Lonsec’s latest Global Equity Fund Sector Review included 36 large cap and three small cap funds.
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Of these, nine large cap funds attained Lonsec’s top rating, Highly Recommended, including T. Rowe Price Global Equity Fund, Arrowstreet Global Equity Fund, Templeton Global Equities Fund, Aberdeen International Equity Fund (upgraded) and new entrant to Lonsec‟s universe, IFP Global Franchise Fund.
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Rui Fernandes, Senior Investment Analyst responsible for reviewing the sector, commented, “The distribution of product ratings were broadly stable across both the most recent and the previous sector review seasons.”

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Sector themes and observations

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Great minds think alike

“The degree of ‘commonality’ across Top 10 holdings is a curious and surprising outcome,” said Fernandes.
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“Only 172 different stocks held these highest conviction positions across the 26 portfolios – a remarkable observation considering that notionally, there is the potential for 260 different stocks (26×10) to occupy these positions out of some 1,500 in the MSCI World Index.”
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Companies that featured in several portfolios included Roche (which featured most prominently across the “Top 10‟ holdings, notably across seven of 26), Phillip Morris International, Nestle, Pfizer, Vodafone, Apple, Google, Hewlett Packard, Johnson & Johnson, and Wells Fargo.
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Fernandes commented, “The funds management industry’s process-driven stock assessments, with similar modelling and assumption methodologies, may be a significant driver of this outcome.”
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“However, there is also the possibility that an undeterminable degree of  ‘herding’ (e.g. safety in numbers) may also be the cause, which may or may not be a conscious decision by investment managers.”
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Investment teams and portfolios stabilise

In last year’s report Lonsec noted that investment managers had mirrored the companies they invested in by seeking to control costs, with consequences for their investment teams. By contrast, this year’s review observed that investment teams were, on the whole, relatively stable.
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“Voluntary turnover has been witnessed across some managers but overall the trend has been muted,” said Fernandes.
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In last year’s report Lonsec noted that investment managers had mirrored the companies they invested in by seeking to control costs, with consequences for their investment teams. By contrast, this year’s review observed that investment teams were, on the whole, relatively stable.
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“Voluntary turnover has been witnessed across some managers but overall the trend has been muted,” said Fernandes.

“In response to the changing global growth dynamics, managers have been flagging their intention to ‘beef up’ their Asian coverage, either with transfers from their European or US offices or new regional appointments.”

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Asia still sparkling

Most investment managers tended to be mildly positive on the overall outlook for global markets, a noticeable change from the cautionary tone observed in last year’s review. However, the outlook for Asia, particularly for the Emerging Asian Region, was positive and continued to be the brightest star in the investment landscape.
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Fernandes observed, “Many see the main opportunity to be the rise of the middle class and increased consumption through the step-up in per capita income. This is believed to touch many sectors ranging from Financials and Consumer Discretionary.”

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Emerging markets – more than one way to ‘play’ the story

“While managers may disagree on the ‘cheapness’ or ‘richness’ (in terms of price) of emerging markets stocks in general, most did not dispute the long-term trends that are favourable for these investments,” commented Fernandes.
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“Managers generally fell into two camps – those that ‘played’ emerging market stocks directly and those ‘played’ them indirectly. For example, Nestle is a developed-market consumer staple stock whose incremental growth has been sourced from emerging markets. The incremental growth from emerging economies was a key attraction of the stock.”
The Lonsec report highlights that most managers had a degree of direct emerging market exposure at the time of review

Of the 26 qualitative products reviewed in this sector, Lonsec observed that there was a notable degree of “commonality” in the “Top 10” holdings as at June 2010 – the stocks considered to be a fundamental manager’s highest conviction positions, being the largest absolute/active weights.

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At the moment, there is much talk about inflation in Asia, especially in China and India. How big an issue is it when it comes to investing in the region?

China and India are high-growth countries and because of that they tend to have inflation. There are times when inflation spikes but the reasons vary. One type of inflation that people get particularly concerned about is food inflation. Food inflation is usually temporary in nature. It will usually be about a bad crop or a shortage of supply. So I’m not that worried about food-related inflation; it’s usually resolvable. Other factors could be more of a concern. The thing to note is that authorities across the region are taking steps to limit inflationary pressures.

What we focus on when looking at economies experiencing inflation is finding companies with pricing power – those that can boost their prices to maintain their profitability. We try to avoid companies that are price takers; that do not have that ability to raise their prices during inflationary times because their earnings will suffer.

What’s driving the record increase in IPOs in Asia?

The IPO boom is because many companies in Asia are looking to expand their businesses. It gives you an idea of the kind of dynamism that’s going on in Asia. The managers of these companies see growth opportunities and they’re looking to grow their capital and invest that capital to take advantage of the earnings potential that is there in Asia.

The consumption story in China is gaining adherents. How are you playing this theme?

There’s a great thematic in investing in the consumption sector within China because of the strong wage growth that’s coming through. With minimum wages growing 20% and the average wage earner seeing 15% to 16% wage growth, consumers are driving the economy more. People are moving beyond a subsistence lifestyle and for the first time are buying items such as fridges and televisions and so on.

The way I’m taking advantage of this theme is to invest in some Hong Kong-listed companies that have businesses that are growing strongly in China and that are expanding the number of stores they have there. I’m investing in some of the department stores within China as well.

Korea has several global brands. Can China replicate this achievement?

