Stockholm, Sweden

Few developed economies rebounded as quickly as Sweden did from the global financial crisis. After contracting 5% in 2009, Sweden’s economy expanded 6.6% a year later, swelled another 2.9% in 2011 and has grown since, even if at a lesser rate.[1]

The remedies that drove Sweden’s revival were the same cures that helped Australia avoid recession after the global financial crisis struck in 2008. Fiscal stimulus and aggressive cuts in interest rates by the central Sveriges Riksbank nurtured an economy that was in reasonable shape when Lehman Brothers folded in 2008. Sweden went into the crisis with a central budget surplus of 3.6% and low net government debt, at around 40% of GDP, having conservatively managed official finances and its banks since the country hosted a banking crisis in the early 1990s (just as Australia did).[2] Another boost was that the EU member has its own currency, the krona, because Swedish voters wisely decided against adopting the euro in a referendum in 2003 – which means, of course, that the country has its own monetary policy.

Having the ability to alter interest rates and other monetary tools to suit economic conditions, however, comes with no guarantee that this power will be used astutely. The Nordic country looks set for some harsh years ahead because its central bank has misjudged the economy. Sweden’s misfortune is that officials at the world’s oldest central bank used monetary policy to attack a frothy housing market, record household debt and largely imaginary inflation. It’s to be hoped that other central bankers (including those at Martin Place, Sydney) are studying the mistakes made at the Riksbank because many of their economies face the same challenges.

With housing in Sweden estimated to be 32% overvalued when judged against rents[3] and household debt at a troubling 175% of disposable income, the Riksbank under Governor Stefan Ingves raised its benchmark rate seven times from July 2010 to July 2011 and looks to have inflicted long-lasting damage on Sweden. In March this year, Sweden became the eighth EU country and the first in the north to record deflation over a 12-month period (over which time Swedish consumer prices fell 0.4%).[4] Five central-bank rate cuts from December 2011 to December 2013 don’t look like averting the counterproductive pain any time soon. The most self-inflicted damage is that deflation, among its many poisons, increases the real burden of household debt.

Sweden’s challenges aren’t just due to mistakes by a central bank founded in 1668, it must be pointed out. The country’s biggest market, the eurozone, is tottering, thus curbing export sales. The collapse of demand across Europe is a big source of the deflationary pressure swamping Sweden. The largest Nordic economy is still growing – it expanded 1.5% in 2013 – and there’s no sign that Sweden will enter a protracted recession any time soon, just years of puny growth. It’s not the central bank’s fault that Sweden’s welfare state discourages saving, thus encourages hyper borrowing, especially for housing. But the country is shaping as an example of the damage anti-inflation zealots can incur when they gain control of monetary policy and use it against a threat that doesn’t exist (inflation) and wield it to fight an asset bubble and rising household debt better controlled by other means.

Murdering a recovery

The Riksbank claims a colourful 350-year history that includes financing the wars during Sweden’s so-called Age of Liberty from 1718 to 1772 to even figuring in the assassination in 1792 of King Gustaf III, the autocratic regent who killed off parliamentary rule 20 years earlier.[5] Its more-mundane inflationphobia and anti-housing-bubble mindset probably traces to the more-recent financial, banking and housing crisis of the early 1990s. During this time, the Swedish central bank raised interest rates to 500% to defend its then fixed-exchange rate and struggled with a collapsing economy where household debt had soared to at least 130% of disposable income from only 95% in 1980.[6] One year after the krona was floated in 1992, the central bank was charged with keeping prices stable, a mandate the Riksbank interpreted as keeping consumer inflation close to, but under, 2%.

Inflation wasn’t a threat after Lehman collapsed in 2008 and the Riksbank was fervent in helping Sweden navigate the crisis. It cut the target repo rate, the level at which banks can deposit or borrow from the Riksbank for seven days, from 4.75% to 0.25% in seven cuts from October 2008 to July 2009. So accommodative was the Riksbank, it pioneered negative interest rates on overnight deposits held at the central bank. The Riksbank set this rate at minus 0.25% from July 2009 to September 2010, to encourage banks to lend rather than park reserves at the central bank. (Denmark cut to below zero in July 2012 while the European Central Bank did so this month.)

Then came the decisions from mid-2010 to raise rates in seven steps to 2%, verdicts that were never unanimous among central-bank board members. Lars Svensson, an influential academic who was deputy governor of the Riksbank from 2007 to 2013 and the advocate of negative rates, opposed tighter monetary policy and he has let the world know of his disapproval – Svensson has a website that hosts posts and other material slamming the Riksbank.[7] Svensson resisted rate cuts because he said inflation was too low (at 1.2% at the time of the first rate increase), unemployment was too high (at 8.8% in mid-2010) and because fighting housing bubbles with interest rates would prove counterproductive.

The Riksbank raised rates over 2010 and 2011 because it judged “a lower repo-rate path can contribute to increased indebtedness” among households and this in itself can lead to “an unfavourable scenario … in the form of a fall in housing prices,” the central bank said in its Monetary Policy Report of July 2013, the month of its last rate increase.[8]At this time, inflation in Sweden adjusted for the impact of rising mortgage costs was running at an annual rate of only 1.6% and unemployment stood at 7.9%.

