Dominic Rossi

It has been a solid start for US equities after a strong 2013. Their resilience has been particularly impressive given investors had ample opportunity to take fright.

Despite much uncertainty over the crisis in Ukraine and the fact that US economic readings were weak (largely due to bad weather), equity investors shrugged off these issues. It was striking how resilient equities proved to be and how contained volatility stayed during this period.

Equity-market volatility is being anchored at low levels by confidence in the positive structural outlook for the US economy. When implied volatility (as shown in the Chicago Board of Exchange’s Volatility Index or VIX) falls below 20 (its long-term average since 1990), we have a favourable environment that allows valuations to expand. Lower volatility was a pre-requisite for the rerating in US equities that we saw in 2013 (since when volatility has averaged 14.3). While many investors became accustomed to elevated volatility through 2008 to 2012, it looks like volatility can stay low for a sustained period, much as it did in the 1990s. Investors should be wary of looking only at the recent past.

In terms of what might trigger volatility, the interest-rate cycle has become the key focus. US Federal Reserve President Janet Yellen recently let slip at a media conference the phrase “six months” in response to how soon the interest-rate cycle could start after tapering is completed. While there was a small spike in volatility and equities fell on the news, there was no reaction from US 10-year Treasuries, indicating the lack of concern among bond investors about inflation risk. Inflation is benign with little prospect of pressure building. Tapering is now well understood. Yellen is doveish on the US unemployment market. We will continue to have a supportive Fed for equities.

In the US, the news is only going to get brighter – we are at an inflection point in the US economy. Yet equity investors are not fully recognising how rapidly the US economy is strengthening. The data is improving in many areas, whether it is loans data, manufacturing output, services output or consumer confidence. US economic growth is going to surprise on the upside and we will be discussing 3%-plus growth again.               The speed of the improvement in the US federal budget deficit is remarkable. Since 2009, the fiscal deficit has shrunk to around US$600 billion (A$640 billion) from US$1.5 trillion. It is not implausible that President Barack Obama will finish his term with a fiscal surplus. In which case, we are looking at a US equity market that is similar to the late 1990s (when we had the Clinton fiscal surplus), where equities should be well supported by liquidity. When a government has a surplus, domestic savings flow to the equity market, allowing valuations to rise. As a result of this supportive liquidity, we could see the so-called cult of equity return and, ultimately, certain sectors and stock markets may well become expensive.

Earnings can go higher

In the US market, we have an unusual situation in earnings expectations. Usually, we start the year with high and unrealistic earnings forecasts that have to be revised down. The opposite is the case this year and we are likely to have a strong earnings season versus subdued expectations.

Beyond that, it is prudent to consider the standard counter-argument to the buy case for the US, which has lately become commonplace. This argument points out that the US is on a price-earnings ratio of 16 times yet corporate profitability is at record highs. And if we cyclically adjust for peak profits, then the price-earnings ratio is 22 times. Given that we are approaching an interest-rate tightening cycle, the argument is that this makes the US market a sell.

This is naïve. Profit margins may well be at record highs, but they can move higher. The distribution of profits between capital and labour in the US is going through a fundamental shift. It’s hard to see why margins need to mean revert; for this to happen, labour’s share of profits would have to move higher. Unless we go back to highly unionised workforces, which is unlikely, profits are going to remain at high levels.

There are a number of reasons why profit margins can stay high, such as the globalisation of labour forces, less organisation of labour, technological change and the ability of markets to press companies to focus on profit margins in a way that just didn’t happen 30 years ago. Clearly, if labour’s share of profits were to fall further, we could expect to see some political pressure. Overall, however, the outlook for corporate earnings remains favourable. Combined with healthy liquidity, these two drivers should sustain a multi-year bull market in US equities.

