Demand for overseas investment positive: CGIII Report

September saw investor concern about global markets at its lowest since the global financial crisis (GFC), according to the Certitude Global Investing Intentions Index (CGIII) Report, released this week.

This is despite potentially negative fallout from short term events in the news when the survey was conducted, such as the then looming prospect of the US government shutdown and ongoing concerns about the US debt ceiling.

The Certitude Global Investing Intentions Index, produced by Investment Trends, tracks the net demand for global assets. It is part of the wider monthly CGIII Report that collates the views of more than 750 leading investors, including high net worth individuals, self-managed super funds and higher income investors.

While the Index fell slightly from 175 in August to 160 in September, this still positions it firmly in “positive” territory – considerably above the “neutral” level of 100. The CGIII Report shows that three quarters of investors expect international markets to rise in the next 12 months. Only 11% believe global markets will fall, down from 15% in August.

At the same time, the CGIII Report found that levels of concern about investment markets dropped to 5.8 from 6.0 out of 10 in August, indicating investors are less worried about global markets than at any time since the onset of the GFC.
Craig Mowll, CEO of Certitude Global Investments says the CGIII result well above the 100 mark shows that local interest in global assets remains strong.

“The September Index clearly shows that buyers of global assets continue to outweigh sellers. In terms of the local market, the CGIII Report highlights that Australians are feeling a newfound confidence about the economy in general, reporting feeling more positive about opportunities at home as well as overseas. In fact, they expect the Australian stock market to rise by 7% over the next 12 months, up from 6% the month before, while looking for gains in global markets of 4% over the same period.”

Other CGIII Report findings show that nearly two in three investors (64%) expect the economy to record healthy growth in the next 12 months, up significantly from 36% in August.

“Australians naturally favour their home market, but there is also plenty of willingness to take up global opportunities among those seeking broader horizons. It seems from these latest findings that long-term investors are looking beyond the short-term events such as the recent events in the US and seeing them more as a buying opportunity than cause for concern.

“It’s also likely that confidence in global markets is being tempered by concerns about sovereign debt issues in Europe and geopolitical issues in the Middle East. Again, these issues don’t appear to be disturbing investors unduly – they seem to be seen more as opportunities to find value for those who know where to look.

Mr Mowll went on to say that the survey also revealed that more investors are looking to outsource their global investment decisions to experts, with 40% in the September survey planning to access global investments through actively managed funds, up from 31% in August. Fewer investors say they intended to gain exposure to international markets by investing directly in shares (31%, down from 39%).

Investors turn towards Asia

September CGIII Report- Key findings

Returns on the rise for shares post-GFC.

Patience has paid off for Australian investors who held on during highs and lows of the market during the Global Financial Crisis (GFC), according to boutique investment research and actuarial consulting company Precept Investment Actuaries.

In a research paper, entitled: ‘Independent Assessment of Historical Australian Share Market Returns over 20 years to 30 June 2013’, Precept Investment Actuaries challenges some pre conceived notions about returns for Australian share market investors.

The in-depth report provides insight into returns – taking into account both share price gains and dividends paid over the period – since the Global Financial Crisis and the implications for future returns.

The main findings of the paper are:

• The average annual long run return on a pre-tax basis over the last 20 years from the Australian share market was 9.6% p.a. excluding franking  benefits and 11.0% including estimated franking benefits.
• The average return of 9.6% over the last 20 years was achieved through an average price gain for shares of 5.2% p.a. and average dividend return of 4.1% p.a. This highlights the often overlooked importance of dividends and franking credits on long term investor returns.
• The Australian share market delivered a return of 22.8% including dividends for the 12 months ending 30 June 2013. This was driven by a rise in share prices of 17.3% for the year together with dividend income of 4.7% excluding franking.
• The 2013 year reflected a favourable sharemarket return of 16.4% for the first 6 months to 31 December 2012 followed by 5.5% for the subsequent six months to 30 June 2013.
• Returns throughout the GFC have been volatile and inferior despite a strong year in 2013. Due to the GFC investors have achieved an average market return of only 2.9% during the last 5 year period from June 2008 to June 2013. However the 20 year average market return is more representative.