The Riksbank’s actions showed the majority of its board were swayed by proponents of the strategy of “leaning against the wind” to control Sweden’s bubbling housing market. This is the tactic for central banks to tighten monetary policy more than necessary to suppress inflation to counter hasty credit growth and rising asset (housing) prices. Opponents of this stance (such as Svensson) say the temporary fall in inflation becomes permanent while the resulting drop in size in new mortgages is too insignificant to affect total nominal mortgage debt. In Svensson’s words: “That total nominal debt falls quite slowly means that movements in real debt and the debt-to-GDP ratios are dominated by faster movements in the price level and nominal GDP.”[9] In short, debt ratios worsen. The five rates cuts since December 2001 that have reduced the repo rate to 0.75% and the fact that the Riksbank forecasts household debt to reach 180% of disposable income by 2016,[10] double to where it fell in the mid-1990s after the banking crisis, would appear to vindicate Svensson’s claims. Perhaps even more damning, Sweden’s government is considering greater oversight of the country’s central bank.[11]

Many goals, many tools

The actions and failures of the Riksbank feed into the debate about whether central banks should extend their remit beyond price stability to financial sturdiness. For if the global financial crisis did anything, it has destroyed the notion that low inflation engenders economic stability. Large asset bubbles that led to a global recession made worse by erratic swings in global capital flows revealed the limpness of only targeting inflation with one instrument, interest rates.

The IMF, in another backpedal since 2008, now sympathises with those who call for central banks to concern themselves with financial stability as well as price stability. An IMF staff discussion released in April this year says that central banks could broaden their remit to financial and external stability (which means the exchange rate and capital flows) and sometime use the cash rate to achieve these goals. “Where possible, these (goals) should be targeted with new or rethought instruments (macro-prudential tools, capital-flow management, foreign-exchange intervention),” the paper says. “But should these prove insufficient, interest-rate policy might have a role to play.”[12]

Central banks have notched some success in heading off financial imbalances, though usually not with interest rates. The Swiss National (central) Bank has stood by its pledge of 2011 to keep the Swiss franc from falling below 1.20 euros (which means stop it rising) but that entails unlimited buying of the euro with Swiss francs and then mopping up excess francs through daily market operations. But there are many problems with a broader mandate for central banks. Financial stability is harder to judge than inflation. Bubbles are easier to spot in retrospect than when they are occurring – central banks may well smother healthy activity if they misdiagnose a spurt in asset prices. An expanded central-bank mandate would inject central bankers into political debates that could put at risk the perceived independence allowed central banks when they only worry about inflation. While judging interest rates entails a political choice between savers and borrowers, decisions on exchange rates and capital controls pit exporters against importers, restrict investors and hit different businesses in various ways, to name just some of the wider political decisions involved. Targeting financial stability could place central bankers in a situation whereby they enrage vested interests for raising interest rates when inflation is low. It’s hard for anyone to argue that a calamity that never occurred has been averted.

Another reason not to make financial stability as another target for monetary policy is that regulatory powers already exist to choke credit booms, controls that often sit within central banks. (The Reserve Bank of Australia lost these powers to the Australian Prudential Regulation Authority in 1998.) Bank regulators can easily suffocate credit frenzies by boosting bank reserve requirements, tightening rules around mortgage lending such as restricting low-deposit lending or capping the amount borrowed to a certain percentage of a person’s income. Regulators in Canada, New Zealand, Norway and Singapore have taken such steps recently. Politicians, as opposed to regulators, can stifle credit booms by altering fiscal policy. Lawmakers can raise stamp duties and other taxes on property or change (or even threaten to alter) tax laws to make housing a less-alluring investment. Sweden’s property boom is partly a result of lax regulation of bank mortgage lending, interest-only loans (no principal is repaid, which means home owners are essentially paying rent to their banks) and that fact that Swedes can claim tax deductions on a percentage of mortgage costs.

Even with all these shortcomings, central bankers, though, are bound to pay more attention to financial stability to avoid a repeat of 2008. The RBA appears to see financial stability as a long-term part of its mandate to keep inflation low and the economy at full employment. It’s “leaning” against Australia’s housing market (that the OECD judges is more overvalued than Sweden’s[13]) by warning about over-rapid price increases and by moving to a neutral stance with monetary policy. But, if you believe media reports, the government[14] is among those that are unhappy with the RBA’s efforts. The central bank, to its critics, is failing to stimulate a sluggish economy when inflation is tame (2.7% in the 12 months to March this year) and likely to slow, and is propping up the Australian dollar, at a cost to exporters and the government’s coffers. It is to be seen whether the RBA under Glenn Stevens is as successful as it was under Ian Macfarlane at calming a sizzling housing market or if, Riksbank-style, it causes a bigger mess.

by Michael Collins, Investment Commentator at Fidelity

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Paul Taylor, Portfolio Manager, Fidelity Australian Equities Fund shares his insights from reporting season.