South Korea has developed some great global brands. Companies such as Samsung, Hyundai Motor and LG Electronics have been highly successful across the globe. China has the potential to develop similar brand names over the next five to 10 years. We’ve noticed how much money some Chinese companies are spending on R&D. The fact is that the Chinese companies don’t want to be the low-cost producers forever. They want to add more value to what they’re producing. As they step up that value chain, they will create brand names, locally at first, and potentially globally.

Corporate governance in Asia is a risk. How do you manage it?

Corporate governance in Asia is a challenge that we have to deal with. Our approach is to make sure that we have identified who the management are, how long they’ve been there and who the owners of the company are. We spend time with management teams to understand whether they are just focused on making money for themselves or for shareholders as well. We want to see if there are other agendas that the managements want to achieve – things that might be good for their egos but perhaps not good for the share prices of their companies. Our focus is really to identify companies that are running good businesses and delivering on the potential.

One of the great things happening within Asia is the adoption of international financial reporting standards. That means that you can compare companies within Asia and properly rate Asian companies against global peers. Most of the developed markets in Asia already comply with these reporting standards. Countries such as India and Indonesia are adopting them over the next couple of years.

How important are smaller countries in the MSCI Asia ex-Japan Index such as Indonesia, Thailand and the Philippines?

The smaller countries within Asia don’t get the same kind of profile as China and India but they are a key part of what’s going on in Asia. Indonesia, Thailand and the Philippines are all countries that have got big populations and are achieving improvements in the standard of living. Their GDPs are growing at healthy rates and wage levels are rising. These countries are urbanising. They are microcosms, to some extent, of what China’s already done. We see that to be a reason for investing in some of the companies in these countries.

How is the Fund positioned at a country level?

The Fund is overweight Hong Kong and Thailand while the key underweights are to Taiwan and Malaysia. Hong Kong is favoured at the moment because I see some of the Hong Kong-listed stocks as doing well out of China. The valuations are more attractive and there are fewer regulatory risks with some of the Hong Kong stocks than there are in Chinese stocks. Taiwan’s a mature market, one with a high GDP per capita. The growth rates are still reasonable but a lot of Taiwan’s growth is about exports, either to China or elsewhere. I see Taiwan’s competitors as being more attractive than the companies in Taiwan.

Chinese internet company Baidu is a large overweight in your portfolio. Can you tell us why you are so positive on the stock?

Baidu is effectively Google for China where there’s a good long-term growth story for internet usage. It does internet search and has over 85% market share for search in China. Google is the second-biggest player and Google has said that it is leaving China because it doesn’t want to be censored anymore.

Baidu has around 72% revenue share of search in China. We think given Baidu’s market positioning the company’s revenue share will become more reflective of its market share in search; in fact, even in excess of its market share. We expect Baidu’s market share in search revenues to become more like 85% to 90%, given the company’s dominance in the space.

Another overweight is Hyundai Motors. Can you tell us your investment thesis on this company?

There are three key reasons for owning Hyundai Motor. The first is the company has a really strong base at home in Korea that’s growing healthily. Another is that the company has fantastic exposure to the emerging markets of China, India, Brazil and Russia, where they’re achieving strong market shares. In addition, Hyundai is growing market share in the developed markets thanks to improvement in the quality of the cars and its brand. Market share has risen from around 3% to 8% in Canada, for example. Hyundai’s market share is now around 6% in the US while in Europe it’s grown from around 2% to 4% in recent years.

What can investors expect from Asia in coming years?

I’m optimistic about the outlook for Asia over the next couple of years and over the next five to 10 years as well. We see that Asia will achieve faster GDP growth than the rest of the world. I think that investing in Asian companies is a great way for investors to take advantage of this expected growth. These companies have strong balance sheets and good cash flows. They are investing in their businesses, developing great products and building brand names. We look for the companies that can take advantage of this growth and deliver earnings-per-share growth to the shareholders.

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The big picture

• One of the biggest issues currently is rising food prices. Food prices began rising in the second half of 2010 and hit record highs in January. The United Nations Food and Agriculture Organisation has recently released its February data and the food price index hit fresh record (20 year) highs in both real and nominal terms, up 2.2 per cent in the month. All of the component price indexes were higher in the month, except sugar, which fell slightly.
• The FAO expects that a combination of higher global demand and lower supply will lead to a fall in global cereal stocks, underpinning the sharp lift in prices recorded over the past year. Over the past year the FAO estimates that export prices of major grains have lifted by 70 per cent.
• At face value, record grain prices don’t seem to be supported by the drop in coarse grain stocks. While expected to fall by almost 16 per cent in 2010/11, stocks hit 8-year highs last year. But given that demand for grains has been soaring, lifting to record highs, it is important to look at grain stocks as a proportion of consumption. In 2010/11, stocks are expected to fall to 18.6 per cent of consumption, not far off the 30-year low of 16.6 per cent in 2006/07. Consumption has risen 22 per cent over the past decade versus a 18 per cent lift in production.
• Now for those in developed or advanced nations, tight grain supplies and record prices is a concern, but hardly a big deal. In the US, food represents just 7 per cent of household spending. In the UK this proportion stands at 9 per cent while food is 11 per cent of household consumption in Australia.
• But in developing nations, the issue of rising food prices is far more significant. Even in the second largest economy – China – food represents 33 per cent of household spending. More broadly across Africa and Asia food holds between 30-50 per cent of household consumption.
• So it understandable that record food prices have led to unrest across the developed world. And when you combine that with young populations that are more likely to agitate for change, widespread access to social media and autocratic governments, you have a volatile mix. According to the United Nations, around 60 per cent of people in North Africa and the Middle East are under the age of 30 whereas the proportion is closer to 40 per cent in Western Europe, the US and Australia. In Australia, 41.2 per cent of the population is under 30 and the proportion is expected to keep falling for the next 40 years.