According to Mark Hancock of Precept Investment Actuaries, the outlook for future returns remains uncertain. However, based on the last 20 years and even the 10 years prior to that, it would be statistically unlikely to have such another disappointing five year period going forward from 2013 to 2018.

“Future outcomes will depend on a range of factors including: how the global economies unfold from here, how corporate earnings respond and how investors perceive value and growth.

“When you take a step back it is evident that patience has been rewarded for Australian equity investors who experienced the prolonged and adverse period of the GFC,” Mr Hancock added.

Melinda Howes, CEO of the Actuaries Institute said the report reinforces the role modern actuaries play in providing research and analysis across a broad range of organisations and industries.

“As ever, actuaries are uniquely placed to objectively analyse and provide an impartial perspective on a variety of topics through long-term analysis, modelling and scenario planning.”

For a copy of the full paper ‘Independent Assessment of Historical Australian Share Market Returns over 20 years to 30 June 2013’ prepared by Precept Investment Actuaries please contact alice@honnermedia.com.au

• Confused about where the economy is heading? You’re in good company, with the boffins from the Reserve Bank also seemingly scratching their collective heads about where things are going. Earlier in the year the policymakers appeared confident that the economy would rebound strongly after the floods and cyclones and flagged the risk that this stronger growth would prompt the Bank to lift interest rates to keep inflation under control. But the economy hasn’t bounced as the Reserve Bank expected, reducing the inflation risk.
• So where did the Reserve Bank go wrong? Essentially it under-estimated the “new conservatism” mood that has taken hold among Australia’s consumers. The Bank thought – with jobs relatively plentiful and wages rising –that consumers would start spending again. But a raft of negative influences swamped the strong labour market outcomes, causing people to either save or just leave the dollars in their pockets.
• Not only are people still feeling the effects of the global financial crisis, but there have been the unprecedented floods across Australia, earthquakes in Japan and New Zealand, proposed carbon and mining taxes and the sharp increase in the cost of living such as higher food, electricity, gas and water prices.
• So where do we go from here? Well the positives are still out there. The global economy is still recording above trend growth, led by China and India. Incomes in Australia are being boosted by higher commodity prices. Mining companies are also pushing ahead with key projects. And the job market still generally remains in good shape. So it still seems more than likely that the domestic economy will pick up pace over time. And that means that interest rates are still more likely to rise rather than fall – but it may take a little longer than expected. And it depends whether any new factors come from left field to delay the process even further.
• The big mistake has been to assume that all the extra money coming into Australia was going to be spent. Miners are funnelling the extra dollars into new projects, many of which are capital, rather than labour intensive. Mining still accounts for a relatively small portion of our economy. Sure, the Aussie dollar has gone up, and that means more people are travelling offshore and buying foreign goods. But that doesn’t help our businesses. And while the rising share prices and higher dividends from our resource companies boost compulsory superannuation accounts, most can’t access the savings for decades.