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Michael Collins

In Europe, there’s a number that punctures immediate hopes for the region. It is the amount of bad debts that sit on eurozone bank balance sheets. Accounting firm PwC estimates that non-performing loans now exceed 1.2 trillion euros (A$1.8 trillion), a figure that has doubled in four years.[1] Until its banking system is steadied, Europe’s economy will be deprived of the lending it needs to recover, heightening the risk that only years of stupor lie ahead.

Forcing banks to confront their woes ranks among the most onerous tasks confronting policymakers in the eurozone, where non-performing loans will peak this year at 7.6% of gross lending, according to Ernst & Young.[2] The EU in October shifted a chunk of the responsibility for fixing banks to the European Central Bank. Late next year, the central bank will assume from national regulators sole responsibility for supervising large banks. The ECB will thus be in charge of ensuring that eurozone banks shed 3.2 trillion euros in assets (which means reduce their lending to trim their balance sheets by about 7%)[3] to comply with Basel III regulations by 2018, according to an estimate by the Royal Bank of Scotland.[4] While shifting supervisory powers to the ECB marks an achievement for Europe’s policymakers towards the banking union the area needs, they need to take even bigger steps to create the proper infrastructure needed to safely and swiftly restructure Europe’s banks. The challenge for lawmakers is that popular support is working against the formation of a union that is needed to ensure that the common currency survives.

A banking union entails having a uniform rulebook, one supervisor for all banks (rather than palming off smaller banks to national regulators as Europe has done at Germany’s insistence), a well-funded bank-resolution mechanism under central political control and a deposit-guarantee mechanism across an area. The key advantage of a banking union is that it spreads the costs of banking failures across the area under coverage, rather than allowing the pain to devastate the state (in Australia’s case) or country (in the case of the eurozone) where the bank is headquartered.

A banking union is not a cure-all, of course, and dollops of liquidity from the ECB and accounting and other tricks are propping up Europe’s banks anyway for now. A banking union won’t nullify the solvency threats from inadequate capital, a jobless crisis and the deflation taking hold in peripheral Europe. Its formation may prompt banks to over-prioritise boosting capital over lending. It won’t lower the equity and bond crossholdings among European banks that make the region’s banking system so vulnerable. But a banking union is the best way for Europe to cope with the excessive amount of soured loans to households and business that trouble bank balance sheets. It will help diffuse the threat posed to governments by oversized banks – due to excessive lending, eurozone banking assets amount to 3.5 times GDP compared with about two times in Australia, Canada and Japan and less than one times for the US. Perhaps far more significantly for Europe is the political symbolism involved with forming a banking union. Big leaps towards a banking union would verify that European policymakers are serious about creating the political, fiscal and financial integration Europe needs to surmount its crisis. For any banking union involves genuine political entwining and some fiscal sharing.

The credibility test

While the EU-controlled European Banking Authority is working on a single set of rules for European banks, the challenge of securing all the steps needed for a banking union for the euro area became apparent when the ECB in October said it will prepare for its supervisory role by conducting a review of the eurozone’s 130 biggest banks. The aim of the exercise that will cover 85% of the eurozone banking system by assets is “to foster transparency, to repair and to build confidence”, the central bank said announcing the review that will include tests on how resilient balance sheets are to shocks.[5]

When asked on Bloomberg Television whether any exam that aims to build confidence sounds rigged, ECB President Mario Draghi was forced to respond that “banks do need to fail” to uphold the integrity of the review.[6] His attempt to protect the validity of the ECB’s bank assessment rang hollow to many used to eurozone fudges – as if the ECB is going to reignite the eurozone crisis by flunking a bunch of its largest banks. It reminded many of the stress tests in Europe in 2010 and 2011 that quickly lost credibility when banks that passed soon needed rescuing.

The announcement of the ECB’s review served to highlight the inadequacies of the steps Europe has taken towards a banking union. The big failure is to establish a jointly funded mechanism to handle bank failures under central political control. A major barrier to any agreement is agreeing on who bears the cost of managing bank failures and who decides that a bank should be allowed to collapse.

The only sizeable progress Europe has made towards a joint bank-rescue mechanism is to sanction off 60 billion euros within the 500-billion-euro European Stability Mechanism to help banks if a Europe-wide system is ever put in place to cope with bank failures. This is an underwhelming amount of money given the estimated numbers of bad loans to households and businesses on Europe’s bank balance sheets. A further restriction is that the money would only be deployed if national governments agree to as-yet unformulated conditions. Another complication is that the rescue fund is under the political control of the so-called troika, the European Commission, the ECB and the IMF, a setup ripe for squabbling. Until policymakers agree on a centrally controlled authority to handle bank failures, national regulators (governments) will stay the backstop for collapsing banks headquartered in their country. This only reinforces the potential all-fall-down embrace between weak banks and debt-laden governments.

While European leaders have set a deadline of 1 January 2015 to have a common resolution system in place, they are unlikely to meet that timetable if no legislation is passed before European parliamentary elections in May. A meeting of European finance ministers in November failed to make any progress towards a year-end deadline to agree on how to fund a joint banking backstop, in the hope of having a European resolution mechanism in place by the time the ECB takes over supervision.