The US equity market is more likely than not to break out strongly on the upside from its current period of consolidation. With compressed yields on US-dollar- and euro-denominated credit, equities will look attractive versus debt as earnings come through. The danger could well be that US equities have a too-strong rather than too-weak a year, given the positive outlook for both liquidity and earnings.  It is evident that some investors have been left traumatised by the bear market in equities and are still fearful. However, in my view, we are in the midst of a bull market and in a bull market you buy the dips. In this light, if we get a mid-cycle correction based on the expected onset of the interest-rate tightening cycle in 2015, then this would be a buying opportunity. I believe the S&P 500 could move to 2,000 to 2,300 from its finish of 1,878.5 on May 9.

Volatility is anchored again like it was for much of the 1990s
CBOE Volatility Index (VIX) since 1990

Source: DataStream, CBOE Volatility Index. 30 March 2014

by Dominic Rossi, CIO, Equities at Fidelity

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Financial information comes from Bloomberg unless stated otherwise.

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Dominic Rossi

The US equity market is poised to rise in coming years and the S&P 500 Index could reach 2,300 from just under 1,900 now, says Dominic Rossi, the Chief Investment Officer, Equities, at Fidelity.

Amid the challenges facing the world and the US economy, equity investors are not fully recognising how rapidly the US economy is strengthening in many areas and that government finances are improving, Mr Rossi says.

“US economic growth is going to surprise on the upside and we will be discussing 3%-plus growth again,” he says. “The speed of the improvement in the US federal budget deficit is remarkable. Since 2009, the fiscal deficit has shrunk to around US$600 billion (A$640 billion) from US$1.5 trillion. It is not implausible that President Barack Obama will finish his term with a fiscal surplus.

“In which case, we are looking at a US equity market that is similar to the late 1990s (when we had the Clinton fiscal surplus), where equities should be well supported by liquidity.”

It is prudent to consider the standard counter-argument to the buy case for the US, which has lately become commonplace, Mr Rossi says. This argument points out that the US is on a price-earnings ratio of 16 times yet corporate profitability is at record highs. And if we cyclically adjust for peak profits, then the price-earnings ratio is 22 times.

“Profit margins may well be at record highs, but they can move higher,” Mr Rossi says. “The distribution of profits between capital and labour in the US is going through a fundamental shift. It’s hard to see why margins need to mean revert; for this to happen, labour’s share of profits would have to move higher. Unless we go back to highly unionised workforces, which is unlikely, profits are going to remain at high levels.

“If labour’s share of profits were to fall further, we could expect to see some political pressure. Overall, however, the outlook for corporate earnings remains favourable. Combined with healthy liquidity, these two drivers should sustain a multi-year bull market in US equities,” Mr Rossi says. “I believe the S&P 500 could move to 2,000 to 2,300 from its current level.”

The S&P 500 Index finished at 1,896.65 on May 12.

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Dominic Rossi

Global stock markets had another stellar year in 2013 as the S&P 500 Index notched record after record. Investors are likely to remain well disposed to equities in 2014 due to the same underlying reason – the prospect of sustained economic progress in the US.

Indeed, the US economy is as healthy as it has been in the past 20 years thanks to the structural improvements in its fiscal and trade deficits. In 2009, the US fiscal deficit was 10% of GDP, or about US$1.5 trillion (A$1.7 trillion). By 2015, this shortfall is forecast to be only 3% of GDP, which is comparable to trend GDP growth and allows the US to stabilise its debt levels. For the first time in 30 years, the trade position has improved during a time of economic growth and the reason for that is shale energy. These narrowing deficits have helped to stabilise the US dollar, which is one of the reasons commodity prices and some emerging markets have been under pressure.

The rally in the US stock market has helped restore the confidence and net worth of consumers. One important point to recognise about the US stock market is that it is a source of economic strength as well as an outcome of it. A hefty chunk of US wealth is invested in the stock market and, despite wealth inequalities, a rising stock market helps the economy. We now have the prospect of the US economy growing at a sustainable 3% real rate in a low-inflation environment, which means the Federal Reserve can afford to prune, or taper, its asset buying. This is a broadly supportive environment for developed world equity markets.

