Potential problems for ETF’s in emerging markets.

Sydney-based specialist equity fund manager, PM CAPITAL, yesterday warned that investment into Emerging Asia ETFs is a dangerous strategy because the instruments are heavily skewed to businesses that are at the mercy of the macro environment and dominated by questionable state-owned enterprises (SOEs).

Kevin Bertoli, portfolio manager for the PM CAPITAL Emerging Asia Fund, said although the timing is uncertain, when the cracks in emerging economies proliferate, it would cause serious problems for ETF’s.

“Emerging markets are typically dominated by businesses that have a high degree of uncertainty, such as those driven by the macro environment or businesses of lower quality with no long term sustainable advantage.  Additionally, the recognition by the Chinese banking system of deteriorating asset quality and liquidity tightening could prolong this year’s disappointing results.”

Mr Bertoli said the equivocal outlook for the region highlighted the importance of active management and a maintaining a high degree of conviction in investment decisions.

“A large portion of the market is investing solely for broad base thematic reasons, such as the rise of China. These investors will typically buy the market as opposed to diving deeply into the underlying stocks, and this can be seen in the rise of ETF’s in the region over the last decade.  However, these investors typically have a low level of confidence in the underlying earnings power of the investment, so when sentiment turns they tend not to differentiate between good and bad businesses. This mentality creates the opportunity to invest in the 10 to 15 per cent of the market that represents good value.

Mr Bertoli said the dominance of state-owned enterprises (SOE) could also create problems for ETF investors.

“On top of the widely know issues surrounding transparency, SOEs ultimately act as leavers for their majority government shareholders to grow the economy. This often results in management being little more than ‘yes men’ who often make irrational investment decisions for the benefit of the country as a whole, rather than in the interests of shareholders.

“Additionally, long term success in China requires the economy to transition to one driven by the public sector; this is going to have a negative impact on SEOs.   Around 43 per cent of China’s total industrial and business profit comes from SOEs, which have showed significant growth reductions over the past twelve months.”

In the first quarter of 2013, SOEs reported 5.3 per cent growth, compared with 2012’s first quarter growth figure of 7.7 per cent*.

“For this reason, we cannot stress the importance of investing from the bottom up, based on fundamentals and in genuine businesses where the valuation displays a meaningful dislocation from its share price.   Investors should also not be investing for investing sake, or for fear of underperforming if you miss a market rally. But with market volatility on the increase, we believe there is ample opportunity for us to deploy our strategy and take advantage of the market mispricing.”

PM CAPITAL’s Emerging Asia Fund delivered 35.0% for the financial year and a five year annualised return of 19.3% (the Fund’s inception date) – the strongest performing Emerging Asia Fund recorded by Morningstar.  This lies in stark contrast to the iShares MSCI Emerging Markets ETF return of 14.3% return for the 2013 financial year (-0.2% 5 year annualised return).

PM CAPITAL adopts a concentrated approach to investing where underlying portfolio holdings are driven by bottom up stock specific stories and not broad based macro themes. The Emerging Asia Fund is ideally looking for opportunities that are being driven by underlying structural dynamics, which have been seen to play out in other parts of the world and can easily be repeated. The Fund is not investing in exotic Asian companies, instead they are simple businesses similar to Australian businesses such as Seek Ltd., Woolworths or Asciano.

*Source Xinhau

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Asian companies have emerged from the global financial crisis with very strong balance sheets and good revenue growth expectations, with many of them potentially planning to deploy excess cash in 2011 through acquisitions, capital expenditure or dividend payouts, a survey by Fidelity International has found.

A survey of Fidelity’s analysts in the Asia Pacific region provided the insights from some of the world’s leading companies which they follow closely and in which they invest.

“The vast majority of companies meeting with us in the region continue to have very strong balance sheets (63%) and deploying their excess cash through capex, dividends and buy-backs will improve shareholder returns, and make another strong year of market performance more likely,” said Matthew Sutherland, Head of Fidelity’s Asia Pacific research team.

When asked about profit expectations, over 77% of Fidelity’s analysts said the companies they met with during 2010 expect to see sales growth of over 10% in 2011, and 50% of analysts said they expect operating margins to grow in excess of 10% in 2011. “

While this expectation is typical for Asia Pacific companies and in line with previous years, it does highlight the fact that 2011 may be another year of solid growth levels for companies across the region,” Matthew said.

Across the region, respondents also said the surplus cash they are seeing in Asia Pacific companies is likely to be spent on dividend payouts, capital expenditure or acquisitions. (All three were ranked at 23.5%.)

“Aside from revenue growth, additional benefits may come from an increased willingness of companies to do something constructive with the overly-large cash piles they built up as a reaction to the problems of 2008/9.

