was irrationally gloomy and prepared to accept a low price.

Since the New Year, Mr Market’s mood has picked up dramatically and the price he is quoting us today is not far off last year’s peak.

The US market is 20% higher than its low point in October, fulfilling the usual definition of a bull market in three months.

There are some good reasons for Mr Market’s renewed enthusiasm. There have been some real improvements in the data coming out of the US. Fourth-quarter GDP growth of 2.8%, for example, underscored the yawning gulf opening up between a recovering America and other slowing developed economies.

Elsewhere, China looks more likely to enjoy a soft than a hard landing and the European disease looks more chronic than acute this weekend.
But the real change has been in Mr Market’s mood. The glass simply looks half-full again.

Morgan Stanley recently asked its clients what they felt about various aspects of the market, and their answers are revealing. They show an almost complete turnaround from the gloom and doom prevailing just a few months ago. For example, asked whether China would suffer a hard landing in 2012, 76% said no and just 6% thought it would. Almost half of the respondents rated the probability of a US recession this year or next at under 20%.

Perhaps because of that, 40% of the investors questioned said that they expected the US to be the best-performing developed market this year.
In a further sign of renewed confidence, 40% also thought that the best-performing sector this year would be Financials, hardest hit last year by the eurozone crisis, with a further 22% favouring industrials, one of the sectors most intimately linked to the health of the global economy.

More than half of investors said that equities would be the best-performing asset class this year after last year’s unexpected trouncing by government bonds.

It is not just what people are saying but what they are doing that indicates a significant change of heart.

A key measure of investors’ enthusiasm is the ratio of positive bets on the market (calls) to negative bets (puts). The speed of the move from down to up bets has only been exceeded once since the data started to be collected 17 years ago.

Another technical measure of the strength of the market’s upward momentum, known as the relative strength index, has barely been beaten in the past five years, including during the rapid market recovery that began in early 2009.

It’s all rather encouraging for believers in the “January Effect”, the old stock-market adage that says that the first month of the year sets the tone for the remaining 11 months.

As with “Sell in May and go away”, the January Effect does actually seem to be more than an old wives’ tale. The hit rate is safely above 50% and the average performance of the market in years with a positive January is getting on for twice as good as the average for all years.

Is all this exuberance a reason to be cautious? In the short term, I think it is. But extreme sentiment is a much better contrary indicator at the bottom of the market than the top.

When everyone hates the idea of investment, you really ought to be tempted; when the mood is more positive, it’s less clear-cut. That’s especially the case if valuations have not yet caught up with Mr Market’s perkier mood. He could remain cheerful for a little while yet.
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Since the March earthquake, the Japanese economy has plotted a v-shaped recovery as supply-chain disruptions were quickly resolved and manufacturing facilities were brought online ahead of schedule. Production normalised in most industries and sentiment indicators rebounded.
As a result, Japan has recovered well and the prospect of a third supplementary budget and substantial reconstruction demand should also prove quite helpful for growth in the future.

However, while domestic supply-side constraints have eased, external demand factors have deteriorated, slowing the pace of Japan’s recovery and impacting negatively on stock performance. Following the strong rebound in the third quarter (the consensus forecast was for annualised real GDP growth of around  6.0%), economic activity is expected to slow in the coming months, with structural fragilities in Europe and the US, as well as fresh supply-chain disruptions stemming from the floods in Thailand, representing key risk factors.

Meanwhile, the strength of the yen is also a major headwind for the Japanese market, fuelling concerns about the outlook for corporate earnings, especially at export-oriented firms. Japanese authorities have intervened in the currency markets and implemented additional monetary easing, but yen strength appears likely to persist in the absence of concerted action. Despite the strength of the yen’s rise against the dollar and the euro, it is worth remembering that the real effective yen rate, a measure of Japan’s competitiveness, is actually still well below its 1995 peak.

Corporate Japan remarkably resilient despite headwinds
Despite headwinds, at the microeconomic level, Japanese companies have seen a significant improvement in earnings and profitability. They have strengthened their earnings base, improved cost efficiencies and appear to have become more accustomed to coping with persistent yen appreciation. They have also increased their overseas presence, particularly in Asia, adapting to sluggish domestic demand and structural shifts in the global economy (eg. emergence of Asian and other developing economies).

Meanwhile, cash reserves at listed Japanese companies have risen to record highs and free cash flow generation has improved significantly. In addition to enhancing shareholder returns through buybacks and dividends, companies have wisely been seeking to capitalise on the strength of their balance sheets and the yen to acquire businesses overseas. This strategy has been supported further by the recent expansion of the government’s foreign investment loan programme, which is aimed at curbing yen strength by getting Japanese companies to increase their foreign currency assets. In the first six months of fiscal 2011 (April-September), Japanese companies made ¥3.1 trillion of overseas acquisitions, a 130% increase on the same period a year ago.

The re-emergence of corporate governance issues
Recent scandals at Daio Paper and Olympus have raised some concerns about corporate governance in Japan, threatening to further cloud investors’ view of the domestic market. With overseas investors accounting for almost 70% of stock trading in Japan, a feeling of distrust in Japanese firms could further thin trading volumes.

