All set for a global recovery.

Modest global growth expected as the world economy saddles up for a recovery, astute investors will think laterally about portfolio construction. 

Global G3 economies are heading towards synchronised, moderate growth in 2014 with a likelihood of low returns, according to the Annual Global Outlook report, released by Russell Investments.

The report is produced by Russell’s global team of investment strategists, who offer their investment insights and economic forecast for the coming 12 months, as well as in-depth analysis of key fiscal components within the global market.

According to the 2014 report, the low return environment will be representative of narrowed credit spreads, equity markets that trade at full valuation, and global bond yields with room to rise.

Australia along for the ride

Russell’s Senior Investment Strategist for Asia Pacific, Graham Harman, said markets were priced well over the past 12 months, which is set to result in moderate single digit returns for 2014.

“While we may be headed towards a low return world, this is not a set and forget year. In this climate, active asset allocation becomes more important as astute investors need to think laterally about portfolio construction,” he said.

Over the coming year, equities are expected to outperform fixed interest and cash, with key drivers being the continued global recovery, a benign inflationary backdrop, investor preference for equities and corporate regearing.

As the investment landscape continues to evolve, Russell identified some key themes for the Australian market in 2014:

• The ‘Great Rotation’ has some way to run, as investors will continue to move out of bond and income funds, and into equities – this is spurred by relative returns and by the low-inflation, growth recovery backdrop
• Emerging markets are expected to perform better in 2014, with China and Japan acting as engines for growth in the Asia Pacific region
• Cash and bonds will both play a key role in portfolio management during this time of lower returns and heightened volatility, as downside risks for bonds appear limited and cash gives investors the chance to buy opportunistically on market dips
• The weakening Australian dollar provides support for the domestic economy. With the AUD still overvalued by 20 – 30 per cent, unhedged international exposures will deliver capital stability and return consistency.

Lower returns no cause for concern

Russell believes the prospect of lower returns does not equate to market pessimism as active management can still produce strong returns for investors.

“There is a challenge now when it comes to achieving a rate of return at a level of risk investors can survive – there are still opportunities for good returns if investors use the full arsenal of a multi-asset investment strategy, including a sharpened focus on managing downside risk and an actively managed and globally diversified multi-asset portfolio,” Mr Harman said.

For more information, please see the 2014 Annual Global Outlook.

USD consistently ranking as one of top three most actively traded ETFs

BetaShares passes $120 million in AUM three months after initial product launch

BetaShares Capital Limited (BetaShares) has announced that its US dollar exchange traded fund (ASX Code: USD) has quadrupled in size in the last month reaching $50 million in assets under management. The strong demand for this product has also resulted in BetaShares reaching another milestone, surpassing $120 million in AUM in just three months post the launch of its initial products.

Listed on 1 February 2011, BetaShares U.S. Dollar ETF tracks the performance of the US dollar (US$) relative to the Australian dollar (A$) using a simple, transparent and highly cost-effective structure backed by US dollars held in a bank account with JP Morgan Chase Bank.

Drew Corbett, Head of Investment Strategy & Distribution at BetaShares said the demand for the U.S. Dollar ETF has exceeded expectations and has consistently ranked as one of the top three most traded ETFs on the Australian Securities Exchange.

“We’re continuing to see strong demand from investors looking to back their view on the US$, particularly in light of the historically high levels of the A$ versus the US$ at present” he said.

Stephen Jani, Head of FX Sales at JP Morgan Chase Bank, said investor motives vary: “There are several reasons why investors want exposure to the US$ including participating in a potential US economic recovery, hedging future cross border business obligations and diversifying portfolio exposure. Whatever the reason, investor demand for the US$ is strong as evidenced by the success of the BetaShares product and growth in funds under management,” Mr Jani said.

The strong flows in the U.S Dollar ETF have also resulted in BetaShares reaching over $120 million in AUM since listing its initial products in December 2010.

