More than two thirds of all global growth this year and next is expected to come from the developing world. The main downgrades to growth are all in the developed world. Citibank recently slashed its forecast for growth in the US this year from 2.3% in July to 1.6%. Next year it expects growth in Europe of only 0.6% (versus 1.2% previously). By contrast, its reduction in the expected growth rate for emerging markets from 6.3% to 6.0% shows the extent to which they are increasingly able to stand on their own two feet.

The main worry in emerging markets – inflation and the prospect of higher interest rates – is likely to fade as the West flirts with a double-dip recession and commodity prices ease. The recent rate cut in Brazil was a straw in the wind pointing to an end of the tightening cycle in the developing world. With inflation still relatively high in many emerging markets, it might be too much to expect rates to start falling but even if they only tread water this would be a positive for markets.

The multiples of earnings on which emerging market shares trade are now – at about nine – back to the levels reached at the bottom of the 2000/03 bear market. They very briefly dipped lower in late 2008 but, that moment of panic aside, emerging market shares are cheaper on this measure than at any point in the past 10 years. They are also cheaper compared with the other main asset class, bonds, than they have been over the same period.

While shares have become cheaper, emerging market sovereign debt has become more expensive, dragged ever higher on the coat-tails of US Treasuries as investors have run for what they perceive to be safe havens.

For these three reasons, I think emerging market shares as a whole will outperform for the rest of this year and into 2012.

However, I don’t expect the indiscriminate sell-off to unwind in the same blind manner. Greater discrimination is already in evidence, with Korea for example a notable laggard as investors rightly took the view that its export-heavy economy would suffer more from a slow-down in the West.

If markets decouple, as underlying economies already have, the winners will be those companies exposed to rising domestic demand in emerging markets and not those dependent on a recovery in the West which remains a dim light at the end of the tunnel.

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Lonsec’s latest Global Equity Fund Sector Review included 36 large cap and three small cap funds.
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Of these, nine large cap funds attained Lonsec’s top rating, Highly Recommended, including T. Rowe Price Global Equity Fund, Arrowstreet Global Equity Fund, Templeton Global Equities Fund, Aberdeen International Equity Fund (upgraded) and new entrant to Lonsec‟s universe, IFP Global Franchise Fund.
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Rui Fernandes, Senior Investment Analyst responsible for reviewing the sector, commented, “The distribution of product ratings were broadly stable across both the most recent and the previous sector review seasons.”

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Sector themes and observations

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Great minds think alike

“The degree of ‘commonality’ across Top 10 holdings is a curious and surprising outcome,” said Fernandes.
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“Only 172 different stocks held these highest conviction positions across the 26 portfolios – a remarkable observation considering that notionally, there is the potential for 260 different stocks (26×10) to occupy these positions out of some 1,500 in the MSCI World Index.”
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Companies that featured in several portfolios included Roche (which featured most prominently across the “Top 10‟ holdings, notably across seven of 26), Phillip Morris International, Nestle, Pfizer, Vodafone, Apple, Google, Hewlett Packard, Johnson & Johnson, and Wells Fargo.
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Fernandes commented, “The funds management industry’s process-driven stock assessments, with similar modelling and assumption methodologies, may be a significant driver of this outcome.”
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“However, there is also the possibility that an undeterminable degree of  ‘herding’ (e.g. safety in numbers) may also be the cause, which may or may not be a conscious decision by investment managers.”
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Investment teams and portfolios stabilise

In last year’s report Lonsec noted that investment managers had mirrored the companies they invested in by seeking to control costs, with consequences for their investment teams. By contrast, this year’s review observed that investment teams were, on the whole, relatively stable.
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“Voluntary turnover has been witnessed across some managers but overall the trend has been muted,” said Fernandes.
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In last year’s report Lonsec noted that investment managers had mirrored the companies they invested in by seeking to control costs, with consequences for their investment teams. By contrast, this year’s review observed that investment teams were, on the whole, relatively stable.
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“Voluntary turnover has been witnessed across some managers but overall the trend has been muted,” said Fernandes.

“In response to the changing global growth dynamics, managers have been flagging their intention to ‘beef up’ their Asian coverage, either with transfers from their European or US offices or new regional appointments.”

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Asia still sparkling

Most investment managers tended to be mildly positive on the overall outlook for global markets, a noticeable change from the cautionary tone observed in last year’s review. However, the outlook for Asia, particularly for the Emerging Asian Region, was positive and continued to be the brightest star in the investment landscape.
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Fernandes observed, “Many see the main opportunity to be the rise of the middle class and increased consumption through the step-up in per capita income. This is believed to touch many sectors ranging from Financials and Consumer Discretionary.”

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Emerging markets – more than one way to ‘play’ the story

“While managers may disagree on the ‘cheapness’ or ‘richness’ (in terms of price) of emerging markets stocks in general, most did not dispute the long-term trends that are favourable for these investments,” commented Fernandes.
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“Managers generally fell into two camps – those that ‘played’ emerging market stocks directly and those ‘played’ them indirectly. For example, Nestle is a developed-market consumer staple stock whose incremental growth has been sourced from emerging markets. The incremental growth from emerging economies was a key attraction of the stock.”
The Lonsec report highlights that most managers had a degree of direct emerging market exposure at the time of review

Of the 26 qualitative products reviewed in this sector, Lonsec observed that there was a notable degree of “commonality” in the “Top 10” holdings as at June 2010 – the stocks considered to be a fundamental manager’s highest conviction positions, being the largest absolute/active weights.

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Key points

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

2010 consolidating the recovery

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

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

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

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

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

Investment returns for major asset classes

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

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

Outlook for 2011

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

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

Looking at the major asset classes for the year ahead:

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

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

What are the risks?

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

Conclusion

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

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