“Interestingly, whilst they are likely to spend on capex, capex may not grow as a percentage of sales. More importantly, they are likely to give more back to shareholders via increased dividends and buybacks. We should thus expect a year with good earnings growth coupled with higher yields and buy-backs, which makes for likely higher total shareholder returns.”

Regulation and inflation are recurring themes of concern faced by companies in 2011.

“The potential fly in the ointment in 2011 is likely to be inflation. It is expressing itself via higher wages and higher raw material costs, and could result in margin expectations being reduced as the year goes on,” Matthew added. “Having said that though, if there was nothing left to worry about, markets would be at a peak. The fact there is still concerns means that markets may continue to ‘climb the wall of worry’ in 2011”.

For a complete analysis of the survey, click here

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Headline developments

• An acceleration in Chinese economic growth in the December quarter to an estimated annualised pace of around 12% along with ongoing inflation worries have reinforced the case for further Chinese tightening in the months ahead. While inflation fell back to 4.6% in December from 5.1% in November this looks like a temporary reprieve with higher food prices this month and the Lunar New Year holidays likely to push inflation back up again in the months ahead. We expect another three interest rate hikes and bank required reserve ratio increases over the next six months. However, there is still nothing indicating that the Chinese are going to crunch their economy. First, while non-food inflation rose to 2.1% in December it is still low. Second, fixed asset investment is already moderating and a further slowing is likely this year as real estate construction slows and stimulus projects complete. Finally, much of the tightening measures we are now seeing are necessary just to mop up the liquidity the Chinese authorities are pumping into their economy to stop a more rapid appreciation in the Renminbi. Monetary conditions are still a long way from being tight. As such, investor fears that China will crunch its economy evident in a 5% or so fall in Chinese shares so far this year coming on the back of a 23% fall last year are overdone. While the Chinese share market may remain vulnerable until tightening stops, Chinese domestic shares are trading on a price to earnings ratio of 18 times which is well below their historic average of 34 times suggesting that a lot of bad news is already factored in.
• In Australia, flooding continues to wreak havoc with now nearly a third of Victoria flood affected. As a result expectations of the damage bill and the hit to economic growth in the March quarter continue to escalate. We now expect the damage bill to property, equipment, infrastructure, etc, to be around $15bn with the floods likely to detract 1% from economic growth concentrated in the current quarter. Fortunately, growth should rebound starting next quarter as the rebuilding effort kicks in and production returns to normal. While the floods will add 0.5% to 0.75% to March quarter inflation, we expect the RBA to look through this and hold off raising interest rates again until it becomes clear that growth is recovering from the impact of the floods. This suggests that interest rates will be on hold out until around May at least.

Major global economic releases and implications

• US data released over the last week remained consistent with an acceleration in the US economy. Surveys of manufacturers remained strong, jobless claims fell sharply and the US leading indicator rose strongly. Housing indicators were mixed with housing conditions flat according to a survey of home builders and housing starts fell due to bad weather but existing home sales rose very strongly. Our overall view remains that the US housing sector has found a base, but its also worth noting that housing activity is now only around 2.5% of US GDP compared to 6% in 2005 so its impact on the US economy is far less than it used to be.
• The US December quarter earnings reporting season got underway in earnest over the last week with 50 major companies reporting. So far 69% of results have come in better than expected including for JP Morgan, Apple and IBM. While upside surprise is down compared to recent quarters this appears to be because analyst expectations have finally caught up to the recovery in earnings with earnings growth estimates for the year to the December quarter already very strong at +32%.
• Japanese economic data was generally upbeat with gains in machine tool orders, a tertiary activity index and Tokyo condominium sales. Against this, consumer confidence fell slightly in December.
• While interest rates are well and truly on hold in key advanced countries, monetary tightening is continuing in emerging countries as part of an effort to deal with inflationary pressures. This is clearly evident in China, Indonesia, Korea and Thailand which all tightened last week but in the past week Brazil also tightened, raising its key policy rate by 0.5%. Inflationary pressures in the emerging world point to further tightening in these countries ahead. So far the increase in inflation is mainly food related so tightening is unlikely to be aggressive but it is worth keeping an eye on.
  Australian economic releases and implications
• Australian economic data was mixed.  New vehicle sales for December rose solidly in December and the TD Securities/Melbourne Institutes’ Inflation Gauge showed significant inflationary pressure in December. But against this, consumer sentiment and skilled vacancies both fell sharply in January, presumably in response to the impact of the severe flooding. Both are likely to rebound once the flood waters subside. While a sharper fall in export prices than import prices implies a fall in the terms of trade in the December quarter, it should be noted that it is likely to rebound this quarter as the flood boosts coal prices.