The week ahead

• Investors are constantly trying to build a picture on the economy. Some pieces are big, others small, but each piece is useful. In Australia, some of the smaller pieces of the puzzle are provided in the coming week. Overseas,the focus is on the larger pieces of the puzzle including the latest economic growth figures from China.
• In Australia, the week kicks off with the May housing finance figures on Monday. The number of loans rose by 4.8per cent in April, but it was only the first gain in four months. And while the number of loans could have risen as much as 6 per cent in May, it probably has more to do with refinancing than loans to build new homes. As such it won’t suggest that stronger housing activity lays ahead.
• On Tuesday NAB issues its latest business survey. Both confidence and business conditions remain weak. And judging by recent surveys by Sensis and ACCI, little change in the soft readings is expected. Also on Tuesday the Reserve Bank releases the latest data on credit and debit card lending. Debit cards are favoured at present as consumers prefer to use their own money to buy goods. It would be good if the Reserve Bank started to provide the break-up between domestic and overseas purchases. If card purchases lift, but the dollars are going abroad,then this is hardly positive for Australian retailers.
• On Wednesday the latest consumer confidence figures are issued. With uncertainty about the carbon tax pervading, the latest sentiment figures are unlikely to be positive. On the same day lending finance data is released together with the “Modeller’s Database.” The lending data covers housing, business, personal and lease loans, so the figures provide a good guide to activity in the banking and finance markets. The “Modeller’s Database” includes the latest estimates on private sector wealth. You may not believe it, but Australians have never been wealthier.
• And on Thursday the Bureau of Statistics will provide some greater detail on the labour market such as state and demographic trends and figures on the number of hours worked.
• In the US, the first piece of market-moving economic data is issued on Tuesday in the shape of the latest trade data. The US has a major budget deficit and it also has a significant and persistent trade deficit. Investors aren’t too worried about the trade deficit just yet, but it’s important to note that the deficit remains large even with the weaker US dollar and soft US economy – factors serving to boost exports and constrain imports. A trade deficit near US$44 billion is expected in May. Also on Tuesday minutes of the June 21/22 Federal Reserve meeting are released, so more insights into policymaker thinking will be revealed.
• On Wednesday, Federal Reserve chairman, Ben Bernanke, delivers his semi-annual testimony on the economy.This statement takes on huge importance – Bernanke needs to be sufficiently upbeat on the economy without over-doing it to ensure that confidence and economic momentum is maintained. Also data on import and export prices is released on Wednesday together with the monthly budget figures.
• On Thursday in the US, data on retail spending, business inflation (producer prices) and new claims for unemployment insurance are released. Retail sales are stronger than in Australia and analysts tip a 0.2 per cent lift in non-auto sales. Business inflation is now “normal” with a 0.2 per cent lift in core prices (excludes food and energy) expected for June.
• And on Friday in the US, consumer sentiment, consumer prices and industrial production figures are releases with the Empire State survey thrown in for good measure. Economists tip a 0.2 per cent lift in core inflation and 0.4 percent rise in production. Overall these figures, together with those from earlier in the week, should confirm that the US economy is emerging from its “nap”.
• In China, the monthly download of key economic data occurs on Friday. As well as figures on production and spending, the June quarter economic growth figures are issued. Economists estimate that annual growth slowed a touch from 9.7 per cent to 9.4 per cent.

Sharemarket

• US earnings season kicks off on Monday. As is traditional, Alcoa gets the proceedings underway with analysts expecting earnings of US35 cents a share, up from US13 cents a share last year. Of the 27 other companies scheduled to report over the week, YUM! Brands issues its report on Wednesday with JP Morgan Chase and Google on Thursday and Citigroup on Friday.
• US earnings have been strong over the past year but the effects of the Japanese tsunami, the Greek debt crisis and the slowdown of the US economy will be influences on the results and outlook statements for companies during the earnings season. Overall Brown Brothers Harriman is tipping earnings of Standard & Poor’s 500 companies to be up 13.6 per cent on a year ago.

Interest rates, currencies & commodities

• The semi-annual testimony from the US Federal Reserve chairman, on-going debt woes in Europe, the start of US earnings season and Chinese economic data should be the key influences on financial markets in the coming week. Overall, we are tipping strength, not weakness, with the Aussie holding near US107 cents and commodity prices generally higher over the week.

• Improve existing products before creating new
• Focus on solutions which deliver targeted outcomes
• Human judgement a key enabler
• Third party administrators a partner for innovation

An annual, independent study released today by CREATE-Research, commissioned by Citi’s Global Transaction Services and Principal Global Investors, finds that while innovation is deemed to have produced mixed results over the last decade, asset owners have retained an appetite for innovation, but only where specific principles are met.

The report, entitled Investment Innovations, raising the bar, surveyed over 500 respondents from pension plans, asset managers, consultants, administrators and distributors from 30 countries with a combined AUM of over US$29 trillion. It asked respondents which financial innovations they believe have worked, which haven’t, what should be the main thrust of innovations over the next three years and what specific improvements and actions they want to see related to these innovations.

The headline findings cite 2008 as a watershed for financial innovation with many of the new products, asset classes, return enhancing tools and asset allocation techniques developed in preceding decades viewed as becoming increasingly fallible, as the financial crisis developed. This prompted a dangerous mismatch in expectations between asset managers, advisors and their clients. Now, client engagement is rising again and the report presents a call to action for asset managers and owners to work more closely together to add value in the innovation process, better aligning their interests and expectations for mutual benefit.