Fudging

The core reason why a banking union is largely stalled in Europe is politics. Germany is the biggest impediment. Berlin says that treaties governing the EU need to be changed to create a single resolution mechanism, a view that stalls progress because changes to treaties usually mean undertaking the slow and uncertain process of gaining voter assent. Berlin opposes the EC having the power to decide whether to restructure or dissolve a troubled bank and wants to keep this decision with national governments. It is insisting that creditors get wiped out (bailed in) as a condition to bank access to EU rescue money, even though Draghi has warned that such bail-ins risk alienating private investors. It is thwarting a eurozone-wide deposit insurance scheme. It is resisting ECB and EU requests to hand its small banks over to ECB supervision.

Berlin’s motives are more than simply wanting to protect its taxpayers from bank failures in other eurozone countries. It thinks that keeping supervision at the national level is the best way to hide the inadequacies of Germany’s banking system that includes some dodgy multinational and some suspect smaller regional banks. The decision to make the ECB responsible for supervising large banks only was a sop to keeping Germany’s generally small banks under Berlin’s political protection.

While politicians are hamstrung, Europe is experiencing a credit crunch – loans to the private sector fell 2.1% in the year to October.[7] At the same time, European banks are financing wobbly firms to avoid capital losses and are allowing troubled borrowers to technically default in a way that prevents write-offs hitting the balance sheets. (The simplest way to do this is to extend troubled loans and pretend they are sound, a drill that bankers call “forbearance”.) Such practices can’t go on endlessly. Maybe concerns that the eurozone crisis will reignite sooner or later will energise Europe’s politicians into taking leaps towards a leaner, better-capitalised and unified banking system that is capable of providing the financial lifeblood that businesses across Europe needs to thrive. The flawed structure of the euro, Europe’s unemployed and all those bad debts demand nothing less.

by Michael Collins, Investment Commentator at Fidelity

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© 2013. FIL Responsible Entity (Australia) Limited.  Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

Financial information comes from Bloomberg unless stated otherwise.

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. 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 should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. 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.

The post Bad debts hobble any European recovery appeared first on AdviserVoice.

Richard Lewis, Head of Global Equities, Fidelity Worldwide Investment, gives his thoughts on whether the worst is over for Europe and the challenge the euro poses for policymakers.

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In this article, Fidelity’s Nick Peters discusses the art of selecting the right manager, why monitoring performance is critical, and why it could make a difference to your overall returns.

Why is choosing the right manager important ?

Indeed, in recent years, the level of dispersion between top and bottom quartile managers has risen from around 10% to nearer 20%. The chart below shows, over five years, that the differential between the best and worst manager in the UK is extremely significant.  Theoretically, it is entirely possible for an investor to be completely correct in their asset allocation decision, only for them to lose money as a result of picking the wrong investment vehicle. Picking the right managers is critical.

No particular style of investing works over all time periods, so combining managers with different styles and processes can help investors to reduce their risk and smooth their investing journey. But finding the right manager is just the start; managers need to be monitored on an ongoing basis, with changes made in a timely and efficient manner when required.

The bedrock of successful manager selection is a rigorous research process.  In terms of technology and resources, a broad global capability is important to ensure that good managers are not overlooked.  It takes considerable time and effort to gain a deep understanding of each manager’s investment process and the drivers of their likely performance. The most effective approaches to manager selection will invariably combine both qualitative and quantitative analysis.

Running the Numbers

This is a vital part of the process and involves looking at both historic performance and fund holding data. The volatile markets of recent years have provided investors with a rich source of data for analysing fund manager behaviour. While past performance is no guarantee of future returns, it seems reasonable to approach a large universe of funds by screening out those which, for example, have never added significant alpha. It is important to assess performance during different market environments. For instance, for a manager with a more defensive philosophy, it is reasonable to expect them to preserve capital in difficult markets and to perhaps lag in strongly rising markets.

Meeting the Manager

The importance of detailed qualitative analysis of managers through regular face to face meetings conducted by professional investors should not be underestimated and forms the cornerstone of any manager selection process. Qualitative analysis usually targets three main factors – people, philosophy and process, and portfolio construction, as well as trying to assess softer factors such as passion, focus and organisational fit.

Investment management is a people business and assessing the fund manager, his team and wider resources is essential in understanding whether past returns can continue. Because every manager has a different investment process, there is no right size of team or organisational structure. What is important is that the organisation provides the necessary level of support for the fund manager. An alignment of interests between the fund managers, their teams and clients is also a positive sign as well as succession planning to mitigate the reliance on one key individual. Another important aspect is length of tenure within the team; a rapid turnover of analysts raises questions.

Identifying a manager’s edge versus similar funds is an important part of the discussion on philosophy and process. In other words, what is it about the process that is likely to lead to consistent performance in the future?

Alongside obvious factors that should be considered such as research process and portfolio construction, there are other intangible factors that need to be looked at in order to understand how a manager makes their investment decisions. A skilled manager has a differentiated perspective and hence tends to act differently on the same information.  Crispin Odey is a good example of a manager with such skill. His interpretation of the various cross-winds impacting global stock markets since the Financial Crisis has boosted his fund’s overall performance.