Major market moves

• Global share markets fell over the past week reflecting a combination of profit taking after strong gains in recent months and worries about the impact of Chinese tightening. While the Australian share market briefly broke out to its highest level since last April, it was knocked back down again in response to a fall back in US shares and worries about the impact of Chinese tightening on commodity demand.
• Worries about the impact of further Chinese tightening also weighed on commodity prices and the $A.
• Bond yields rose as global economic data continued to surprise on the upside.

What to watch in the week ahead?

• In the US, the main focus is likely to be on December quarter GDP data (due Friday) which we expect to show an acceleration in growth to a 3.5% annualised pace after 2.6% annualised growth in the September quarter. US data for consumer confidence (Tuesday) is likely to improve slightly after a soft reading in December, data for new home sales (Wednesday) and pending home sales (Thursday) are likely to rise modestly and durable goods orders (Thursday) are likely to remain solid. Meanwhile, following its meeting on Tuesday and Wednesday the Fed is likely to signal greater optimism about the outlook for the US economy but not enough to warrant any imminent tightening in monetary policy. The December quarter profit reporting season in the US will also continue with 150 or so S&P500 companies due to report.
• Japanese data for inflation, the labour market and retail sales will be released on Thursday.
• In Australia, the importance of December quarter inflation data (due for release on Tuesday) for monetary policy has been somewhat reduced by flooding in Queensland and other states. Increases in prices for food, housing costs and petrol prices are expected to push up the consumer price index by 0.7% in the December quarter pushing the annual rate of inflation up to 3%. Underlying inflation is likely to also rise by around 0.7% in the quarter or 2.5% year on year.

Outlook for markets

• Share markets are vulnerable to a short term correction. After very strong gains since August last year many technical indicators show that shares generally are overbought, measures of investor sentiment are at high levels suggesting that a lot of good news is factored in and the seasonal tendency is for share market strength in December and January to be followed by weakness in February. Further Chinese tightening could be the trigger for a further short term correction in shares.
• However, shares are likely to put in good gains through 2011 as a whole so any short term pullback should be seen as a buying opportunity.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that 2011 is on track for strong economic growth which should in turn drive another year of solid profit growth, the global liquidity backdrop is highly favourable underpinned by very low interest rates in key countries & quantitative easing in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. By end 2011 we see the Australian ASX 200 index rising to 5500, once it shrugs off the current malaise which appears to reflect a combination of worries about the floods and Chinese tightening.
• The Australian dollar is at risk of a further correction in response to ongoing uncertainty about the impact of Chinese tightening on commodity prices and as a result of the negative impact on local growth from the floods. However, the broad trend is likely to remain up as the $US and the euro remain under downwards pressure, interest rates in Australia remain relatively high and high commodity prices keep the terms of trade near early 1950s highs. By year end the $A is likely to have reached $US1.10.
• The risk of a sharp back up in global bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels, at some point market expectations are likely to swing back towards monetary tightening in the US and Australia and the record inflows into bond funds seen in recent years are at risk of becoming record outflows. Fortunately, bond yields in Australia are more in line with long term sustainable levels so the risk of a sharp back up in Australian bond yields is less than is the case for global bonds.

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• Contrary to the expectations of the gloom and doomsters, 2010 turned out to be a positive year. The global economy expanded by around 4.5 per cent, the world didn’t slip into recession and global sharemarkets generally rose.
• Sure, the year wasn’t without its problems. Investors fretted about a double-dip recession in the US, European debt, and an over-heating of the Chinese economy. But worse case scenarios were avoided.
• Australian interest rates rose over 2010 and probably will again in 2011.
• At face value, the Australian sharemarket disappointed. But in large part that’s because the Aussie dollar soared – the second strongest currency in the world over the year. In US dollar terms, the Australian
  sharemarket actually out-performed the ‘world’ index.

Click here to download this doucument (pdf)

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Key points

• 2010 has been somewhat disappointing for investors, with continuing economic recovery but various macro scares resulting in a constrained and volatile ride for share markets and other related investments.
• 2011 is likely to see global growth continue, and this combined with attractive valuations and easy money is likely to underpin renewed acceleration in the recovery in shares and other growth oriented investments.
• Key risks relate to the US housing market, sovereign debt in advanced countries and emerging market inflation. However, with shares cheap and so much liquidity around its also possible that returns surprise on the upside after the consolidation of 2010.

2010 consolidating the recovery

The key global themes of 2010 have been continued global economic recovery, benign inflation and easy global money, yet all against a backdrop of periodic macro threats resulting in a mixed and perhaps disappointing ride for investors. Global growth in 2010 has actually turned out a little better than expected, coming in at around 4.7%, with emerging countries leading the charge. Even advanced countries with growth of around 2.8% have come in a bit better than we expected. Despite fears of a global dip back into recession the recovery has continued.