A further rerating of equities is possible but there is less potential for earnings growth to take stock prices higher. The US is the place likely to deliver the best earnings growth, but generally stock prices will rise faster than profits. It follows that valuations would move higher and investors should be aware that there is some risk that equities could become expensive and prompt corrections.

Worrying Europe

While investors can expect the US economy to expand, nominal economic growth will remain low. As inflation is generally tame across major economic areas, the logic for tighter monetary policy is simply not there. Discussions about the rapid normalisation of rates appear overdone. Real interest rates are likely to remain negative for some time given the debt dynamics of developed economies. Public debt levels today are higher than they were in 2008 due to the transfer of debt from the private to the public sector.

Despite the pressing need, the tapering or the unwinding of quantitative-easing support will be a focus in 2014. Once tapering begins in the US, it will present a bigger challenge to Europe than it does to the US because of the deflationary dynamics in Europe. Given that the US labour force participation rate is historically low – having fallen to a 35-year low in 2013 – and real incomes are not growing in the US, there is little to prompt the Fed to taper. It would be best to see 3% growth and material improvements in employment before tapering begins.

Although we’ve seen some incipient signs of recovery in Europe, this should be viewed as a statistical event coming off extremely low levels of growth. There is little inventory in Europe, so even a slight shift in demand affects industrial production and growth. A modest cyclical improvement should not be confused with a structural recovery, as the preconditions are not yet in place for the latter to occur.

This broader structural adjustment process is expected to persist for another two or three years. While there has been some progress, such as with unit labour costs in the peripheral countries, it has come with high social costs and there is still the risk that Europe faces a deflationary future given government policies. An inflation rate of close to 0% is not inconceivable next year. Nominal economic growth could thus amount to around 1%. Given that 10-year government bonds are in the region of 4.1% in countries such as Italy, the debt problem is worsening. Countries need primary surpluses just to even out the compounding interest effects. This makes it hard for Europe to grow out of its debt problems. Investors can expect some form of debt default (via rescheduling or restructuring) sooner or later in the eurozone. The key weakness for Europe’s equity market remains an undercapitalised banking system exposed to peripheral sovereign debt risk. Our research shows that while the strong banks have become healthier, the weak banks are in worse shape.

The improvement in European equity markets seen thus far has been largely driven by rebounding or economically sensitive areas with low returns on equity such as Greek banks. This is not the kind of rally to get excited about. The euro at its current level also represents something of a headwind to further progress. Valuations remain attractive, however, and half of the stocks in the European market have a dividend yield above the yield on credit, where yields are close to historic lows.

The better placed

In Japan, investors are waiting for evidence of Prime Minister Shinzo Abe’s commitment to his third arrow of structural reform. The equity market in Japan tends to be policy driven. The first two arrows of Abe’s radical economic program – fiscal spending and monetary stimulus – should lead to faster in GDP growth in the next 12 months. Against this backdrop, there is room for Japanese equities to move higher. But whether this rally will turn into a multi-year bull market is another matter. Delivering on the third arrow is the key and this requires some bold policy adjustments. Japan’s long-term real growth rate will not increase unless the workforce expands or productivity improves. There are two routes to boosting the workforce; increasing female participation rates, or immigration; the latter is an unlikely option.

The stable-to-stronger US dollar is putting downward pressure on commodity prices and, by extension, some emerging markets. Emerging markets now require a more nuanced strategy that recognises the divergent drivers within the emerging world. From 2003 to 2007, the rising tide of China and the weaker US dollar/strong commodity prices lifted many emerging countries. We are in a different environment now where the underlying heterogeneity of emerging markets has reasserted itself. Some markets will stumble, some will thrive.

In my view, emerging markets must turn away from export-led economic models and embrace structural reform. Those that do, such as China, should do well while those that do not may face headwinds. It is clear that emerging markets can no longer rely on the benefits of a weak US dollar and elevated commodity prices.