Another important indicator is a culture of continued innovation to maintain the performance edge.  The UK equity boutique Heronbridge  has an annual meeting specifically to discuss what went wrong in the previous year and what improvements can be made to the process to reduce the chances of errors (and underperformance) in the future.

Other indicators of success include signs of commitment, high internal standards and involvement in the investment process.  Alken, another boutique investment manager has an innovative approach to analysis: they literally let research analysts do what they want. Their team of six analysts are well aware that they are remunerated on ideas getting into the final portfolio. However they are given as much time as they require to analyse an idea before presenting it to the portfolio manager. This leads to well researched and thorough stock due diligence.  Most Alken analysts have a batting average (number of outperforming recommendations/total number of recommendations) of well over 50%.  Many active managers have a success rate of below 50%.

The Devil is in the Detail

Looking at the historic exposures within a fund over time allows an investor to conduct the “Ronseal test” on a manager – does the fund do what it says on the tin? It is important to identify those managers who not only have a solid process, but who apply that process consistently over time and do not change their style. It is important to verify the performance is consistent with the manager’s process and style.

For example, warning bells should sound when looking at a manager with a value style has a portfolio  full of expensive stocks. Managers who invest outside their core area of expertise may be lucky and pick the stock that does work, but it is skilled managers who will provide consistent performance over time.

Of equal importance as finding the right manager is the ongoing monitoring.  The aim is to make sure the process continues to be consistently applied over time and to identify inconsistencies between the process and what is subsequently happening within the portfolio.  Understanding the key drivers of underlying stock holdings is an advantage when assessing the manager as this makes it easier to understand the rationale for buying a stock and to make sure this is consistent with the fund manager’s approach.

For example, a small cap manager who has always focused on finding growth companies with robust balance sheets could be tempted to sacrifice the “quality” requirement as the growth stocks become expensive. This could have negative implications for performance, but more worryingly from an investor’s perspective is the fact that it represents a move away from the manager’s successful historic investment process, making it more difficult to have comfort that the pattern of strong past performance can continue.

It is difficult to overplay the importance of the qualitative aspects of manager selection and the advantages of building a long term relationship with fund managers. This is especially true of managers with short track records or those who work at boutiques. Investing in the right vehicle, as we are all aware, can have significant implications so finding the right manager and monitoring them is critical.

By Nick Peters, Portfolio Manager within Fidelity’s Investment Solutions Group

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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. 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 should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. 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.  © 2013 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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Federal Reserve building, Washington DC.

Stan Druckenmiller, a star US hedge-fund manager, slams the Federal Reserve for “running the most inappropriate monetary policy in history”. But what seems to scare investors more is the prospect that the Fed’s quantitative easing will end soon.

Financial markets wobbled after Fed Chairman Ben Bernanke on May 22 said the Fed could wind down the unorthodox monetary tool, whereby a central bank, having already slashed its cash rate to close to zero, conjures liabilities on its balance sheet to buy financial assets. The aim of the policy is to lower long-term interest rates to encourage consumers to spend and businesses to invest.

The policy, first tried in Japan in 2001, has helped the world avoid the deflation and depression that dogged the 1930s. While the ability of quantitative easing to spur economic growth is more debatable, for it has failed to stir a lasting recovery, it’s clear the practice carries side effects, including beneficial ones for financial assets.

Druckenmiller and others say the Fed’s asset-buying misallocates resources (hard to prove) and will unbuckle inflation expectations (no sign of that happening). Other alleged spin-offs are so-called currency wars (inadvertent) and inequality because the practice favours asset owners (as the Bank of England admits). The asset-buying has certainly propelled bonds to record low yields, even Netherland bonds that were first issued in 1517, and boosted stocks to fresh peaks.

A definitive assessment of quantitative easing must wait until the practice ends. Many worry it will finish badly. They fret that the great monetary experiment of our time is yet to be halted seamlessly in any country as its economy reignites. Japan has conducted bursts of quantitative easing over the past 12 years (thus temporarily ending it), but without revitalising its economy. But there are no reasons why quantitative easing can’t end smoothly enough for the US as its economy rebounds. It may, however, prove more troublesome for other parts of the world.

The intentions

The declared Fed policy is that it will reduce its asset purchases worth US$85 billion (A$90 billion) a month in steps any time now, if economic, especially jobless, readings justify a less-promiscuous policy. The Fed expects that by mid-2014 it will have stopped the asset-buying that has swelled its balance sheet to US$3.7 trillion from US$894 billion at the start of 2008. By then, the Fed expects the jobless rate to be under 7%, from a four-year low of 7.3% in August.

The Fed can alter, even reverse, its actions at any time if the economy changes beat. Bernanke, aware that policymakers wrecked recoveries in the 1930s by braking too soon, says he won’t allow “a premature tightening”. But such comments to Congress have failed to soothe investors and speculators. Since the end of May, these “feral hogs”, as Richard Fisher, the President of the Dallas Fed described them to the Financial Times, have walloped bonds (thus boosted interest rates) and driven up the US dollar while undermining stocks, especially emerging ones, and commodities.