While inflation has been a bit of a concern in emerging countries, this has mainly been due to higher food prices. In advanced countries underlying inflation has fallen, with the US coming close to joining Japan in deflation.

Global monetary conditions as a whole have remained very easy as advanced countries have kept interest rates near zero and the US and Japan have embarked on more quantitative easing. While there has been some monetary tightening in emerging countries this has arguably just offset capital inflows which have resulted from resistance to upwards pressure on their currencies.

Contrary to the global experience, Australian economic growth has come in a little less than expected as housing construction has rolled over, rate hikes and greater caution with respect to debt have weighed on consumer spending, public sector stimulus has come to an end and mining exports and investment are yet to fully ramp up. Nevertheless, the labour market has been very strong with unemployment falling to 5.2%

However, despite a solid economic growth backdrop investment returns have generally been sup-par. All was fine up until mid April, but the June quarter saw macro worries return in a big way – led by the European sovereign debt crisis, worries about a double dip in the US on renewed housing sector weakness and concerns that Chinese policy tightening would crash its economy. This all weighed on returns for listed growth assets. Returns for major asset classes are shown in the following table.

Investment returns for major asset classes

• While returns are well down on 2009, the key winners over the last year have been global listed property, Asian and emerging shares, and commodity prices.
• Global bonds have also had solid returns as government bond yields fell on growth worries and deflation concerns and credit rallied.
• Returns from global shares were pretty subdued, but turned into losses once the rise in the $A is allowed for.
• Australian shares were also a disappointment, with global macro worries made worse by Australia’s exposure to China (with Chinese A shares being one of the world’s worst performers in 2010), monetary tightening in Australia and the rise in the $A.
• Australian unlisted commercial property provided good returns as investors took advantage of attractive yields
• By contrast, Australian housing was subdued as poor affordability in response to last year’s price surge and higher mortgage rates flattened sales and house prices.

The subdued and mixed experience across asset classes saw subdued returns from super funds.

Outlook for 2011

While aftershocks from the Global Financial Crisis will continue to cause volatility, 2011 is likely to be a year of continuing global recovery. The key themes of relevance for investors for 2011 are likely to be:

1. Continuing solid global growth. Business conditions indicators remain at levels consistent with solid growth ahead. There remains plenty of pent up demand globally and while fiscal conditions are tightening monetary conditions remain very easy. In the US, strength in the corporate sector is driving a pick up in employment and capital spending, housing indicators appear to have found a floor and retail sales growth is surprising on the upside. In Europe, strength in Germany has offset weakness in debt impaired countries. 2011 is likely to see global growth of around 4.3%.
2. Emerging world to remain stronger, but gap to narrow. Thanks to stronger domestic demand, growth in the emerging world is likely to remain stronger than in the advanced world, but reflecting relatively tighter monetary conditions the gap between the two is likely to narrow with emerging country growth of 6.5% versus 2.5% in advanced countries. China is likely to grow by 9.5%, India by 8% and Brazil by 4.5%.
3. Essentially benign inflation. Excess capacity is likely to ensure inflation remains low in advanced countries. Less spare capacity is likely to see inflation stay somewhat higher in emerging countries, but declining food prices – including in China – are likely to remove upwards pressure.
4. Fiscal tightening, but easy money. Fiscal tightening is already in train and likely to be the equivalent of one percentage point of GDP in 2011 in advanced countries and somewhat less in emerging countries. However, the negative effect will be offset by continued, very easy monetary conditions with still high unemployment ensuring monetary tightening will be unlikely before 2012. While emerging countries will likely be tightening to keep inflation under control this is unlikely to be aggressive (especially with food prices likely to fall) and will continue to be offset by a reluctance to allow faster currency appreciation resulting in capital inflows.
5. Solid earnings growth. As economic growth continues, earnings growth will likely remain solid. Profit growth is likely to be of the order of 10-15% in the US and Australia, and 20% in emerging countries.
6. Solid, but two speed, Australian economic growth. Growth in Australia is likely to be around 3.5% though 2011, but this will mask huge strength in the mining sector as a 50% boost in mining investment adds 2% to GDP growth, and tougher conditions elsewhere. The overall growth back drop will probably be enough to push unemployment down to 4.75% by end 2011, but for home builders and manufacturers it may feel pretty tough. Inflation is likely to be benign initially but to start rising towards 3% later in the year as growth constraints start to impact. While the RBA will leave rates on hold until the June quarter, we expect more hikes designed to contain inflation ultimately taking the cash rate to 5.5% by end 2011. Soft non-mining growth will likely head off the need for a more aggressive rise.