The week ahead

• After two solid weeks of ‘top shelf’ economic indicators, the calendar thins out somewhat over the coming week. The highlight is probably the release of minutes from the last Reserve Bank Board meeting, but there are also some key lending figures that bear watching.
• On Monday the Reserve Bank releases the January data on credit card lending and debit card transactions. Consumers still remain very cautious about going into debt with the average credit card balance just 1.9 per cent higher than a year ago – below the rate of inflation.
• On Tuesday the Reserve Bank releases minutes of the March 1 Board meeting while figures on car sales and lending finance are released the same day. Reserve Bank Assistant Governor Guy Debelle also delivers a speech but it is unlikely to provide direction for investors or traders. And the Board minutes will merely confirm that interest rate settings are on hold with members preferring to assess more information before deciding the next move.
• Car sales were largely flat in February – we tip a 0.5 per cent decline. And there will be keen interest as to whether the recovery in lending finance continued in January. However if the weak housing finance figures are anything to go by, the recovery in lending probably stalled in the latest month.
• On Wednesday the December quarter data on dwelling starts (commencements) is released. In the September quarter new starts slumped by 13.2 per cent and the pronounced slide in building approvals since April and the recent drop in construction loans to 2-year lows points to softer activity ahead.
• On Thursday, detailed labour force data is released with the latest estimates of employment by industry to be released. And the Reserve Bank releases its quarterly Bulletin on Thursday but there are no indications as yet what articles it will contain. Usually they cover a broad range of topics and provide fresh insights into Reserve Bank thinking on the broader economy.
• Turning our attention overseas, a solid schedule of US economic data awaits investors over the coming week with inflation being the highlight. On Wednesday new figures on business inflation (producer prices) will be released while consumer price data is issued on Thursday. Investors have grown used to seeing core gauges of prices (excludes food and energy) rising by 0.1 per cent each month, but it’s entirely possible that both the PPI and CPI core measures lifted 0.2 per cent in February, indicating that inflation has bottomed.
• The other event of note is the meeting of Federal Reserve policymakers (FOMC) on Tuesday. No change in rate settings or the amount of ‘quantitative easing’ is expected but the commentary should show that policymakers are more positive on prospects for the economy.
• In terms of the other data releases, the Empire State manufacturing survey is released on Tuesday together with trade prices and January data on capital flows.
• On Wednesday, figures on housing starts accompany the data on producer prices as well as the December quarter current account figures. Economists expect a correction in housing starts in February – down by 2.5 per cent to a 580,000 annual rate after the out-sized 14.6 per cent gain in January. Harsh winter weather has been playing havoc with construction but overall starts are still bumping along the bottom.
• On Thursday, data on industrial production, the leading index and the Philadelphia Fed survey are released alongside the figures on consumer prices. A healthy 0.6 per cent lift in production and solid 0.8 per cent gain in the leading index will confirm that the economic recovery is in good shape.

Sharemarket

• In 2010, there was the ‘funk’ caused by European debt, now global sharemarkets are fearful of a geopolitical contagion in North Africa and the Middle East. The last geopolitical contagion affected Asia in 1997 – a financial crisis characterised by speculative attacks on currency markets. At the heart of the issue were concerns about the health of banking systems and debt levels especially in Thailand, South Korea, Malaysia and Indonesia.

This time around the issue is more about politics – with people across North Africa and the Middle East expressing their concern that their governments are not doing enough to deal with soaring food prices. Across the region around 60 per cent of people are aged below 30 and they are agitating for change. The key concern with the Africa/Middle East crisis is that oil production could be disrupted. Just like the European Debt worries of 2010, it is fear that is causing sharemarket wobbles than actual fundamentals. The world is actually well supplied with oil and OPEC members say they are prepared to lift production quotas if necessary.

Interest rates, currencies & commodities

• On commodity markets, gold and oil prices are dominating attention due to fears of a widening in the Middle East crisis. The risk for investors is that when the situation in Libya is resolved, then oil and gold prices may retreat just as quickly as they lifted. But there are also a few other commodities that bear watching at present as well. Wheat and corn prices have eased in recent days on the potential for better crops in the US and eastern Europe. If production were to lift markedly, pushing down grain and food prices, disquiet in the Middle East would ease.

The post Investor Signposts: Week Beginning March 13 2011 appeared first on AdviserVoice.

Most people tend to regard the national accounts as just an update on economic growth. But the publication is far more comprehensive than that, covering indicators such as inflation, productivity, savings and wage costs. So from a big picture perspective what can we conclude?

Well if we were to sum the economy up in one word it would be ‘patchy’. The economy is growing, but certainly not uniformly. For instance 11 of the 19 industry sectors actually went backwards in the September quarter. And if you stripped out the rural sector, the non-farm economy also went slightly backwards.

Still, we shouldn’t panic. The economy is still expanding, and given the firm result in the June quarter we should have expected some softening in the September quarter. However the soft result is clearly a wake-up call.