The financial reaction surprised Bernanke. Perhaps he failed to realise how addicted market players have become to their central-bank fix – so much so that promising reports on the US economy now trigger turbulence for they reinforce that the Fed’s asset purchases will slow soon. Another problem, though, is that some people see so-called tapering as a squeeze on credit, the scourge of the Great Depression. But tapering is not a tightening of monetary policy. If the Fed spends one dollar buying assets, it is easing monetary policy. Once the Fed stops buying assets, then monetary policy is in neutral.

The reason why the ending of quantitative easing is unlikely to be threatening to the US is that the central bank doesn’t need to sell the assets purchased under the program (outside of its normal trading of securities on the money market to control the cash rate). The central bank can hold the bonds to maturity, for, under a system of fiat money (when notes and coins are backed by nothing), the size of a central bank’s balance sheet is peripheral. The dimensions of the monetary base (notes and coins in circulation and bank reserves held at the central bank) have no influence on the Fed’s ability to control the cash rate and thus inflation. When central banks in the 1990s moved to a system of announcing cash-rate targets, they snapped the link between the money supply and the cash rate.

The political reality, though, (and Fed officials are attuned to that) is that the puffing up of the Fed’s balance sheet has sparked warnings of inflation, asset bubbles and economic imbalances. Bernanke admitted to such risks on May 22 when he told Congress the Fed’s loose policies could “undermine financial stability”. Fed officials want to shrink the balance sheet for they anticipate blame for any financial mishaps while it stays bloated. The Fed can be expected to sell assets to trim its balance sheet, and if it does, it’s tightening monetary policy. The Fed will only do this if the economy is humming enough to stoke inflation beyond its 2% limit. By selling assets, the Fed wouldn’t need to raise the cash rate as much as otherwise to keep inflation benign. This will help the recovery for it will receive fewer Fed-raises-rates jolts.

A bond surprise

Amid the tapering talk, US 10-year Treasury yields have risen about 130 basis points from 1.67% on May 1. (They peaked 2.99% on September 5.) The ending of quantitative easing may have a less-dramatic effect on US yields over the rest of the year, though. Investors have priced in the Fed’s intentions and the economic data is modest. (The US economy expanded at an annual rate of 2.5% in the second quarter). Investors are reassured that the Fed will be flexible about curtailing its asset-buying if circumstances demand and they think the central bank is determined to keep the cash rate low. Analysts only expect one 25-basis-point rise in the US cash rate in the next 12 to 18 months.

The biggest risk with ending quantitative easing is that even small increases in borrowing rates could torpedo the US recovery. The US economy’s rebound is wobbly as it is battling reduced fiscal stimulus, stricter bank-lending practices, a feeble eurozone recovery and a slowdown in China. Another risk to the Fed in shrinking its balance sheet is that it will realise losses on bond sold, if interest rates are climbing. That will force a de facto tightening of US fiscal policy. These concerns can be offset by the fact that any dip in economic growth could lead to a renewed loosening of monetary policy.

Investors can expect endless speculation about how and when the Fed will act. The jobless rate will be the best guide but the official rate fails to capture the intricacies of the labour market. The better official employment numbers shroud that many of the jobs created are low-paid and part-time and that many people have dropped out of the workforce. The gains in jobs may not empower the economy that much. The Fed could remain a bond buyer until the official jobless rate is well under 7 per cent\.

The reactions on financial markets to every economic release or Fed utterance can be considered a cost of slowing or reversing quantitative easing. The Fed should worry about bond yields for higher interest rates threaten the recovery. The Fed’s job is to control US inflation and promote US economic growth. It can ignore gyrations on currency, commodity, property and stock markets that have no obvious consequences for the US economy.

It’s hard to see how the ending of quantitative easing can ignite inflation when it will only boost interest rates, which would subdue inflationary pressures. The threat of deflation dispels notions of a bond bubble so it’s not likely that Bernanke will trigger a 1994-style bond crash. The big surprise of the ceasing of quantitative easing could well be how little disruption this causes in the US.

Trouble elsewhere

The ending of quantitative easing, however, may be more complicated elsewhere. The widespread use of the US dollar in trade and in pricing assets and the fact that many currencies are linked to the greenback ensure that US monetary-policy shifts are transmitted around the world. The problem is that while the US economy is recovering many other countries are struggling. Those with currencies tied to the US dollar are losing their export competitiveness as higher US interest rates are boosting the greenback.

The region most at risk is Europe, even with a free-floating euro. The ending of the Fed’s asset-buying may trigger a rise in global bond yields that, however gentle, hampers Europe’s economy, while exposing the limits of the European Central Bank’s bond-buying promise to save the euro. Investors may discover that the ECB can’t keep bond yields of troubled sovereigns at low-enough levels to keep governments solvent, just as a slowdown shoves more pressure on public finances.