Prof. Amin Rajan, CEO of CREATE-Research and the study’s author, said:

“The global economy is still in a state of uncertainty and strong headwinds in the shape of financial regulation, scarcity of talent and revised client expectations are buffeting the industry. Against this backdrop, there has to be a clear line of sight between innovations and client needs. Asset owners will demand creative solutions which deliver tangible value. New products developed without such fundamentals and without clear client engagement will struggle to gain traction.”
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Key findings of the report include:
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• Some 35 innovations saw significant adoption in the last decade. 57% of respondents said that emerging markets equities delivered most value while leverage recorded the worst performance, according to 40% of respondents
• 50% of pension plans believe a switch from products to solutions will be a key driver of innovation over the next 3 years
• A mismatch exists between asset managers’ and clients’ expectations – 39% of the clients think further product innovation will deliver genuine value over the next three years versus 64% of the asset managers
• Lack of client engagement is viewed as a major cause of failed innovation: 73% of pension funds surveyed are only rarely/occasionally engaged when asset managers innovate their financial products
• 88% of asset managers foresee further product innovations over the next three years, although of these, 52% believe they will be incremental, improving existing innovations, rather than creating new ones

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Grant Forster, CEO of Principal Global Investors Australia, said: “The findings show that lack of client engagement is viewed by the industry as a major factor behind failed innovation. First and foremost, there should be a direct link between innovation and client need. That means building tailored investment solutions that are relevant and additive to clients’ business objectives, rather than creating copy cat products or those which rely on financial engineering. We believe that our multi-boutique model provides a strong platform to execute this strategy, enabling a deep knowledge of products combined with an ideas-centric, client driven approach.”
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The report finds that pension plans increasingly want to see an overlay of human insight, foresight and empathy in the investment process, as quant models can only deal with historical data. This is highlighted by the failure of existing risk models during the last two vicious bear markets.
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The report also highlights that product quality, better alignment and operational excellence will dictate the thrust of innovation in the near term. Asset managers intend to adopt more robust processes for promoting new ideas and stress-testing the resulting products. They also expect to rely more on their administrators in order to focus on their own core capabilities and continue an upward advance in the investment value chain.
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Neeraj Sahai, Global Head of Citi Securities and Fund Services, said: “Underpinning the drive for innovation is the need for ongoing operational excellence. The findings show that looking ahead over the next several years, market participants are focusing on becoming more efficient, reducing risk and modernising the back and middle office, in partnership with administrators. This drive will be a key differentiator for distinguishing the leaders and the laggards of the new era of innovation.”
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Click to download the full report –  Investment Innovations 2011

The outlook explores the recent softening in economic data has raised concerns over the sustainability of the U.S. recovery and the growing concern for the US fiscal outlook.

The falling unemployment rate and strengthening Australian dollar is also addressed in this research piece.

Expectations for the Fed bank and RBA are also summarised.

click to view full report

“The global financial crisis has focused investor attention on one kind of risk, market risk – the risk associated with market volatility – and whether we are still in a bear market.

“As a result, investors have made avoiding or minimising this risk their priority, resulting in them keeping most, if not all, their money in cash, rather than focusing on their ultimate goal which is a retirement income that will last.

“Even now, when volatility has largely returned to pre-GFC levels, many investors are still keeping a significant proportion of their retirement savings in cash options such as term deposits, in the belief that this is the least-risky strategy.

“However, while this approach minimises market risk, it exposes investors to a number of other risks including inflation risk, income risk and opportunity risk,” Mr Dickman says.

He said that inflation risk, which is when higher levels of inflation eat away at returns and capital, is a major issue for those who have money in term deposits.

“As the interest rates offered on term deposits fall – as they are already starting to do – the return on the capital will also decrease.

“Inflation also means that capital locked up in a non-growth asset will have less value at the end of its two, three or five year term.

“Opportunity risk is associated with this. If the money is locked away in a term deposit for two, three or five years, it is money that can’t be used elsewhere – therefore opportunities for better returns and capital growth are being missed,” he said.