Looking at the major asset classes for the year ahead:

• After undergoing a decent correction in 2010 shares are well placed to put in strong gains in 2011. Shares are cheap (with forward price to earnings multiples around 12.5 times compared to longer term averages around 14.5 times) suggesting risks are well allowed for, the continuing economic recovery should underpin further gains in profits, the global liquidity backdrop is positive underpinned by very low interest rates and quantitative easing in some countries and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. 2011 is also the third year in the US presidential cycle, which usually sees above average share market gains. The Australian ASX 200 index is expected to rise to around 5500 by end 2011. Strength in the $A is likely to see unhedged international shares underperform Australian shares.
• Key sector outperformers in Australia are likely to be resources, cyclicals such as media and undervalued retailers, and telcos.
• Asian and emerging markets are likely to remain out performers reflecting similar valuations to Australian and global shares but better growth prospects, lower debt related risks and likely strong capital inflows from traditional advanced countries.
• Commodity prices are likely to remain strong with the oil price likely to breach $US100 a barrel in 2011.
• Commodity strength is likely to push the $A to $US1.10 by end 2011, but expect occasional sharp corrections as US growth strengthens.
• Cash remains unattractive reflecting low interest rates. Cash returns are likely to be around 5%.
• Low starting point bond yields and a rising trend in yields as the global economic recovery continues is likely to result in poor returns from international government bonds. Corporate debt remains far more attractive with higher yields.
• Unlisted non-residential property is likely to see good returns on the back of yields around 7% and modest capital growth thanks to favourable space demand/supply fundamentals and investor demand.
• Australian house prices are likely to flat line due to poor affordability and the threat of more rate hikes.

Our return expectations imply that most super funds should see a return to solid gains after the soft returns of 2010.

What are the risks?

The main risks are recurring sovereign debt crises in Europe and possibly also in other advanced countries, another bout of US house price weakness, and a more persistent rise in inflation in emerging countries, leading to a sharper than expected tightening in China. In Australia, it’s worth keeping on eye on the RBA as excessive tightening could threaten the Australian housing market.

Conclusion

The second year after a bear market ends often sees volatile trading and poor returns as share markets are constrained by worries about a double dip back into recession or concerns about the removal of stimulus measures. This has certainly been the case in 2010. However, the experience of past cycles points to the resumption of better returns in the third year and we expect this to play out in 2011.

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Mark Burgess, incoming Chief Investment Officer at Threadneedle, looks ahead to 2011: “Our central case for 2011 is one of reasonable global growth led by emerging markets. Against this backdrop world equity markets look good value, particularly against government bonds. In addition, many companies have strong, healthy balance sheets and are sitting on large cash piles, having held back on investment during the recession. We expect corporates globally to start to use this cash to increase capex, raise dividends, buy-back stock or undertake merger and acquisition activity. We believe that emerging markets will continue to grow and outperform the rest of the world, helping to fuel demand for consumer goods and commodities.

“At the same time we must be mindful of the risks to this scenario. The credit crisis elicited a range of untested policy responses and we are yet to see the full consequences of these policies. The banking sector globally needs to continue to raise capital, which will restrain credit expansion and hence economic growth. In emerging markets there is the potential for growth to turn into a bubble and inflation to become a risk. Globally, markets remain fragile and any major shocks could cause volatility.

“This volatility should create opportunities for nimble, experienced investors with a proven ability to look through short-term noise and indentify long-term winners.”

INVESTMENT THEMES FOR 2011

Policy responses to remain a key driver of markets

Growing economic divergences highlight critical global imbalances that require intervention. The Eurozone is in crisis, China is tightening policy and the actions of developed markets threaten to spark currency wars. These issues all demand that policymakers adopt appropriate measures in a timely manner, yet policy response remains the single most difficult risk to assess. We believe that the ride will be bumpy but that policymakers will eventually arrive at the right place, allowing supportive fundamentals and ample liquidity to support asset prices.

• The European Central Bank must act urgently, as it has been reactive and fallen behind the curve in protecting the Eurozone. The ECB should recognise that policy must support the weaker economies and not simply be tuned to the mantra of “one size fits all”. This will necessitate a policy that is far too easy for stronger members, but the viability of the monetary union is at stake. We believe the ECB is likely to adopt some combination of lower rates, below-market rate loans to troubled economies, liquidity provisions and outright bond purchases.
• As QE becomes a more prevalent policy tool it is certain to evoke fears of competitive currency devaluation. There will likely be growing calls for capital controls in many developing economies reluctant to see an unwanted surge of liquidity into their economies. Such steps should not undermine the global growth story, but will likely stoke higher volatility across markets.
• China’s deflationary boom is turning inflationary, representing a paradigm shift in the economy at the heart of global imbalances. The ability of Chinese policymakers to tighten policy without rattling investors will require more skill than in past cycles.
• Ongoing de-leveraging continues to unleash powerful deflationary forces, which should allow developed economies to sustain modest growth whilst pursuing reflationary policies.