Emerging markets are vulnerable in a different way. When quantitative easing started in 2009, US money fled to emerging markets to seek higher returns. The US-sourced capital may gush home if US yields rise. Investors fret that more emerging countries might need to raise interest rates, and thus curb growth, to attract capital to offset current-account deficits and protect their currencies from a slump that triggers inflation via higher import costs. Central banks in Brazil, India, Indonesia and Turkey lifted key rates and took other steps in recent months to prop up their currencies and balance their balances of payments. (India’s moves included capital controls).

The Fed’s actions, however, might be less of a concern than the other causes of economic slowdowns already underway in much of the emerging world. Brazil confronts falling commodity prices, sluggish growth and inflation. China is battling excessive lending. Inflation-prone India is heading to its biggest balance-of-payments crisis since 1991 because politics have stymied reform. Central European countries such as the Czech Republic, Hungary and Poland are largely untouched because their economies are better balanced. Heightened US economic activity sucking in imports may offset some of the short-term damage of the tapering, which will probably prove a hiccup for emerging countries rather than trigger a crisis. Most of the capital directed at the emerging world in recent years was for long-term investment and many countries have low foreign-debt-to-income levels and enough reserves to cope with the whims of speculators. The emerging world’s favourable demographics, abundant raw materials, rising middle class, pro-business policies, large savings pool and low labour costs will nurture its industrialisation for years to come.

Australia is better placed to cope than most countries from any Fed-induced buffetting. Australian bond yields will tick up to some extent with US yields but not fully as China’s slowdown is crimping growth and containing inflation. While rising local yields will slow the economy and steeper global interest rates will add to foreign-debt repayments, the Australian dollar will probably slide to more competitive levels and help our economy overcome the sag in the resources boom.

Over in Washington, the US-taxpayer-funded Fed should just focus on managing the US economy. It should ignore the global repercussions of its policies unless they will hurt the US. Authorities elsewhere should just better brace their economies for a less-lax US monetary policy.

Financial information comes from Bloomberg unless stated otherwise.

By Michael Collins, Investment Commentator, Fidelity Worldwide Investment

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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. 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 should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. 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.  © 2013 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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Paul Taylor’s Top 5 tips.

In an equities market where bottom-up stock picking is becoming increasingly important, Paul Taylor, Fidelity’s Portfolio Manager of the Australian Equities Fund, which celebrates its tenth anniversary this year, shares his Top Five Tips for investing.

Tip 1: Do your homework.

Think about investing in the stock market the same way that you think about buying a home.

“When people buy a home, they go and look at the home, they do title searches, they look at the area, they look at what prices other houses have sold for in that area. They look at what railways are going to be built or what changes to infrastructure or facilities,” said Mr Taylor. “Investors need to go through the same process when they look at stocks.”

“Read the annual report – it has an incredible amount of information – and go and visit the store if it’s a retail store. Try the product. There are a lot of ways to better understand a company so approach it in exactly the same way that you would approach buying a house.”

Tip 2: Keep an investment journal.

Write down when and why you buy or sell a stock.

“I think this process has helped me a lot,” said Mr Taylor. “Investors should write down when they buy or sell a stock and this helps outline your investment thesis. As you go through time, you can then re-examine that investment thesis and ask yourself – what was the original reason for buying shares in that company? Does that reason still hold? You need to always understand why you own a company or why you don’t.”

Tip 3:  Take a long term approach.

Investing in equities has a time frame of years, not months.

“My third investment tip is that the equity market is about taking a long term approach,” My Taylor explained. “Fundamentals don’t always play out on a three-month, six month or even a twelve month basis but they do on a three-year time frame. So investors need to take that view – they need to think about what company is going to be a great company in three years’ time, five years’ time or even longer. Be patient and take the long term view when equity investing.”

Tip 4: Investors need to attend Annual General Meetings.

Attend the AGMs of those companies you invest in.

“Investors should always actually attend the AGMs of those companies they invest in because it’s an opportunity to talk to the management team and the board about their strategies, and you also have an opportunity to ask questions which is extremely valuable. A lot of information comes out of an AGM so get involved in your investment, get out and talk to the management team and the board.”

Tip 5:  Try not to put yourself in the position of having to sell a share.

“Often when you have to sell a share, it’s usually the worst possible time to sell that share. Try and make sure you have enough cash to take advantage of opportunities but don’t back yourself into a corner,” explained Mr Taylor.

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About half [48.2%] of Fidelity’s research analysts believe the companies they cover will derive future growth from outside their home country/ region. Of these, China was overwhelmingly selected as the major source of that growth. ‘Other Asia’ was the next most popular source of growth [11%], followed by Latin America [8%] and then the core Eurozone [5%]. Perhaps surprisingly, India only registered with 4% of companies as the one major source of future growth.

Matthew Sutherland, Fidelity Worldwide Investment’s Head of Research – Asia Pacific, said: “Asia is still thought to be a major source of growth because even a hard landing in China is better than the best case scenario in the west, China’s economy is migrating from one driven by capital formation to one driven by consumption. This change will take time, but explains why companies are now looking at Asia, and China in particular, as a new consumer base rather than a place to shift operations to cut costs. The risk, however, is that if the Asian consumer disappoints, there isn’t really a plan B.”