Mr Dickman added that perhaps the biggest risk for investors at the moment is income risk.

“Investors who took their money out of other investments to put into cash when the government introduced the bank guarantee have most likely sacrificed income.

“Term deposits may seem a safe haven now, but people probably don’t realise that this choice means they have introduced future income risk into their portfolio.

“With the first of the baby-boomer generation now entering retirement, as well as the trend of longer life expectancy, a stable, regular income will become a priority. This is something people won’t get from a term deposit where the interest is usually paid at the end of the term.

“Indeed, the burgeoning ageing population, combined with the higher health costs associated with people living longer, makes it even more important for Australians to be adequately prepared to fund their retirement.  A potential risk in its own right is relying on future governments to pick up the tab for those who run out of money.

“Therefore retirees in particular need to consider other investments, and find a balance between their desire for low-risk investments and their need for returns that will generate ongoing income in their retirement.

“It comes back to the value of taking a balanced approach through a diversified portfolio, and understanding that different investments offer different benefits, returns and risks.

“No single investment will provide investors with all three elements of high liquidity, high returns and low risk, so a combination is needed.

“Diversity also helps to manage all types of risk.

“Investors must assess each individual asset class on its own merits and make investment choices based on their own needs of income, liquidity, growth and risk,” Mr Dickman said.

• The Reserve Bank has given a clean bill of health for the Australian financial system, highlighting the strength of domestic banks compared with their overseas peers.
• The Reserve Bank has indicated that the natural disasters earlier this year is unlikely to significantly impair bank assets and profitability. However the central bank did highlight that growth amongst domestic banks is likely to be more limited when compared to pre-crisis levels due to regulation.
• The central bank also commented on the improvement in wholesale bank funding, however it did note that banks have been less reliant on wholesale markets largely due to the increase in household deposits.

What does it mean?

• The Reserve Bank has effectively given Australia’s financial system the tick of approval highlighting that the recent natural disasters are unlikely to significantly hurt bank asset quality or significantly impair overall performance. Importantly the Reserve Bank believes that the underlying resilience of the domestic economy has kept the banking system in good stead. In fact the latest financial stability review goes so far as to suggest that domestic banks are still outperforming overseas peers.
• Even throughout and subsequent to the global financial crisis, Australia’s financial system remained in good stead. And looking forward it is likely that the banking will continue to be well ahead of its international peers. However the central bank did comment that nonperforming assets remain higher than a few years ago, but still low on comparison with international counterparts.
• The near term weakness in the domestic economy has largely been as a result of the rapid fire rate hikes and the resulting lift in consumer conservatism. However the string of natural disasters has also sapped momentum from the economy and it is likely to have a marginal impact on the banking sector. Also the Reserve Bank did warn that banks are unlikely to be able to grow at pre-crisis levels, largely due to tighter regulation and attempts to grow at those levels could induce risks.
• The central bank did once again weigh into the topic surrounding bank funding costs, commenting on the improvement in access to wholesale funding. However given the fact that consumers have been saving rather than spending, banks have been less reliant on the wholesale market, and “as a result their liquidity positions have improved further”. The central bank also did highlight that looking forward Australian banks are well placed to meet the new capital standards to be introduced under Basel III.
• Interestingly the Reserve Bank has once again highlighted that the level of conservatism being shown by households has resulted in improving household balance sheets. Additional savings and low unemployment should be beneficial in the longer run, resulting in stronger future spending. At the same time the Reserve Bank believes that the level of household debt remains historically high, and it would be helpful for borrowers to show further restraint.

• In the near term it is looking less likely that the Reserve Bank will need to raise interest rates. Inflation remains well contained, while several sectors of the economy including housing, construction and retail are showing signs of weakness. Monetary policy is already mildly restrictive and as such the Reserve Bank can afford to wait a few more months to assess data flow before once again moving on rates.
• Overall CommSec believes that the longer term fundamentals for the domestic economy remain sound. Employment growth is likely to remain healthy, while activity levels will pick up in the second half of the year. More importantly the Asian region continues to grow at a steady clip and as such the demand for commodities should ensure that the “once in a century” terms of trade boost remains part of the economic landscape. The additional flow of income which is currently being saved by businesses and consumers will drive up future spending adding further momentum to the domestic economic growth story.