In terms of risks, the evolution of the credit cycle in China is a worry given the lack of transparency surrounding the country’s financial system. It’s clear that credit creation in China has outpaced economic growth for some time and the country’s debt is now equal to about 200% of GDP. In a country that does not have mature western-style financial markets, the extent of the debt compared with the size and experience of the financial system is a concern. The question is how a country like this could deal with deleveraging. Ultimately, investors can expect a lower rate of economic growth in China due to these challenges.

Over the past decade, commodity-producing nations prospered and investors rerated sectors and stocks connected to hard assets such as metal miners and steel companies. At the same time, intangible assets were devalued. It’s likely that we will see a rerating of companies with intellectual property in healthcare, technology and finance. These sectors are the ones that will lead stock markets.

Within pharmaceuticals, for example, we are on the verge of major therapeutic breakthroughs in areas such as oncology. In IT, internet companies remain innovative and valuations look cheap. The telecoms sector looks likely to be the beneficiary of M&A activity, especially in Europe, where regulators may take a positive view of any consolidation that increases capital investment. Lastly, while regulatory pressures plague financial services, there is scope for valuations to re-rate from low levels over the next few years.

by Dominic Rossi, Global Chief Investment Officer, Equities at Fidelity

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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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“Tight liquidity has driven a lot of the recent appreciation among some bonds.

“We have seen substantial flows into traditional safe havens such as US 10-year T-bonds and German Bunds, but long-term the current levels of these interest rates are unsustainable. They may appreciate a little more, but fair value for inflation and other risks is probably some way below where they are now.

“Rather, we have seen investors moving into other high quality bond markets such as Canada and Australia, in an effort to escape eurozone uncertainty.

“Investors are also increasingly moving into credit in the investment grade space, as corporate profitability is strong at the high-end and balance sheets have improved. Some high-quality companies are looking better than some governments,” said Mr Wells.

“We’ve also seen an increased appetite for Asian bond markets, as many Asian economies do not have the same debt problems faced by the eurozone and many other developed markets. In particular, demand for Asian investment grade bonds is increasing. Investors are also looking at Chinese RMB bond funds, where the appreciation of the currency is now available to global investors.”

Dominic Rossi, Global Chief Investment Officer, Equities, at Fidelity Worldwide Investment added: “Asia’s increased bilateral trade offers some protection from downturns among the bigger developed markets.

“However, financial markets have not developed quite as quickly and Asia is still dependent on foreign capital, from equity markets in particular. Although much better insulated than 20 years ago, volatility persists due to the impact of foreign capital inflows and outflows. It will be many years before the wider Asia region develops a deeper domestic savings pool to defend against today’s exogenous factors.

“This volatility is the key obstacle to a rally in equities,” he said. “Equities are cheap, not because earnings are low – in fact corporate profit margins are actually very strong – but because volatility is deterring fresh investment flows. With volatility hovering above 20% it’s very difficult for equities to attract and compensate investors for such high levels of volatility.”

Mr Rossi suggested there were four key issues to address before a rerating of equities can take place:

1. Bank deleveraging in Europe – most banks in peripheral areas of Europe still have loan-to-deposit ratios in excess of 120% and are without access to wholesale funding. These banks must make further progress and this will likely take years rather than months. On the positive side, transparency is improving and non-core asset sales are progressing.
2. Eurozone debt crisis – we expect to see weeks and months of negotiations over policies and access to bailout funds. Greece’s underlying competitive issues remain unresolved. Spain and Italy have already come under increased market pressure and the European Union will need to produce a debt restructuring program for Spain. There is a lot more work to be done in these markets.
3. US “fiscal cliff” – although markets are mainly focused on the eurozone, I expect the US fiscal situation to make the front pages before the end of this year. The Congressional Budget Office has already warned that if the US Congress can not agree on spending cuts, they forecast a contraction of economic activity in the first half of next year. If this happens, we should expect 2013 earnings estimates for US companies in the S&P 500 Index to come down from current levels.
4. Commodity prices – there’s an inverse relationship between commodity prices coming down on one hand and equities being rerated on the other. While prices have come down, we need to see an across the board decline in commodity prices before monetary authorities can ease policies further and we see a depreciation in currencies.