From a global perspective, Asia is a more important region to more companies than either Europe or America. About 38% of companies are ‘very reliant’ or ‘entirely reliant’ on the health of the Asian economies, whereas 29% are very reliant or entirely reliant on developed Europe.

More than 110 of Fidelity’s equity and fixed income research analysts in Europe and Asia were surveyed. As each research analyst speaks with the senior management of 30 listed companies on average every quarter  – a key part of Fidelity’s ‘bottom-up’ fundamental investment process –  the survey reflects the thoughts of thousands of CEOs and other top management at listed companies in Europe and Asia.

China becoming more expensive
Seeing ‘Made in China’ on many manufactured products is likely to be on the wane over the next few years – double the amount of companies will be looking to ‘offshore’ operations to SE Asia [26%] than will be looking to offshore operations to China [13%].

Mr Sutherland said: “Wages in factories and, to a lesser extent, rural enterprises have risen significantly in the recent years – perhaps as much as 100% from 2003 to 2008 – as factory labour has become scarcer and the forces of urbanisation have whittled down rural labour stocks.

“It is apparent that China is maturing rapidly as an economy and that as wage costs there continue to rise – labour costs are now only 14% more expensive in Mexico compared with a 240% difference a decade ago, for example – companies are starting to look elsewhere.

“Companies will continue to offshore to reduce costs but the destinations of that new investment are changing – more so for European companies than Asian, perhaps reflecting their higher cost base.

“For Asian companies, South-East Asia will be by far the biggest beneficiary of this followed by China at 13%. For European companies, though, India beats China and SE Asia as the top destination for offshoring. This reflects the fact that Asian companies are offshoring manufacturing, while European companies are offshoring services,” Mr Sutherland said.

About the survey
114 analysts (90% of Fidelity’s analysts across Europe and Asia) responded to the survey in the period 3rd to 12th October 2011. The regional split of analysts was 58 from Europe and 56 from Asia (inc Japan).

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, the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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“Asian markets are attractively priced following the recent market correction,” said David Urquhart, Portfolio Manager of the Fidelity Asia Fund. “The region is now trading at a forward price to earnings ration (P/E) of 10.5x, which is at a deep discount to the five year average of around 13x. This is more than one standard deviation away from the five year average and is the second cheapest that you could buy Asian markets in a decade.

“Asian corporate balance sheets continue to be in very healthy shape, and economic growth continues in Asia. On a Price to Book basis the current valuations are 1.8x book value, versus five year average of 2.1x and with the return on equity much higher than that of 10 years ago.

“So, from a valuation standpoint, this is the second best time to be buying Asian stocks in 10 years. There are risks in the US and Europe but these risks are more than priced in at the moment. I am still comfortable with the growth outlook in Asia, which should significantly outpace the rest of the world in the coming years.”

Mr Urquhart said there are also some positives for Asia that arise from slower global growth. Many Asian economies – including China, Singapore, Korea Taiwan and India – introduced policy tightening measures due to their strong growth. “Slower global growth and the resultant lower commodity prices, especially oil prices with Asia being a big energy importer, will help to reduce some of the inflationary pressures in Asian economies. This will provide policy makers a reprieve on what was expected to be further tightening measures.

As a result, “I have recently moved China from underweight to a small overweight. Currently, China is trading at a forward P/E of 9.5x, which is at a significant discount to its 5-year average of 13.5x. I am definitely seeing more attractive buying ideas in China.”

He added that “in an environment of slowing global growth, the focus has shifted away from growth opportunities – where risks of disappointment are increasing, and more on the value opportunities that exist in the market. Typically when you see the P/E of a stock that is the same as the sustainable dividend yield you are getting a great buying opportunity. This is especially so when these companies still have good prospects for growth. Recently there have been an increasing number of attractive opportunities that have emerged.”

As for the impact of the slowing US economy on the region, Mr Urquhart said “S&P’s recent downgrade of the US Treasury debt from AAA to AA+ is a psychological blow to the American pride, but the economic consequences are minimal. When we see companies downgraded a notch from AAA, there is no material impact on the cost of funds or availability of funding. The market reaction – US bonds actually rallying – is consistent with this view. Rather, it highlights that the main concern of the market is about weaker than expected US growth in Q2, the apparently more difficult policy response environment – delays in getting the debt ceiling lifted – and so the market is placing a higher probability of recession in the US.

As for the prospect of a double dip recession in the US, Mr Urquhart said “We have just seen of US listed companies report Q2 results, and with 83% of them having reported, earnings are on average 5% better than expected. Clearly corporate America continues to be in good health and this is also being reflected strong hiring by the private sector. Unfortunately the government (local and federal) are going through austerity measures to reduce debt and this is seeing some dismissals and so the overall unemployment remains more subdued. Despite the slower growth expectations, I don’t foresee a double-dip scenario in the US. Q2 growth in the US was impacted by the supply chain disruption caused by Japan’s tsunami, especially for the auto industry, and by higher oil prices. US growth is expected to slow to less than 2% for 2011 and 2012, rather than 2.5 – 3% that the market has previously projected. However, as we move into Q3 and Q4 the auto industry’s supply chain disruption should begin to unwind.”

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