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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Bank Indonesia’s policy U-turn is among a series of decisions Asian officials have taken recently to insulate the world’s fastest-growing region from slower global growth and any European upheavals.

The good news for investors is that Asian authorities have scope to buttress their thriving economies against global troubles. Public debt is relatively low and interest rates are at levels that allow them to be cut to good effect.

Policymakers in China, Korea, Malaysia, the Philippines and Singapore are among those who are bracing their economies because evidence is mounting that strife in the developed world is hampering the region’s growth. Of special note was a report that showed China’s exports fell 2.1% in September from the previous month, to herald the second consecutive monthly drop in China’s trade surplus.

This helped to crimp China’s economic growth to 9.1% in the year to September, the slowest pace in two years. In October, a key manufacturing index for China dropped to its lowest level in three years. Korea’s export growth also cooled in September and October, while the country’s industrial production fell 1.9% in August after shrinking 0.3% in July. Singapore’s exports unexpectedly dropped in September and the island’s GDP only grew at an annual rate of 1.3% in the September quarter. Taiwan’s economy shrank 0.3% in the September quarter, its first contraction since 2009.

The drop in global demand is prompting countries such as Malaysia, the Philippines and Singapore to lower growth forecasts for 2011 and 2012. The International Monetary Fund (IMF) has trimmed its growth prediction for Asia to 6.3% for 2011 and 6.7% for 2012 – still healthy rates, it must be said. “While domestic demand remains strong, Asia has clearly not ‘decoupled’ from advanced economies,” the IMF said.

The list of steps that Asian countries have taken of late to shield themselves from a troubled global economy includes the Philippines introducing Asia’s first fiscal-stimulus package for 2011. After exports dropped for a fourth straight month in August, Manila on October 12 announced a package of public works and anti-poverty measures worth 72 billion pesos (A$1.7 billion), while cutting its 2011 growth forecast by 0.5% to 5%.

A day later, Beijing announced tax breaks and easier access to bank loans for small businesses, as Europe’s woes added to the urgency of countering the effects of China’s recent tightening of monetary policy on small manufacturers. Amid concerns about how China’s bad-debt-laden financial system would cope with a renewed global crisis, Central Huijin Investment, which is part of the country’s sovereign wealth fund, revealed it is buying stakes in the country’s four big banks. China’s Prime Minister Wen Jiabao said on October 25 that Beijing will make adjustments at a “suitable time and by an appropriate degree” to keep China’s economy moving.

Malaysia’s government on October 7 announced that in its fiscal 2012 budget it will hand cash to the poor, raise wages for public servants and boost spending on transport, to help higher private investment and consumption make up for sluggish global growth. Kuala Lumpur reduced its forecast for 2011 growth by 0.75% to 5%.

Well-placed Asia
Also in October, Singapore’s central bank said it will slow its currency’s climb to help its economy withstand a drop in exports. “Given the stresses and fragility in the advanced economies, the prospects for growth in Singapore’s major trading partners have deteriorated,” the central bank said, announcing the decision. The Monetary Authority of Singapore, which uses movements in the Singapore dollar to fight inflation, said it will still let the currency appreciate because inflation above 5.5% exceeds its target.

So far, Indonesia and Pakistan are the only countries in east or south Asia to have cut benchmark rates this year (as the Reserve Bank of Australia did on November 1). Bank Indonesia, explaining why it lopped its reference rate by 25 basis points to 6.5% last month, flagged further rates cuts and other measures “to mitigate the impacts of declining global economic and financial performance on Indonesia”. 

Other central banks have ruled out any more of the rate increases that have featured across Asia since the start of 2010 as part of a drive to quell inflation.

While the Bank of Thailand in October refrained from raising rates for the first time this year because the country is grappling with the worst floods in more than 50 years, the Bank of Korea’s policy-setting committee was explicit about how the uncertainty from Europe is prompting it to keep rates on hold.

“The committee judges that downside risks to growth have expanded – due mostly to the likelihood of the sovereign debt problems in Europe spreading,” the committee said in a statement on October 13, after deciding to keep rates steady for a fourth consecutive month. The Bank of Korea has increased rates five times in 2010 and 2011 to get inflation, which is above 5%, under its 4% ceiling. (The Bank of Thailand has raised rates nine times since July 2010.)

Authorities in countries such as China, Hong Kong, India, Korea and Singapore are constrained by inflation from undertaking bolder monetary and fiscal steps to protect their economies. (The Reserve Bank of India, in fact, on October 24 raised rates for the 13th time in 19 months to control inflation that is running close to 10%.) But most have enough scope to make a difference thanks to how policymakers have normalised monetary and fiscal policies since stimulating their economies three years ago.

As occurred in Australia, once the crisis of 2008 to 2009 eased, central banks boosted interest rates to more normal levels in nominal terms. So they can cut again, if the situation warrants.

While fiscal deficits are still above pre-crisis levels in many countries, pacy economic growth has improved government finances and officials have capacity to spend if needed. The G20 economies had a public-debt-to-GDP ratio of more than 100% in 2010, a figure that is projected to reach 125% by 2015. Public debt levels in Asia ex-Japan, by contrast, are only around one-third of GDP and are projected to decline to less than one-fifth by 2015.  

As well, banks, companies and consumers are in good shape debt-wise across the region. Asia ex-Japan companies, for instance, are holding about US$1 trillion in cash and are confident enough about their outlooks to be boosting cash-payout ratios (thus increasing dividend returns).
So Asia’s politicians and central banks shouldn’t have to make too many unexpected steps to shield their economies as much as possible from global woes.

This document is issued by FIL Investment Management (Australia) Limited ABN 34 006 773 575, AFSL No. 237865 (“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 is available 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. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is Perpetual Trust Services Limited (“Perpetual”) ABN 48 000 142 049. Perpetual is not the publisher of this document and takes no responsibility for its content. Reference to ($) are in Australian dollars unless stated otherwise. 2011 FIL Investment Management (Australia) Limited.   Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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