Key points from the Reserve Bank Financial Stability Review:

Global banking System: “Confidence in the banking systems of major countries has generally improved since the previous Financial Stability Review.”

“The major international banks have continued to report profits and strengthen their balance sheets. Some banking systems are still under considerable strain, however, notably in parts of Europe, where recovery is being undermined by market concerns about sovereign debt sustainability.”

Banking system: “The Australian banking system has continued to perform better than those in many other countries, consistent with the relative strength of the domestic economy over recent years. Non-performing asset levels remain higher than a few years ago, though they are low in comparison with those in the major economies. Their largest component – nonperforming business loans – was beginning to show slight signs of improvement towards the end of last year, and the flow of loan loss provisions has already fallen significantly.”

“Australian banks are well placed to meet the new capital standards, particularly given the significant bolstering of their capital positions in recent years.”

Funding costs: “Australian banks have maintained ready access to wholesale funding markets in the past six months, but they have also had less need to raise wholesale funds over this period as growth in deposits continues to outpace growth in credit. This shift towards deposit funding has enabled banks to further reduce their reliance on short-term wholesale debt. As a result, their liquidity positions have improved further. Banks’ capital positions have also been substantially bolstered in recent years”.

Household balance sheets: Households “continue to exhibit a more cautious approach to their borrowing… reducing the growth in their debt outstanding to a rate more in line with income growth. Household indebtedness remains historically high, however, and recent increases in interest rates have lifted the aggregate debt servicing requirement. While indicators of financial stress are relatively subdued, a continuation of this recent borrowing restraint would help build additional resilience into households’ balance sheets.””

What is the importance of the economic data?

• The Reserve Bank issues its Financial Stability Review half-yearly. The RBA says that “these Reviews assess the current condition of the financial system and potential risks to financial stability, and survey policy developments designed to improve financial stability.”

What are the implications for interest rates and investors?

• A strong financial system is crucial for sustained economic growth. And the Reserve Bank’s positive assessment of Australian banks should provide investors with further confidence in the economic recovery currently underway.
• The financial stability review suggests that the Reserve Bank is more comfortable with the position of the domestic banking sector and the state of household and business balance sheets. But we continue to expect that the next hike is unlikely to take place before mid year.
• Our equity analysts have Westpac, ANZ, and National Australia Bank on a HOLD rating. This reflects the expectations of earning stability and fair valuations at present.

Short-term interest rates converged once the European Central Bank (ECB) began to set monetary policy for the entire eurozone. Over time, inflation declined in the periphery, which brought down long-term bond yields and reduced the risk premium for peripheral markets. Further economic benefits followed as the “one-size-fits-all” eurozone policy benefited the periphery more than the core. Interest and exchange rates were invariably too high for Germany, for instance, which meant that its export sector struggled.

The eurozone debt crisis of 2010 has upended this situation. Faced with steep unemployment, broken banking sectors and indebtedness, economies in the peripheral south and west such as Greece, Ireland and Spain are enduring the deepest recessions of the financial crises.

At the same time, economies in the centre such as Germany, France, the Netherlands and Belgium are enjoying stronger growth. Germany is the standout; buoyant activity there is, in fact, masking weaker performances at the periphery in overall measures of eurozone activity.

German exports are more competitive because, after the asymmetric impact of the financial and sovereign debt crises of 2010, eurozone interest rates have been kept low to support struggling peripheral member states and the euro fell. This is, however, just one aspect of the reversal of core-periphery fortunes. As the table below shows, a range of political and economic factors are combining to reinforce the continued outperformance of core Europe.

Periphery or core?

Still partly the preserve of national governments, fiscal policy has become the weak point of the eurozone experiment. At the periphery, large public deficits exacerbated by banking sector bail-outs have led to unavoidable and painful austerity measures, which have caused sovereign spreads to rise precipitously for Greece, Ireland and Portugal.