QE consequences

Quantitative easing has unleashed a wave of liquidity that must find a home. At the same time, it has stirred strong opposition in some quarters.

• QE2 is explicitly targeting asset prices and liquidity is likely to find its way into the areas offering the best value and potential returns. Currently this means higher risk assets such as equities. This is one of the reasons why we remain overweight in equities versus bonds.
• Specifically, emerging market equities and bonds are likely to be well supported. We may be in the early stages of a bubble in these assets.
• Subsequent waves of QE will become increasingly difficult to defend on the world stage. This could tip the current phase of currency devaluation into full-blown protectionism. Stocks with significant overseas earnings could suffer in this scenario (this is not our central case).

“Emerging market exposure is a consensus trade, but it can continue to reap rewards throughout 2011. It doesn’t make sense to stand in the way of this tide of liquidity.” Sarah Arkle, Chief Investment Officer (Vice Chairman from Jan 2011)

Stock picks: Sun Hung Kai, Barrick Gold

Untested policies

The credit crisis elicited a range of innovative and untested policy responses. This is likely to lead to ongoing volatility, rotation and unforeseen consequences.

• An important skill in 2011 will be the ability to look through short-term volatility to see the longer-term pricing anomalies.
• Ongoing uncertainty means that it will be more important than ever to be aware of risks in portfolios and ensure that all risks are understood and intended.
• Active management and stock picking are likely to add significant value in 2011.

“We are in completely uncharted waters here. Investors expecting a reversion to mean may be disappointed.” Jim Cielinski, Head of Fixed Income

The haves and the have-nots

Two-speed economies are developing at a global (emerging vs developed world), European (core vs periphery) and US level (skilled vs unskilled workforce). These distortions create socio-political tensions but also provide opportunities in a number of sectors.

• US unemployment remains high but in certain sectors, wage bargaining power is evident. When analysing companies, we will be emphasising their ability to retain talented staff without instigating wage inflation.
• With interest rates at all-time lows and QE2 targeting higher asset prices, employed, asset-rich consumers with mortgages should feel wealthier in 2011. This will support high-end consumer discretionary stocks.
• European banks with exposure to the periphery have been de-rated significantly. This creates the scope for a sharp rally if solvency fears are addressed decisively by the ECB. We remain underweight but continue to monitor the sector closely.

“You can’t take someone that was laying bricks on a building site in 2007 and put them into Google’s product development team. Specialist skills are in short supply and will be rewarded in 2011.” Cormac Weldon, Head of US Equities

Stock picks: Tiffany, Polo Ralph Lauren

The search for yield

We believe that inflation is not a risk in the developed world and that interest rates will be kept at historic lows in these markets. As such, government bond yields are unlikely to rise significantly and investors will seek income in higher-yielding areas.

• Emerging market and corporate bond valuations remain attractive relative to their improving fundamentals. We continue to favour these bonds over government issues in fixed income.
• Income stocks are likely to be in favour in equities. Moreover, companies that are reinstating or raising their dividends are likely to be re-rated.

“Why would I lend money to the UK government at 3.5% when I can get 5.1% with the prospect of dividend and capital growth from AstraZeneca?” Leigh Harrison, Head of Equities

Stock picks: AstraZeneca, Vodafone, BT

The emerging market consumer

Emerging markets will continue to produce superior growth in 2011 and growing wealth among consumers in these markets will support demand in a number of areas.

• We continue to invest in luxury goods stocks in Europe, where robust earnings growth has seen multiples decline despite rising share prices.
• More recently, we have expanded this theme into European premium auto stocks, eg BMW, where the valuation is attractive relative to its Asian joint venture partners.
• Banks in under-penetrated markets such as Indonesia and India are likely to attract capital as investors follow through the consumer theme.

“Luxury goods stocks were the first beneficiaries of growing emerging market wealth. The developing consumer credit cycle will create bigger ticket opportunities as this theme matures.” William Davies, Head of European Equities

Stock picks: BMW, Bank Rakyat

The return of capex

Companies have been very cautious in their investment plans in this cycle, preferring to maintain high levels of cash. Corporate balance sheets are strengthening and capital expenditure to depreciation ratios are at all time lows. We believe this trend will change in 2011.

• Improving economic confidence and high commodity prices are likely to drive increased capex in the extractive industries. Industrial stocks will be among the key beneficiaries.
• The replacement of ageing IT infrastructure at a wide range of companies will support earnings in the software and hardware sub-sectors.