“BetaShares was set up to address product gaps in the Australian ETF market and based on the strong demand of our ETFs to date, we believe we’re well on the way to achieving that goal,” Mr Corbett said.

“When you look around at ETF markets globally, there is always a strong local player tailoring solutions for the local investor. Reaching this milestone confirms BetaShares as that local provider and we look forward to innovating and delivering further ETF options for Australian investors,” he concluded.

Further information can be found at www.betashares.com.au and the ASX website.

• 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.

International equity fund manager, Insync Funds Management, considers the key global investor themes of 2011-2012:

• China – we believe inflation in China will emerge as a much bigger theme than the markets are anticipating in the coming months

After the GFC China really opened the floodgates of monetary and fiscal policy, money supply has increased over 50% in the last two years and the Government has embarked on a public works program that is the biggest since WW2 – to put this into context there are currently 7000 skyscrapers under construction in China compared to only three in the US!

Fixed investment is running at over 50% of GDP and this is clearly unsustainable. (the US peaked at 18% in their recent construction boom). Our sources tell us that inflation could be double the reported figure of 5% and this will require China to slow growth dramatically to bring this under control.  This will have an obvious impact on the Australian economy and we expect the Australian currency to weaken over time.

• Higher inflation is not only limited to China; much of the emerging world has inflation rates that are higher than the authorities would like

In fact, this is one of the primary causes of the unrest that is sweeping the Middle East. This will require a tightening of policy in those countries as well as slower growth.

• In Europe we do not believe the peripheral debt issues have been resolved but have only been deferred

This is confirmed by the credit markets where spreads are still at very high levels. At some point Governments will have to face reality and look at some form of restructuring – which will most likely involve some pain to bondholders.

• Finally, we believe the US economy may surprise to the upside this year

Corporations (especially large multinationals) are sitting on record levels of cash and this combined with accelerated depreciation in the US will lead to a decent recovery in corporate investment. In addition, the US is still home to the best companies in the world, many of which have large global operations (50% of the S&P earnings are ex US).

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

You do not always have to invest directly in emerging markets to take advantage of opportunities within them, says one of the world’s largest fund managers.

“I am cautiously optimistic about the prospects for global equities,” says Amit Lodha, Portfolio Manager of the Fidelity Global Equities Fund. “My optimism stems from improving economic data out of the US and recent actions by authorities there to stoke the economy. These developments mean that the likelihood of an economic double dip has receded in the near term. At the same time, emerging market economies should continue to grow strongly, as long as inflationary pressures remain manageable.

Mr Lodha said, “On the corporate front, earnings growth should remain fairly strong going forward, although this is largely factored into stock prices. I also expect M&A activity to be more prevalent this year, as cash rich companies deploy their reserves to tap growth, which should be positive for markets.”

Nevertheless, he cautioned there were also areas of concern. “Europe continues to grapple with tricky sovereign debt issues that need to be worked out. At the same time, the unprecedented stimulus applied to the global economy post the credit crisis is giving rise to inflationary pressures which will need to be countered by monetary tightening. It is unclear how equities will react to such developments because the magnitude of the stimulus applied makes it difficult to compare.”

He suggested one of the best ways to look for opportunities was to look at individual companies, individual investment opportunities. “I look for under-appreciated growth. Ultimately, I am looking for companies which are expanding their profit margins and growing their cash-flows. I look for industry structures which offer attractive profit characteristics. For example, if an industry is becoming more consolidated, I would want to look for potential beneficiaries within that sector. I also consider M&A potential when comparing stocks.

“For example, there are many ways to take advantage of the significant scope for an increase in car ownership in emerging markets, other than the obvious one – the emerging market car manufacturers. One can invest in raw materials producers (such as the iron ore producers), the dry bulk carriers that transport the raw materials, the steel mills, the auto part manufacturers, the tyre makers, the distributors and so on.”