When the euro was introduced on 1 January 1999, sovereign bond spreads in the periphery converged to record lows. From 2001, the average spread over German government bonds stayed within a 10-basis point range until 2007 (based on an unweighted average of bonds from Portugal, Italy, Ireland, Greece and Spain). It was at this point the prevailing forces that had favoured all countries in the eurozone first showed signs of abating. As we now know, the credit crunch caused a serious de-convergence in sovereign spreads that remains with us.

There has been a positive correlation between higher peripheral sovereign spreads and funding costs in the aftermath of the credit crisis, suggesting that there is a meaningful spill-over effect from the public to the private sector. That increased cost of corporate funding is a significant headwind for companies in the periphery that reinforces my view that divergence will remain a defining theme in the eurozone for much longer than investors expect.

Divergent labour trends also seem here to stay. Peripheral countries face significant unemployment. Spain must deal with nearly 20% of its workforce being out of work. Ireland and Greece also have double-digit unemployment, which, in the case of Ireland, has encouraged an upturn in emigration. Part of the explanation is the fact that labour costs surged in peripheral countries during the good times (by more 30% in Ireland and Spain from 2000 to 2008), when wage indexation agreements were often a feature.

On the contrary, Germany’s unemployment rate (at about 7.5%) is less than the European average. Once “the sick man of Europe”, a perceived lack of competitiveness several years ago encouraged deep labour market reforms and collectively bargained minimum wages were effectively abolished. As a result, Germany controlled unit labour costs, meaning the economy became more competitive relative to its peripheral peers.

With strong demand for its high-quality capital goods as well as for premium auto brands like BMW, the German economy can be expected to benefit from further growth in emerging-market consumption for years to come. And the good feeling is not confined to the export sector; the domestic economy is also humming. The German consumer, so often a laggard historically, appears to be enjoying a welcome revival of confidence. If the Bundesbankers were still in charge of national monetary policy, they would be applying the brakes.

Structural change

Peripheral eurozone countries, meanwhile, must overcome major hurdles to be competitive again. This will become more apparent as competition from emerging economies intensifies. Without the safety valve of a floating exchange rate, their economies face “internal devaluations” (deflation) that could have painful social costs.

In terms of EU governance, the outlook is similarly polarised. The EU and IMF have already announced a 750 billion euro (A$985 billion) package to cover several years of deficit financing.

However, European leaders have been keen to respond to the accusation of “incremental reactive policymaking” in response to the sovereign crisis. As a result, the EU summit in March was expected to see policymakers deliver a “competitiveness pact”, designed to draw a credible line under the debt crisis.

Significantly, however, now that the negotiating power of peripheral states has been weakened, the architecture of the pact has been dominated by a vociferous Germany and France.

Beyond the expected expansion of the European Financial Stability Facility lending capacity to 440 billion euros, the focus of change is away from austerity and more structural – debt brakes, an end to automatic wage indexation, increases to retirement ages and corporate tax harmonisation.

All of this points to further pain for peripheral Europe. While there may be investment opportunities for the agile, from an asset-allocation perspective I believe that investors in Europe can profit from concentrating the focus of their portfolios on the core eurozone economies that are benefiting from powerful and self-reinforcing trends.

DataStream. End Q3 2010

]]> Until recently, the defining theme of European economic monetary union since its introduction in 1999 was the convergence of the peripheral economies (ex-Soviet bloc and outlying countries) and core Europe (France, Germany, the UK and so on). The move to a single currency provided the impetus for fiscally weaker, less-competitive peripheral economies to catch up to the stronger, more-competitive core.

Short-term interest rates converged once the European Central Bank (ECB) began to set monetary policy for the entire eurozone. Over time, inflation declined in the periphery, which brought down long-term bond yields and reduced the risk premium for peripheral markets. Further economic benefits followed as the “one-size-fits-all” eurozone policy benefited the periphery more than the core. Interest and exchange rates were invariably too high for Germany, for instance, which meant that its export sector struggled.

The eurozone debt crisis of 2010 has upended this situation. Faced with steep unemployment, broken banking sectors and indebtedness, economies in the peripheral south and west such as Greece, Ireland and Spain are enduring the deepest recessions of the financial crises.