All we have been hearing about over the past year is our booming terms of trade (rising export prices and falling import prices). The concern has been that this income boost would filter across the economy boosting wages and prices. Certainly that is a risk, but it is not the full story. As the Reserve Bank has previously suggested, if the income boost is saved, not spent, it is less of a concern. And that is happening. Businesses are cautious about spending and borrowing and cautious Aussie consumers have been saving more.

If you measure the household savings ratio in trend terms, the result for the September quarter is the highest in 23 years. Now if there were signs of this conservatism coming to an end that would be a concern for policymakers. But there is no evidence of slippage. Threats of higher interest rates, rising living costs, media hype about housing affordability, a soggy sharemarket and global concerns are all causing people to squirrel away more of their income.

And while it is important to focus on the effect of the mining boom across the broader economy, it is also important to focus on the broader effects of factors like higher interest rates and the stronger Aussie dollar. These factors also have multiplier effects across the economy and at present they appear to be nullifying the impact of the mining boom.

Certainly one piece of good news in the latest national accounts was the low reading for inflation – the household consumption deflator was only up by 0.3 per cent in the quarter and 2.0 per cent for the year (well below the decade average of 2.5 per cent). Then there were labour costs. In real terms, real unit labour costs were down by 2.2 per cent on a year ago – no wonder employers have been looking to take on staff.

But all the extra people added to the workforce over the last year have been at the cost of weaker productivity. Productivity has lifted just 0.5 per cent over the year. There are more people with jobs but at present it isn’t translating to more output across the economy.

The week ahead

Ordinarily the Reserve Bank Board meeting would be the dominating influence in the coming week. But with rates up in November, inflation under control and the economy losing momentum in the past quarter, clearly now is not the time to be lifting rates further. The Reserve Bank Board meets Tuesday and the final meeting for 2011 should be relatively uneventful.

Still, even with the Reserve Bank firmly camped on the interest rate sidelines there is still a swathe of economic figures to be dissected over the week. On Monday, TD Securities and the Melbourne Institute release the monthly inflation gauge for November while the Performance of Construction index is released and various surveys of job advertisements will be released. Also on Monday the latest data on tourism arrivals and departures is published.

In an underlying sense inflation is well contained, with significant discounting by retailers keeping price pressures in check. And while job ads probably rose in November, recent data suggests that businesses were becoming a little more circumspect about putting on staff.

On Tuesday, estimates of industry productivity are issued – one for the data aficionados.

On Wednesday, housing finance figures for October are released while Reserve Bank Assistant Governor Lowe also delivers a speech. We suspect that new home loans fell again in October – highlighting the softness of the sector – with the value of loans down 2 per cent.

And on Thursday the November employment report is issued. In October the jobless rate surprisingly rose from 5.1 per cent to 5.4 per cent as more people went in search of work. We suspect that the labour force participation rate may have eased modestly from 65.9 per cent to 65.8 per cent in the month. And with employment estimated to have lifted by 25,000, this would cause the jobless rate to return to 5.1 per cent.

In contrast to Australia, economic data will be thin on the ground in the US in the coming week. Consumer credit figures are released on Tuesday with data on wholesale inventories issued on Thursday together with the weekly figures on claims for unemployment insurance. On Friday monthly trade figures are released alongside the monthly budget data and the survey of consumer sentiment.

The trade deficit is expected to be largely unchanged at US$44 billion while consumer sentiment may have improved from 71.6 to 72.2 in December.

Apart from the US data, investors will also be focussed on new Chinese economic indicators to be released on Friday. Trade figures for November are slated for release together with figures on property prices. Also data on money supply and fixed direct investment are slated for release over the period December 10-15.

Sharemarket

We have made no adjustment to our sharemarket forecasts for four months and we remain comfortable with the current view. CommSec expects the All Ordinaries and S&P/ASX 200 indexes to end the year at 4,800, before rising over 2011 to end the year around 5,400 points. It’s worth noting however that when we last adjusted our forecasts, that the All Ordinaries and ASX 200 were much closer together. But currently the All Ordinaries is around 90 points above the ASX 200. The widest gap on record was 129 points on June 3 2008. The All Ordinaries tends to out-perform in a flat to falling market, so the gap with the ASX200 may ease over 2011 should the market lift as we expect.

Interest rates, currencies & commodities

The Reserve Bank is constantly watching so-called “market pricing” to determine what traders and investors are pricing in for the cash rate in coming months. There is no definition about what this “market pricing” is, but the main guides are the overnight indexed swap (OIS) rate and 90 day bank bill futures.

The current 1-year OIS quote is 4.93 per cent, meaning that financial market traders and investors believe that there may be one rate hike over the next twelve months, but they aren’t yet totally convinced. In terms of the bank bill market, the implied yield on December 2011 bills is 5.30 per cent. Given that the current physical 90 day bill rate stands at 5.00 per cent, this again highlights current thinking that there may be just one rate hike over the next year.

Certainly economists have tended to have a more bearish view of where rates will be in 2011 – in other words, they expect a few more rate hikes. The current consensus view is that the cash rate will be around 5.50 per cent in late 2011. Still, this consensus estimate hasn’t been adjusted since the Reserve Bank Governor delivered testimony last Friday as well as the soggy figures on economic growth and retail trade. No doubt the consensus view is more likely to gel now with so called “market pricing.”