While these recent cases have understandably raised doubts about the transparency of management, it is important to remember that they relate specifically to individual companies and are not reflective of corporate Japan as a whole. Indeed, over the past ten years or so, a significant shift in Japan’s shareholder base has helped to increase pressure on management to improve governance and enhance shareholder value.

An oft-cited limitation of Japan’s corporate environment in the past was ‘keiritsu’- an economically inefficient system of tight inter-corporate linkages (the Japanese word literally means ‘headless combination’) built around cross-share holdings between groups of companies. However, this particular driver of potential corporate malfeasance is much less relevant today because the cross- shareholding ratio (the ratio of holdings of other listed companies by listed companies on a market value basis) has fallen from around 33% at the start of the 1990s to a record low of 11% (as of 31 March 2011). At the same time, the ratio of Japanese shares held by overseas investors has risen from less than 5% to around 27%, something which is supporting the adoption of western corporate governance norms.

Furthermore, it is reasonable to say that Japanese companies have improved their organisational structures and decision making processes more generally. As a result, they are far better placed to respond quickly to changes in the economic environment and/or their respective industries. A recent example would be Panasonic’s decision to downsize its mature and loss-making businesses, and to focus more on new growth areas such as high-margin energy-efficient household appliances.

Cheap across the board- but selection still the key
Japanese equities now look extremely cheap against a wide range of measures. The market is not only cheap relative to its own long-term history on asset and earnings based metrics like price-to-book and cyclically adjusted price-to-earnings ratios (also known as ‘Shiller PE ratios’) – it is now cheap on a global sector-by-sector basis. Analysis from Deutsche Bank shows that Japanese equities were the most expensive in the world on a sector-by-sector basis 100% of the time in the late 1980s. However, in the intervening years that premium has reversed to the point where, now, Japanese sectors are the cheapest in the world 60-70% of the time.

Another way to assess the valuation of stock markets is to look at the ‘equity risk premium’ (ERP). This is calculated by deducting the current 10-year domestic bond yield from the expected return of a given equity market. As the chart below shows, Japan has a current ERP of 4.9%. This is lower than what’s currently available in China and the UK for example. However, a better gauge of value is gained by looking at past numbers for the same market. Doing this reveals that Japan’s ERP looks very favourable, with the widest positive differential versus its historical average out of all the major global equity markets. Indeed, this leads Soc Gen to make the notable conclusion that, ‘relative to Japanese government bonds’ the Nikkei appears to be the cheapest (main) market in the world compared to its historical norm.

All this said, investors need to be aware that cheap markets do not always equate to value, because often low valuations are fully deserved. The key then is to be very selective and to seek out those quality companies that are well managed but about which the market, for whatever reason, has become unjustifiably negative. Such instances are comparatively rare, but in the current environment of overall investor nervousness, we believe they certainly do exist.

Conclusion – a stock-picker’s market
While macroeconomic issues continue to mask a healthy corporate sector in Japan, Japanese equities remain underappreciated by investors.

Over the past 10 years, Japanese companies have strengthened their earnings base, enhanced cost efficiencies and improved free cash flows. Despite some recent negative news stories, a shift in the composition of shareholders has actually contributed to improvements in governance and shareholder returns. Furthermore, the Japanese market has finally worked off its valuation premium and now compares very favourably with its own long-term history and its global peers on virtually all main measures.

Over the medium term, a combination of solid corporate fundamentals, more shareholder-friendly activity, historically low valuations and poor sentiment is likely to provide a very favourable backdrop for stock selection in Japan.

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More than two thirds of all global growth this year and next is expected to come from the developing world. The main downgrades to growth are all in the developed world. Citibank recently slashed its forecast for growth in the US this year from 2.3% in July to 1.6%. Next year it expects growth in Europe of only 0.6% (versus 1.2% previously). By contrast, its reduction in the expected growth rate for emerging markets from 6.3% to 6.0% shows the extent to which they are increasingly able to stand on their own two feet.

The main worry in emerging markets – inflation and the prospect of higher interest rates – is likely to fade as the West flirts with a double-dip recession and commodity prices ease. The recent rate cut in Brazil was a straw in the wind pointing to an end of the tightening cycle in the developing world. With inflation still relatively high in many emerging markets, it might be too much to expect rates to start falling but even if they only tread water this would be a positive for markets.

The multiples of earnings on which emerging market shares trade are now – at about nine – back to the levels reached at the bottom of the 2000/03 bear market. They very briefly dipped lower in late 2008 but, that moment of panic aside, emerging market shares are cheaper on this measure than at any point in the past 10 years. They are also cheaper compared with the other main asset class, bonds, than they have been over the same period.

While shares have become cheaper, emerging market sovereign debt has become more expensive, dragged ever higher on the coat-tails of US Treasuries as investors have run for what they perceive to be safe havens.

For these three reasons, I think emerging market shares as a whole will outperform for the rest of this year and into 2012.

However, I don’t expect the indiscriminate sell-off to unwind in the same blind manner. Greater discrimination is already in evidence, with Korea for example a notable laggard as investors rightly took the view that its export-heavy economy would suffer more from a slow-down in the West.

If markets decouple, as underlying economies already have, the winners will be those companies exposed to rising domestic demand in emerging markets and not those dependent on a recovery in the West which remains a dim light at the end of the tunnel.

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