“Mining equipment companies have been buffeted by changes in economic sentiment in 2010. They are attractively valued and there is scope for significant upgrades to earnings.” Simon Brazier, Co-Head of UK Equities

Stock picks: IMI, Komatsu

Mergers and acquisitions

Cash balances are high, valuations are attractive and companies will crystallise value in the market by undertaking earnings-enhancing corporate activity such as m&a. Meanwhile, private equity companies are under pressure to invest. Emerging market corporates are also likely to take advantage of currency strength to acquire footholds in companies in the developed world. This, together with share buy-backs, will drive a significant phase of m&a.

• Companies with unique assets, superior growth or access to proprietary technology will be among the main takeover targets.
• Management quality and valuation may not always be key drivers: small and mid-caps are likely to attract interest despite full relative valuations.
• Companies deploying cash in shareholder-friendly ways are likely to outperform as investors become more focused on the efficient use of capital.

“2011 could be the year when a household western name gets taken over by an emerging market rival.” Jeremy Podger, Head of Global Equities

Stock picks: Mid-cap resources, industrial companies

Commodity prices will remain underpinned

The outlook for commodity prices is positive, given the recovery in the world economy and the dominance of resource-hungry emerging markets in the global growth profile.

• Commodity-rich nations will continue to witness capital inflows, further strengthening FX positions and credit worthiness. This should support equity valuations and further spread tightening in fixed income.
• Companies using more expensive raw materials in their production processes will witness margin pressures.
• Rising commodity prices could be a source of inflationary pressure.

“Our growth forecasts imply additional demand of around 1.5m to 2m barrels of oil per day in 2011. If it becomes apparent that OPEC does not have sufficient spare capacity to meet this demand, the oil price could move sharply higher.” David Donora, Head of Commodities

• Mark Burgess becomes Chief Investment Officer from Jan 2011, when current CIO Sarah Arkle moves into her role as Vice Chairman.

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Global investment manager, ING Investment Management (ING IM), says global economic growth is forecast to be significantly lower in 2011 with a widening divergence in the performance of emerging versus developed economies, high volatility in markets and rising uncertainty over macroeconomic issues.

It warned that untested policy prescriptions from governments and central banks – which it has termed ‘test tube policies’ – could further contribute to significant market volatility. ING IM also said that much of the developed world has made only 30% – 40% of the adjustments needed to adapt to the new environment and challenges, and estimates there is a 60% chance that global economies and markets will muddle through 2011.

Eric Siegloff, Global Head of Strategy and Tactical Asset Allocation, said: “We are likely to face a tough and volatile economic and investment environment next year with the divergence between the emerging and developed economies widening further. Companies and investors will also need to brace themselves for unexpected consequences from the ‘test-tube’ macroeconomic strategies being employed by governments and central banks.”

ING IM expects real global GDP growth to be around 3.8% in 2011, compared with its forecast of 4.8% for 2010. GDP growth in the emerging economies is projected at 6.5% (2010: 8.1%) while forecast developed
world GDP is 1.6% (2010: 2.2%), widening the economic performance gap between the two further.

These forecasts could be further modified by the 25% possibility that the world could lurch into another serious downturn, compared with a 15% chance of a surprise on the upside with strong economic growth. Developed economies may continue to be dominated by deleveraging and output gaps that would lead to deflation and low nominal growth.

“Investors will need to take a much more dynamic approach to their investment strategies in the more turbulent and divergent financial market conditions we predict in 2011. This means a greater focus on growth, and in particular dividends, income and yield – or what we call ‘DIY’, added Mr Siegloff.

“With such a high degree of uncertainty, investors need better risk management and a total return approach instead of focusing on benchmarks. In the low return world we are predicting, beta alone will not deliver. You need to place a greater focus on asset managers who can consistently provide alpha,” he said.

Australian economy remains well positioned

The Australian economy is growing solidly with output and income growth strengthening and unemployment falling. While growth in the major advanced economies is expected to slow, the emerging economies of Asia are continuing to grow strongly.

As a result, Australia’s major trading partners are expected to grow at their fastest pace in over 20 years and this is boosting global demand for commodities and driving Australia’s terms of trade. According to INGIM, this surge is expected to provide substantial impetus to domestic growth, supporting rising incomes and activity, underpinned by strong growth in exports and business investment as we move froward into 2011.

James Wright, Chief Investment Officer and Head of Australian Equities said: “We expect the Australian economy to grow more strongly than the rest of the developed world in 2011. While inflation is expected to rise, the withdrawal of monetary and fiscal stimulus and the appreciation of the Australian dollar will help to contain demand and inflationary pressures.”