The spot iron ore price has posted a stunning rebound over the past 4½ months. In mid July the price hit lows of US$117.50 a tonne. It was a case of two steps forward, one step back, through to mid September with a similar trend through to the current day. Currently the iron ore price stands at a 6½ month high of US$167.80 a tonne and is again within sight of the record high of US$186.50 a tonne posted in late April. Recent data shows that the Chinese economy continues to expand strongly, suggesting further upside in commodity prices.

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• In delivering testimony to the House of Respresentatives Economics Committee, the Reserve Bank Governor has given clear signals that interest rate settings are on hold for now.
• The Governor didn’t want to dissaude people of the view that while rates could rise in the future, it would “not imminently” occur.
• The Reserve Bank Governor was asked about market views about where rates will be in a year’s time and responded: “I’m not sure myself actually”. But he did note that there was value in getting rate hikes out of the road “so you can sit and rest for a while”.

What does it all mean?

• Australia’s top economist – the Reserve Bank Governor – has candidly remarked that he wasn’t sure where rates would be in a year’s time: “I’m not sure myself actually.” Of course no one does know with certainty where rates will be in the future, although some economists regularly give the impression that they do have a more accurate crystal ball than the Reserve Bank. The Reserve Bank Governor said “the fact is I can’t tell you with certainty about what we will be doing in six months time.”
• But while not providing numerical forecasts for rates over the coming year, the Reserve Bank has certainly given plenty of hints that they have done enough for now.
• Governor Stevens noted that official rates were now a little above normal. And while he noted that recent rate decisions were “finely balanced”, he thought that most people would be happy to get the rate hike out of the road “so you can rest for a while.” And while he acknowledged criticism of the last rate hike (RBA “criticised for being trigger happy”), the RBA Governor defended the decision, noting that there wasn’t too many times when you look back with regret that you lifted rates too early.
• The Reserve Bank Governor and the Bank’s Assistant Governor Guy Debelle observed that while economists expected cash rates to be around 5.50 per cent, market pricing tipped rates of 5 per cent mid next year. The Governor suggested that market pricing regularly changes but he didn’t want to dissuade people of the view that in the future there would be gradual increases in rates and not sufficiently close together.
• Overall, the Governor suggested that market pricing was about right – that is, that there could be a rate hike before mid next year and perhaps another increase late in the year.
• The Reserve Bank Governor has confirmed that inflation was likely to remain in the target band over the coming year, no doubt underpinning the view that he could now pause on rates for a while: “Over the coming year, we think that inflation will be pretty close to where it is now, consistent with the target.”
• The Governor noted that a “normal” cash rate was 5.50 per cent, but banks had lifted rates a percentage point above the cash rate. “Most recently, as you know, the Board decided to lift the cash rate by 25 basis points. Many lenders raised their loan rates by more than this. These moves have left the overall setting of monetary policy a little tighter than average, as judged by interest rate criteria.” The Governor noted that the Board judged at the last meeting that “it was prudent to take an early Economic Insights Reserve Bank Governor signals pause on rates modest step in the tightening direction.”
• Governor Stevens has referred to the “sea-change” in consumer behaviour with people now cautious to spend and borrow. He acknowledged that while this is tough for retailers, noting that consumption was below average at present, but said it was likely to persist for a while longer. He noted that the trend would be helpful given that significant investment was planned: “I suspect a little more caution on consumption is not a bad thing if we are to fit it all (investment) in.”
• The Reserve Bank officials have highlighted supply side deficiencies with Assistant Governor Philip Lowe noting the need for investment in transport, education and health. The Reserve Bank Governor also said that increased investment in electricity, water and urban infrastructure “would be desirable.” Further, Stevens noted that if the amount of new private sector investment were to be efficient, it would need to be accompanied by public sector investment.
• Certainly the Reserve Bank is laying down the challenge to government to do its part in keeping down inflation and the level of interest rates by correcting supply side deficiencies.
• The Reserve Bank Governor rejected concerns about the size of Australia’s public debt: “we do not have a problem of public debt sustainability.” He further noted that government debt “is not a material problem.”
• The Governor sought to highlight changes in banking over time, noting the reduction in bank operating costs and reduction of the net interest rate margin. He also sought to correct perceptions that banks were given free access to the Federal Government’s AAA rating to raise wholesale funds, stating that the Government “sold the guarantee at quite a nice price” and would collect $1 billion per annum in fees from banks as a result.

What are the implications for interest rates and investors?

• Investors will welcome the relative candid comments by the Reserve Bank Governor on interest rates, and the economy more broadly. Glenn Stevens reckons that rate settings are appropriate to keep inflation in the target band over the coming year. Certainly he acknowledges that no one knows the future with certainty, but Glenn Stevens must be pretty happy with a situation where the economy is recording good growth and where inflation is within the target band – especially when other economies are struggling with weak growth, high unemployment and deflationary risks.
• Many economists, analysts and media commentators will attempt to put their own spin on the RBA Governor’s comments. We would simply suggest that people get a transcript of his testimony and read it yourself. The messages are fairly clear – especially for a Reserve Bank that has been accused in the distant past of being quite opaque.
• Monetary policy can now be described as “tight” – not markedly so, but rates are between a quarter and a half a per cent above “normal”. As we noted when rates were lifted earlier in the month, the RBA has effectively taken out insurance by lifting rates – the hope being that you do a little now and a lot less in the future.