At the same time, economies in the centre such as Germany, France, the Netherlands and Belgium are enjoying stronger growth. Germany is the standout; buoyant activity there is, in fact, masking weaker performances at the periphery in overall measures of eurozone activity.

German exports are more competitive because, after the asymmetric impact of the financial and sovereign debt crises of 2010, eurozone interest rates have been kept low to support struggling peripheral member states and the euro fell. This is, however, just one aspect of the reversal of core-periphery fortunes. As the table below shows, a range of political and economic factors are combining to reinforce the continued outperformance of core Europe.

Periphery or core?

Still partly the preserve of national governments, fiscal policy has become the weak point of the eurozone experiment. At the periphery, large public deficits exacerbated by banking sector bail-outs have led to unavoidable and painful austerity measures, which have caused sovereign spreads to rise precipitously for Greece, Ireland and Portugal.

When the euro was introduced on 1 January 1999, sovereign bond spreads in the periphery converged to record lows. From 2001, the average spread over German government bonds stayed within a 10-basis point range until 2007 (based on an unweighted average of bonds from Portugal, Italy, Ireland, Greece and Spain). It was at this point the prevailing forces that had favoured all countries in the eurozone first showed signs of abating. As we now know, the credit crunch caused a serious de-convergence in sovereign spreads that remains with us.

There has been a positive correlation between higher peripheral sovereign spreads and funding costs in the aftermath of the credit crisis, suggesting that there is a meaningful spill-over effect from the public to the private sector. That increased cost of corporate funding is a significant headwind for companies in the periphery that reinforces my view that divergence will remain a defining theme in the eurozone for much longer than investors expect.

Divergent labour trends also seem here to stay. Peripheral countries face significant unemployment. Spain must deal with nearly 20% of its workforce being out of work. Ireland and Greece also have double-digit unemployment, which, in the case of Ireland, has encouraged an upturn in emigration. Part of the explanation is the fact that labour costs surged in peripheral countries during the good times (by more 30% in Ireland and Spain from 2000 to 2008), when wage indexation agreements were often a feature.

On the contrary, Germany’s unemployment rate (at about 7.5%) is less than the European average. Once “the sick man of Europe”, a perceived lack of competitiveness several years ago encouraged deep labour market reforms and collectively bargained minimum wages were effectively abolished. As a result, Germany controlled unit labour costs, meaning the economy became more competitive relative to its peripheral peers.

With strong demand for its high-quality capital goods as well as for premium auto brands like BMW, the German economy can be expected to benefit from further growth in emerging-market consumption for years to come. And the good feeling is not confined to the export sector; the domestic economy is also humming. The German consumer, so often a laggard historically, appears to be enjoying a welcome revival of confidence. If the Bundesbankers were still in charge of national monetary policy, they would be applying the brakes.

Structural change

Peripheral eurozone countries, meanwhile, must overcome major hurdles to be competitive again. This will become more apparent as competition from emerging economies intensifies. Without the safety valve of a floating exchange rate, their economies face “internal devaluations” (deflation) that could have painful social costs.

In terms of EU governance, the outlook is similarly polarised. The EU and IMF have already announced a 750 billion euro (A$985 billion) package to cover several years of deficit financing.

However, European leaders have been keen to respond to the accusation of “incremental reactive policymaking” in response to the sovereign crisis. As a result, the EU summit in March was expected to see policymakers deliver a “competitiveness pact”, designed to draw a credible line under the debt crisis.

Significantly, however, now that the negotiating power of peripheral states has been weakened, the architecture of the pact has been dominated by a vociferous Germany and France.

Beyond the expected expansion of the European Financial Stability Facility lending capacity to 440 billion euros, the focus of change is away from austerity and more structural – debt brakes, an end to automatic wage indexation, increases to retirement ages and corporate tax harmonisation.

All of this points to further pain for peripheral Europe. While there may be investment opportunities for the agile, from an asset-allocation perspective I believe that investors in Europe can profit from concentrating the focus of their portfolios on the core eurozone economies that are benefiting from powerful and self-reinforcing trends.

DataStream. End Q3 2010

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