2011 equities outlook

Global equities

ING IM believes the key drivers for global equity markets in 2011 will be positive earnings growth, attractive valuations, abundant liquidity and strong corporate wealth. These will underpin three strong themes for next year – sustainable income and growth, increased corporate spending, and emerging markets.

Sustainable income and growth: Here, dividends will become an even more important income generator, while low payout ratios, strong balance sheets and high profitability will support further growth.

Corporate spending: Corporate confidence is rising, and strong cash flows and balance sheets will lead to increased activity in buybacks, dividends, M&A activity and capital expenditure.

Emerging markets: There are still many attractions here for investors, including low public and private debt levels and high economic growth. ING IM still believes that emerging market equity valuations are not in ‘bubble’ territory as some market commentators claim.

“The 2011 outlook for global equities is good and we expect returns to be in line with earnings growth. However, investors will need to focus on yield and also on growth markets,” said Mr Wright.

Australian equities

ING IM. believes solid population growth and the demand for raw materials, as well as robust employment will be positive for Australian equities

Just like the two-speed world expected in 2011, in Australia the two-speed economy is expected to continue, with the industrial sector more closely tied to developed market demand and the buoyant resources sector tied to emerging market demand.

“Strong business investment, rising commodity exports and robust income growth supporting household consumption will continue into 2011 which will support the local markets. However, we do expect continuing volatility which will create value-capture opportunities for active managers,” said Mr Wright.

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Only a week earlier on July 15, US central bank minutes show that Bernanke expects the US economy to stagger along below its average growth rate for up to six years.

The less-than-glowing assessments from the US central bank chief and disappointing economic indicators on the US and global economies are feeding pessimism among investors and have undermined global stock markets of late.

Investors are concerned that the world’s biggest economies – the US, Japan, the eurozone and China – are slowing. And that even if another global recession is avoided, it might feel like one anyway.

While a return to another recession cannot be ruled out, five factors suggest that investors may be too pessimistic about the outlook.

The first is that the global banking system is more stable now because western banks are in better shape. In the US, loss rates on most types of loans seem to be peaking, while bank capital ratios have risen to new highs. In Europe, while some have questioned the worth of the stress tests on banks, the results showed that only seven out of nearly 100 banks have problems. The improved health of western banks and the higher bank earnings should promote the lending that lubricates the economy. Although evidence on credit conditions is mixed, it seems reasonable to say that conditions are at least not worsening any more.

The second factor is that US companies are cash rich. Past US recessions have been associated with weak corporate cashflows, which has forced companies to lay off workers and reduce spending. Today, however, according to the latest quarterly data from Bloomberg, Russell 3000 companies have around US$2.9 trillion in cash and short-term investments, 19% more than a year earlier. Companies have already made significant cost reductions during the recent recession and are reaping some of the benefits of this in higher cash flows. There should, therefore, be less pressure on them to make further cuts that detract from economic growth.

Market fillip

Thirdly, self-correcting markets are changing relative prices in a way that supports economic growth. Oil prices, for example, are around half their peak reached in mid-2008. That helps keep costs under control for businesses and consumers.

Another factor is that emerging economies are humming. Many emerging markets, especially in Asia, are confident enough of the future to have started winding back stimulus measures to ensure that inflation stays under control. China, a key driver of the global economy, is cooling its property markets and allowing greater flexibility in its exchange rate to moderate its export growth and boost domestic demand. India in July raised interest rates for the fourth time since March. Despite such actions, the IMF expects the economies of China and India to expand 10.5% and 9.4% this year, while fellow BRIC member, Brazil, is forecast to expand 7.1%.

Lastly, more stimulus is possible. While many European countries are installing austerity measures to rein in budget deficits, this is not a universal strategy. Many countries retain significant scope, at least on the monetary side, to prod their economies if conditions turn bleak. In his prepared statement to Congress, Bernanke said central bankers “remain prepared” to act if circumstances required. With the US cash rate near zero, policy options in this regard would include the Fed buying more Treasury, federal agency and mortgage-backed debt securities.

While the pessimists could be proved correct, the greater likelihood remains that the global economy is moving to a new phase of slower growth rather than any kind of renewed downturn.

From a technical perspective, it is worth noting that heightened volatility at this stage of the recovery cycle is not unusual. Past crisis periods have quite often been followed by extended periods of choppy consolidation, such as that which occurred in 2004 when markets, after some bouts of gloom, eventually pulled out of the technology bust. Such thoughts might engender some optimism in Bernanke and others.

China’s, India’s and Brazil’s economic growth since the start of 2007 (quarterly, year on year)

DataStream

Financial information comes from Bloomberg unless stated otherwise.

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