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Key points

• The GFC has ushered in a period of more cautious consumers in the US and to a lesser extent in Australia. Household savings rates are likely to be higher than over the last decade as households seek to cut debt ratios in the face of reduced credit availability, greater economic uncertainty and constrained wealth.
• This will result in a more constrained & fragile recovery in the US. In Australia consumer restraint is likely to be offset by mining sector strength.

Introduction

About 18 months ago a big concern was that the collapse in wealth, reduced credit availability and economic uncertainty associated with the global financial crisis would trigger a downwards spiral as households seek to repay debt and cut spending, causing a further fall in asset prices and hence wealth, triggering more efforts to cut debt, etc. In the event this was headed off by monetary easing and fiscal stimulus. But where does this leave us in terms of household balance sheets and debt levels? Will consumers go back to their old ways or remain more cautious going forward? This is not an issue for emerging countries, but is a big issue in the US and Australia.

Household debt levels remain high

The ratio of household debt to income remains high, particularly in Anglo countries. See the chart below.

Source: OECD, ABS, Thomson Financial, AMP Capital Investors

The rise in household debt levels prior to the GFC reflected: the increasingly easy availability of credit following financial de-regulation in the 1980s; falling interest rates which made debt more affordable; younger generations becoming more comfortable with debt as memories of serious economic problems faded; and rapidly rising wealth levels which reduced the need to save and supported a higher level of debt. This went hand in hand with a fall in household savings rates from around 10% of household disposable income prior to 1980, to around zero in both the US and Australia. As a result, consumer spending rose much faster than income did.

The GFC has sent most of these factors into reverse. Credit conditions are tighter, economic uncertainty has made consumers more wary of excessive debt and wealth levels have fallen. So pressure remains to reduce debt.

US households are leading the charge

Household deleveraging is well in train in the US. This is to be expected. Thanks to much lower share prices and a 20 to 30% fall in house prices the ratio of household net wealth to income is still 23% below pre GFC levels. Unemployment near 10% has led to far more cautious attitudes to debt and lending standards have toughened. Consistent with this household debt has fallen nearly 15 percentage points relative to household income from its high point in 2007. See the next chart.

Source: Thomson Financial, AMP Capital Investors

With the household savings rate running around six percent from near zero before the GFC, US households are continuing to pay down debt.

Source: ABS, Thomson Financial, AMP Capital Investors

Unfortunately there is no easy answer to how far debt levels need to fall. Debt levels have been rising ever since debt was first discovered. A simpler approach may be to focus on the saving rate. With US wealth levels unlikely to recover to 2007 levels quickly it’s likely US household savings rates may persist around current levels or even higher for some years to come.

This implies the world has lost the US as global consumer of last resort. From the early 1980s till recently US consumer spending grew faster than income (as the savings rate fell). This made it easy to reflate the global economy in tough times and there was a ready market for excess goods and savings from emerging countries.

However, it’s worth noting it’s not the level of the savings rate which matters but its change. The big drag on consumer spending and economic growth came as the savings rate rose from 2008 meaning consumption weakened relative to income. Having now adjusted to a higher rate of savings and debt reduction, consumption can move more in line with income going forward even if US consumers maintain a circa six percent savings rate. This would mean slower US consumer spending growth than in the pre GFC era but not the contraction some still fear. Maintaining a six percent saving rate will result in a further reduction in household debt ratios. The Bank Credit Analyst (a research group) estimates if US households maintain a savings rate of 6% then in 3 to 4 years US household debt will have fallen from 122% of household income today to around 94%, which is where it was in the late 1990s. This would leave US household balance sheets in good shape, but of course the path to get there will likely be bumpy.

Australian consumers also cautious, but not as much

Anecdotes from retailers attest to a more cautious attitude on the part of Australian consumers. Australian consumers also indicate a strong desire to pay down debt.

Household savings

However the pressure is not as intense as in the US. The ratio of household net wealth to household income, having recovered sharply from its GFC low, is now down by only 12% from its pre GFC peak. Unemployment is just 5.1%. And Australian’s don’t seem to be having much trouble servicing their mortgages despite much higher mortgage rates in the US – non-performing mortgages are running around 1% compared to around 8% in the US. Consequently, Australian households have been less concerned about paying back debt, compared to their US counterparts. As a result household debt has essentially gone sideways relative to household income over the last few years. See the next chart.

This has meant there has been less upwards pressure on Australia’s household savings rate. After a brief spike last year it has since fallen back. See third chart.

Source: RBA, ABS, Thomson Financial, AMP Capital Investors

Consumption has also been less exuberant in Australia, averaging 57% of GDP compared to 70% in the US.

Source: Thomson Financial, AMP Capital Investors

The mortgage equity withdrawal phenomenon – where households borrow to finance spending against the rising value of their home – was also less significant in Australia. Rather the increase in debt was largely focused on housing as increased debt enabled Australian’s to trade houses amongst themselves at ever higher prices.

This leaves much riding on the sustainability of high Australian house prices. If they tumble as in the US then the loss of wealth would likely impart significant upwards pressure on the household savings rate in a desire to reduce debt levels, resulting in significant weakness in consumer spending. On this front our view remains that while Australian house prices are significantly overvalued, the absence of widespread speculative demand and investor participation, slower growth in housing debt and a serious undersupply suggest the housing market is not in a bubble. In the absence of much higher interest rates, much higher unemployment or a huge increase in the supply of land – all of which seem unlikely in the near term – it’s hard to see a collapse in house prices. Which suggests that while growth in consumer spending may remain constrained it is likely to be reasonable.