“In the meantime, as these issues are worked through, we believe a strategy for investors to focus on is capital preservation with a particular focus on equity income and appropriate fixed income.”

25 June 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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While emerging markets will not be immune from eurozone-inspired volatility, their attractions will become more conspicuous as the developed world’s problems are laid bare during the final, volatile phase of the sovereign debt crisis, says Dominic Rossi, Fidelity’s Global Chief Investment Officer of Equities.

Economic weakness and financial contagion in Europe will inevitably impact global growth. However, Fidelity does not see a slowdown in emerging markets as a big concern because these markets face inflationary pressures to which slower growth is a partial solution. This allows monetary policy in emerging markets to become more accommodative.

While the prospect of capital appreciation is very low in developed equity markets, Mr Rossi believes opportunities exist in income and in emerging markets.

“Within equities, investors should focus on high-quality, defensive companies with stable and reliable earnings streams, which pay high and sustainable dividends. The dividend income offers a measure of protection to investors against further market volatility. These companies are typically large, robust household names, which may well prove to be a relatively safe place for investors to park some of their cash, when consideration is given to the mounting stresses in the banking system,” says Mr Rossi.

He adds that the contrast between emerging and developed markets will become even more conspicuous in 2012. Investors should be aware of buying opportunities in emerging markets that allow them to increase exposure at attractive prices.

“We believe that emerging markets will ultimately deliver better economic and stock market performance in 2012 than their overly indebted developed counterparts. The long-term case for emerging markets is intact and the fact we are in a ‘two-speed world’ in economic growth terms will only become more obvious,” says Mr Rossi.

“In episodes of heightened volatility, emerging markets will not offer near-term respite as equity correlations converge, but investors should begin to reward their superior economic fundamentals and their better ability to recover from the slowdown in global growth over the course of 2012. The headwinds in emerging markets are cyclical in nature rather than structural, so the case for investment is robust on a medium- to long-term view.”
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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It’s now evident that the problems in the periphery are increasingly beginning to impact the core. The fact that sovereign bond yields have moved up in Belgium, Austria and France is a worrying development that will ultimately put more pressure on the European Central Bank’s (ECB) bond purchase program.

We have already seen considerable purchases to support the peripheral nations; these purchases are draining reserves from the wholesale inter-bank lending market. This, in turn, has deleterious consequences for the wider real economy via reductions in bank lending and introduces the prospect of a second credit crunch.

So far, the ECB has been buying bonds on a sterilised basis using its balance sheet to fund purchases, meaning there is no increase in the money supply. With the need to support an enlarged group of sovereigns, the ECB may be forced to consider increasing the money supply to allow it to make unsterilised purchases of bonds. This policy change to quantitative easing has significant political barriers to overcome, however, principally in the form of German opposition.

The theme that has been driving bond markets in 2011 has been the reappraisal and re-pricing of peripheral sovereign bond debt. As we move into 2012, I think investors need to keep a close eye on the bond yields of Belgium, Austria and France.

In 2012, the theme driving markets may well be the reappraisal of core, AAA-rated sovereign debt. We have started to see the beginnings of this process and the markets are ahead of the rating agencies once again.

Are we entering into a final phase of the crisis?
Given we are talking about AAA sovereign nations now becoming involved, this has to be the final phase of the crisis, simply because there is nowhere else for contagion to spread.

The wave of deleveraging, and the reassessment of risk that accompanies it, will have washed right through our financial economy. While 2012 is likely to be a troubled year, the attendant volatility that we see in financial markets should also mark the last down-leg of this crisis.