One dampener though is the need for consumer spending to be constrained to make way for a likely boom in mining investment. Higher interest rates along with the surge in utility charges is likely to ensure that this will be the case.

Concluding comments

Over the last decade real growth in consumer spending in Australia averaged 3.5% pa, which was above average GDP growth of 3% pa. Going forward it is likely to average 2.75% pa, with rising spending on health, education and utilities likely to see slightly weaker growth in retail sales.

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Shoprite operates one of the most profitable supermarkets in the world because in the past 15 years it has built 71 stores exporting its high-volume, low-cost business model to 16 of Africa’s 53 countries, where organised, large-scale retailing is mostly a new concept.1

The example showcases the 21st century investment potential of the world’s second-largest continent by landmass and population. The gains made in Africa over the past decade hint of the rewards that could await investors.

The quadrupling in oil prices over the past 10 years, for instance, has enriched the region’s oil exporters such as Nigeria and Angola. Foreign oil companies have boosted investment, while taxes on oil have swelled government coffers and allowed for public spending on infrastructure and basic services. At a macro level, oil-producing countries have reduced public and external debts and bolstered foreign-exchange balances.

Not all African countries have oil, but many boast other resources, from aluminium and bauxite to phosphate rock, coal and uranium, not to mention gold in South Africa or the 10 diamond-producing nations behind Africa’s US$8 billion (A$8.9 billion) a year diamond industry.

The Chinese have noted this mineral wealth. To improve its energy security, China has invested in the oil producers, in Niger for its uranium and Tanzania for its copper, among other places.

China, in total, provided about US$33 billion in aid and investment to Africa between 2002 and 2007.2 Given China’s energy needs, it seems likely that Chinese money will propel African trade, investment and economic growth for a while yet.

Strong consumption

One reason why Africa is overlooked by investors is a perception that domestic demand is constrained, a view reinforced by frequent images from the continent of poverty, famine and conflict.

The consumption potential of a region or country is determined by demographics, income levels and economic growth rates, and Africa’s scores on these measures are improving.

The continent has over a billion people and the UN forecasts that number could soar to two billion by 2050.3 Because this population is relatively young, the continent has an estimated working-age population of more than 500 million people that is predicted to more than double by 2040. Other favourable demographics include a shift towards urbanisation (city folk generally earn and spend more) and a low dependency ratio (the number of dependants to the working-age population).

Income levels are rising thanks to strong economic growth that, as the graph below shows, has seen Africa outperform the global and advanced economies in the past seven years.4 GDP per capita for Africa more than doubled from about US$680 in 2002 to more than US$1,545 in 2008, according to the UN.5 If this growth rate is sustained, regional per capita GDP would double again by 2013.

More interesting from an investor’s perspective is the jump in the number of higher-income earners. According to McKinsey,6 Africa already outscores India on the number of middle-class households (defined as those earning more than US$20,000). Moreover, those with annual earnings of at least US$5,000 (a level above which consumers spend roughly half their incomes on non-food items) could jump to 106 million by 2014, from 59 million in 2000.

As Africa’s middle class expands, opportunities will arise for consumer companies, rather than just material companies – resources accounted for nearly a quarter of Africa’s GDP growth between 2002 and 2007. McKinsey projects that consumer goods and services will generate sales of US$1.4 trillion on the continent in the next decade, compared with US$540 billion from resources over the same period.

Investors can benefit from Africa’s consumption growth because a lack of competition, solid economic growth and cheap labour allows consumer companies to enjoy high margins, notwithstanding the region’s challenging business environment. Stocks that give investors exposure to African consumers include Guinness Nigeria and the South Africa-based media conglomerate Naspers.

Guinness Nigeria benefits from that country’s robust economy and having industry-leading profit margins for its core product beer. Naspers is a more diversified operator that has significant exposure to the fast-growing satellite and cable TV markets of some of sub-Saharan Africa’s 47 countries. In June, Naspers said it had gained 634,000 additional subscribers in sub-Saharan Africa in just 12 months.

Risks

Naturally high risks surround such potential. Political risk is often elevated, if not a deal stopper, as many African countries are susceptible to conflict or sudden changes of government.

Many countries are under one-party or military rule so there is no rule of law to protect businesses or investments. Corruption can be endemic. Foreign companies tend to confront vested interests, weak regulations and poor corporate governance.

These risks, however, vary among countries. South Africa in many ways resembles western markets. At the other extreme are chaotic examples such Zimbabwe, whose economy has collapsed since President Robert Mugabe came to power in 1987, and Zaire, which was plundered by its President Mobutu during his reign from 1965 to 1997. The task for investors is to find those countries that may offer high returns for the risk.

Even when viable markets are identified, there is often a lack of investable instruments for investors as Africa’s financial markets are underdeveloped. Equity and bond markets suffer from liquidity constraints and sometimes regulations discriminate against foreigners. However, once again, these flaws vary across the continent.

At the same time, the case for investing in Africa is bolstered by low correlations with developed markets owing to the region’s aloofness from the global economy.

But while the risks are higher than elsewhere, so too are the potential rewards. Just ask Shoprite. It intends to have 50 stores in Nigeria within the next three years.

Regional versus global growth comparison

IMF Africa Regional Economic Outlook, April 2010

1 http://www.shoprite.co.za/pages/127416071/About.asp
2 McKinsey Quarterly, June 2010 edition
3 UN Department of Economic and Social Affairs, http://esa.un.org/unpp/p2k0data.asp
4 IMF Africa Regional Economic Outlook, April 2010
5 UN Statistics Division, http://unstats.un.org/unsd/snaama/downloads/Download-GDPPC-USD-regions.xls
6 McKinsey Quarterly, June 2010 edition

Important information

Investments in small and emerging markets can be more volatile than other more developed markets

References to specific securities should not be taken as recommendations.

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About 135 million people around the world are estimated to have escaped from poverty between 1999 and 2004. That means that a population greater than Japan’s (126 million) was added to the pool of global consumers in just five years.

Over the next few decades, the number of people considered to be in the “global middle class” is projected to jump from 430 million a decade ago to 1.2 billion by 2030, according to the World Bank. Most of the new entrants will come from China and India, where consumption is surging. The World Bank predicts that by 2030, 93% of the global middle class will be from developing countries, up from 56% ten years ago. (The bank defines the global middle class as individuals earning an income between the per capita income of Brazil and Italy.)1

These facts explain why so many companies are developing presences in emerging markets; from Asia to Brazil, from sub-Saharan Africa to Russia. They want to capture rates of consumption growth that are unimaginable in mature western economies.

Asia’s potential consumption is huge. The outlook, though, is complicated by a preference for saving that is partly due to the lack of a social safety net. China’s government, for instance, boosted the incentive to save when it privatised housing and the pension system in 1999 and suggested households should be responsible for their own education and healthcare needs.

As a result of the global credit crunch, however, countries including China have conducted massive stimulus programs and many governments are under pressure to implement social reforms. A combination of income growth and social reform would ignite Asian consumption in coming decades.

While China may be one country everybody is watching to see the consumer revolution take hold, private consumption in India accounts for a higher share of GDP than in China – about 55% versus around 50% in China and about 70% in Australia. In India, rising incomes and readily available retail credit have encouraged consumption growth of 5% to 7% a year over the past decade.2

The outlook for further growth is compelling thanks to India’s rising proportion of young workers. McKinsey forecasts that India’s middle class will grow from 5% of the overall population now to 41% by 2025.

As this occurs, Indian spending habits are likely to change. At present, spending in shopping malls is a tiny percentage of total spending because most money is spent with small traders in public markets. The difficulty for foreign retailers is that India bans foreign investment in multi-brand retailing, so local players such as Reliance, Bata India and Pantaloon Retail are gaining footholds in the expanding formal shopping market.

While consumerism is still to fully grip China and India, it is embedded is some emerging markets such as Brazil, the most western of the BRICs. The South American country, for example, is now the third-biggest market for beauty products after the US and Japan.

Changing patterns

As incomes grow in emerging markets, the proportion that is spent on necessities shrinks. As the disposable income of emerging consumers grows, so too does the allure of the coolest fashions and the latest gadgets. Consumption patterns in emerging markets are already changing as this trend develops.

While western consumers grow resistant to advertising, forcing companies to be more innovative, multinationals are using time-tested aspirational advertising to build brands in emerging markets.

Guinness, for example, is what the upwardly-mobile Nigerian man ought to be drinking, according to an advertising campaign in the African country. And drinking it he is. Nigeria has recently become the largest market for Guinness in the world.

Another area reliant on advertising that is growing strongly in emerging economies is western-style fast food. Yum! Brands, whose portfolio includes Pizza Hut and KFC, has opened 200 restaurants in India that are achieving revenue growth of 40% a year. In China, the company has around 3,000 KFC outlets and 500 Pizza Huts. Incredibly, it sees the potential for 20,000 restaurants in China.3

Tourism and leisure are classic areas of discretionary spending that are set to surge thanks to the growth in the middle class. Companies such as Ctrip.com, which is China’s dominant online and telephone travel agency, stand to benefit. Li Ning is the leading player in sports apparel in the mid-end segment, just below the high-end names of Nike and Adidas. So it’s well placed to capture consumers trading up from the low-end of the sports clothing market.

And then there’s the potential for the luxury goods market. The elite in emerging markets are happy to indulge in ostentatious purchases to underline their status and reward themselves for their endeavours. This invariably means luxury western brands are in great demand from a relatively small, but high-spending, portion of the population.

The western luxury goods companies have noticed. They have expanded their presence in key financial centres where wealth has accumulated, such as Shanghai and Moscow.

These companies benefit from the fact they have no local competition. In the low- and mid-market areas, there are abundant local competitors who can compete on price. The top end, however, enjoys the exclusivity and allure that comes with high prices. Companies such as Burberry, LVMH and Richemont are poised to benefit as the top strata of the emerging middle class expand.

While industrial investment themes may reward investors only over specific parts of the investment cycle, the steady growth in consumption represents a compelling and enduring theme over the 21st century that deserves long-term inclusion in any equity investor’s portfolio. After all, every few years there’s another Japan worth of new middle-class consumer to target around the world.

Massive growth in the global middle class

World Bank. 2009

1 World Bank. worldbank.org. As quoted by Citigroup. “Emerging market consumerism”. 15 September 2009
2 DataStream. National statistics. June 2010
3 Citigroup. “Emerging market consumerism”. 15 September 2009
All information comes from Bloomberg and Citigroup unless stated otherwise.

Important information

References to specific securities should not be taken as recommendations.

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