The speed at which the crisis has moved from Italy to Spain and now core Europe has been alarming, but it also suggests a crescendo. The evolution of the crisis path now suggests a tipping point at which quantitative easing by the ECB becomes palatable to Germany as the only option that avoids a eurozone break up. The path between the inconceivable and the inevitable has now become very short.

How should investors be positioning themselves?
Within equities, investors should focus on high-quality, defensive companies with stable and reliable earnings streams, which pay high and sustainable dividends.

In Europe, dividend yields are considerably in excess of their 15-year average and there are a number of equity funds which are targeted towards this particular income-yielding section of the market; the income offers a measure of protection to investors against further market volatility. These companies are typically large, robust household names like Unilever, which may well prove to be a relatively safe place for many investors to park some of their cash, when you consider the stresses that the banking system remains under. 

Investors will certainly want to be exposed to emerging markets as we emerge from this crisis.

Andrew Wells, Global Chief Investment Officer Fixed Income at Fidelity Worldwide Investment
The alarming rate with at which the sovereign bond crisis is moving has unfortunately become one of its central features. Markets, by their nature, will test any perceived weakness and now that the ECB is buying Italian bonds, markets are probing the ECB’s preparedness to deal with Spain. 

The attention on Italy was largely brought to the boil by the political weakness of the Berlusconi government. The situation in Spain is different. Fundamentally, the fiscal situation is actually worse so the market focus on Spain is not a surprise at all.

One of the actions the ECB could take to stem the flow of attacks on these sovereigns is to publically discuss a yield level at which they would support Italian and Spanish bonds. This is unlikely to happen however, due to political considerations. The difficulty is that public support would effectively imply a transfer of assets from Germany to the periphery. I don’t think we can take Germany’s preparedness to write blank cheques for peripheral eurozone nations for granted by any means.

What Are The Prospects For The Euro?
Given the events that we have seen in Europe in recent weeks, the euro has actually held up unexpectedly well. There are a lot of speculators in the currency market who want to take bets against the euro, but whenever we see good news in the shape of German unemployment numbers or signs of concerted policy action, these short positions are covered and the euro snaps back.

It is debatable how much longer this can continue as news flow deteriorates. The weight of negativity against the euro is beginning to build towards a tipping point that introduces significant weakness. We are already seeing Asian investors lose confidence in the eurozone and in the euro currency itself.

Although, if we were to see a significant correction, that would in my view bring about a buying opportunity in beaten-down, yet high-quality European assets particularly in Germany and France.

Is the endgame of the crisis now taking shape?
I think we are now entering into ‘an endgame’ phase of the crisis. The solution is to get Germany to accept some inflation via quantitative easing that is unsterilised, and by that I mean that it increases the money supply.

However, this goes completely against the national psyche of the Germans, given the nation suffered a devastating hyperinflation in the 1920s that continues to echo in the collective consciousness of its politicians and central bankers today.

Unfortunately, the alternatives to quantitative easing have now been exhausted and I believe the act of persuading the Germans to consider QE has already begun behind closed doors.

Quantitative easing that increases the money supply will begin to erode the value of eurozone debts and provide respite for the eurozone region to recover. 

What is the outlook for bonds as an asset class given these ongoing debt issues?
We are now in a reflationary phase of the economic cycle in developed economies that has, in fact, traditionally been associated with strong bond performance. Economic growth is slowing and inflation is coming down, quite markedly in certain areas.  The challenge for investors is to understand that bonds can be a good place to be if your bond manager is exposed to the right risks.

A strategic approach is obviously paramount, particularly with regard to sovereign bonds. However, strong cases can be made for high-quality corporate bonds and inflation-linked bonds. And while they entail more risk, a good case can also be made for high yield corporate bonds on the grounds that yields have risen to distressed levels that are not borne out by relatively robust corporate fundamentals.

Many companies are in a better position than their governments now. We are seeing a reassessment of risk in bond markets and, with the exception of financials, corporate bonds can offer an attractive risk/reward payoff.

Given that I think quantitative easing and an increase in the money supply are likely outcomes once Germany’s objections become lost in the continuation of this crisis, then inflation must be considered a significant tail risk.

Right now, inflation breakevens (the difference between yields on nominal government bonds and inflation-linked government bonds – an indication of the inflation bond markets are discounting) are very cheap as we have not turned this corner on QE just yet. The problem is if you wait for the corner to be turned, you will be too late as inflation will be the word on everyone lips and the markets will react quickly to build in those new expectations.

I would certainly encourage investors to think about introducing inflation protection to their portfolios now, while it is attractively priced.

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Dominic Rossi, Global Chief Investment Officer of Equities at Fidelity Worldwide Investment, said “markets have reacted positively to the intent shown by policymakers, yet my overall view is that the deal is not the game changer investors are looking for. Italy’s 120% debt-to-GDP (gross domestic product) doesn’t look any more sustainable today than yesterday. Europe is destined for a multi-year workout during which economic growth will be very restrained and equities are likely to remain cheap. The path of equities will therefore require better news elsewhere. Earnings growth in the United States continues to surprise on the upside and we may be approaching a policy shift in China. The catalyst for higher equity values lies outside Europe rather than within.”

Trevor Greetham, Director of Asset Allocation, at Fidelity Worldwide Investment, said “the European Union leaders surprised positively after the squabbling of recent days but were low on detail on the critical point of leverage for the bail out fund to backstop Spain and Italy. We may have to wait until November for specifics of possible BRIC/IMF (Brazil, Russia, China, India / International Monetary Fund) involvement alongside a partial insurance scheme for primary issuance. The critical test will be what happens to the eurozone economy. Provision of liquidity goes hand in hand with further austerity in the periphery with Italy now the focus. Meanwhile, if the United Kingdom experience is any guide it will be hard for national regulators to prevent banks deleveraging their balance sheets now forced public capital injections are threatened.”

Richard Skelt, Fidelity portfolio manager, said “the agreement lessens the risk of systemic shock once the agreed mechanisms are in place, and markets are responding positively to this. Looking out beyond the immediate relief rally, a number of headwinds remain. There is a continued policy emphasis on austerity at the expense of growth within Europe which will create a drag for the southern European countries particularly, and the measures imposed on the banking system are also likely to be negative for credit and growth. The longer term path for equities will be determined by the economic cycle globally and less so by political activity in Europe.”

Eugene Philalithis, Fidelity portfolio manager, said “I think the package makes significant progress in terms of the various bank funding and liquidity channels, although some details still need to be resolved.  The proposals to leverage the European Financial Stability Fund and expand its scope are also positive for sovereign funding liquidity. The agreement on the bank recapitalisations is also a significant step forward, the intention of governments being to prevent banks meaningfully shrinking their balance sheets through selling assets or cutting off the supply of credit to the economy.

“Anecdotally, I had a meeting with a bank loans manager this morning who mentioned that banks will most likely dispose of non-core assets, such as infrastructure loans and possibly commercial real estate, while keeping the corporate book largely untouched as it is performing well and pays more than their cost of funding.  But the supply of new credit to the economy could still be hampered, which is likely to be negative. The statement made it clear that private sector Involvement in Greece is a special case, and it will remain to be seen whether the markets accept this and contagion is prevented.  But even with a 50% haircut in Greek government debt, the debt:GDP ratio is expected to fall to 120% by 2020, hardly providing an immediate solution to the solvency problem. 

“Concerns still remain with the lack of detail on implementation for some of these schemes, but there is another meeting in early November where more detail may be provided. Finally, the commitment to enshrine fiscal prudence within national legislation means more austerity is on the horizon for Europe, which leaves the European Central Bank as the only solution for growth.  Without looser monetary policy growth prospects in Europe do not look bright. I think we will see a relief rally in equities and bank debt, as well as peripheral bonds (excluding Greece), and a stronger euro potentially, but at some point the economic fundamentals may overwhelm the initial optimism, so I will take a cautious approach to adding risk.”

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