He noted, ”Pricing power in the car manufacturing chain currently lies with the iron ore producers or the copper producers, as both materials are in short supply and are critical for the manufacture of a car. These manufacturers need not be listed in emerging markets. For example, some of the largest mining companies in the world – BHP Billiton and Rio Tinto – have seen huge growth in their revenues and earnings due to the increase in demand for raw materials from emerging markets, yet they are listed in the developed markets of the UK and Australia.

“Similarly, the auto manufacturers do not have to be listed in the countries from which demand is coming. Take Daimler and BMW; they are both listed in Germany, but are seeing very strong demand in emerging markets like China and India, where their brands hold strong appeal. The brand, in turn, gives them pricing power as well.  Pricing power and the uniqueness of an asset are key attributes of the businesses that I like. When the stocks of such businesses also have good valuation support that gives a fair margin of safety on investment, they will become part of the portfolio irrespective of where they are listed.”

He added, “Geographic positioning tends to be a product of where I am finding the best stock opportunities. Where a stock is listed is less important to me than where the company actually generates its revenues.  For example, BHP Billiton is listed in the UK, but its revenues are primarily driven by Chinese demand for its commodities. Meanwhile, Tata Consulting Services is listed in India but its revenue stream is driven by demand for IT services in the US. If you look at Europe, we have seen a lot of negative macro newsflow. However, this obscures the fact that there are lot of world class companies that are on attractive valuations. Companies like LVMH and Volkswagen are finding excellent growth drivers in emerging markets.

“That said, Asia is part of the world that I want to be exposed to, both directly and indirectly. The growth of economies in Asia is a theme that will be with us for the rest of our lifetimes. My recent visits to both India and China have given me further conviction that the long-term growth story associated with these countries, and the region as a whole, remains intact.

“However, the theme is well recognised in the market, which means the valuations of companies listed directly in these markets can be rich, and one needs to be very selective. I also play this theme through companies that are exposed to the growth but may be listed elsewhere.  Near-term, country-specific developments also need to be monitored carefully, particularly as Chinese authorities remain focused on tightening measures and India grapples with political uncertainty and infrastructure bottlenecks.”

Mr Lodha said his fund’s largest overweight was in the technology sector, where there are currently interesting new products being launched, such as smartphones and tablets.  “I also expect the sector to benefit from a pick up in corporate spending, as enterprise demand looks set to normalise with companies planning long-term IT strategies again. Cloud computing, for instance, is an area which should see increased interest. Despite generating good cash flows, some of the large cap technology names trade on attractive valuations.

“Energy is another area where I find comparatively more ideas.  This reflects both interesting opportunities at stock level as well as my positive view on the end-demand for oil in the medium to long term, as we are starting to see a significant increase in car ownership in emerging markets for example. More cars are now sold in China than in the US. I have exposure to E&P businesses, some of which are operating in promising under-explored areas, such as Columbia, as well as energy services firms, particularly those with specific expertise such as deep sea drilling. The fund is also overweight telecommunication services, as I expect smartphone adoption to boost data usage and telecom operators’ revenues in countries like Japan.

“Conversely, the fund is underweight utilities in view of unattractive growth prospects and regulatory overhangs, as well as consumer discretionary and staples following some profit taking in areas such as tobacco, brewers and clothes retailers.

“While the fund remains underweight financial services firms as a whole, I have reduced the underweight recently in view of signs of a pick up in loan growth. I continue to prefer US banks, which have been more proactive in addressing their issues and are consequently in a stronger position compared to their European counterparts. The fund also exposure to some well-run emerging market banks that stand to benefit from increased penetration. I have also recently added some attractively valued Japanese financials that would benefit from asset reflation.”

Greg Michel, head of fixed income at INGIM said the global appetite for Australian bonds is likely to continue with investors drawn to current yields of 5% to 6%, outstripping available yields available from global alternatives.

“The Australian economy has proven to be resilient to the effects of the GFC and continues to expand at a robust pace. The bond market has been in a bear market phase since early 2009 and bond yields are now close to long term average levels,” he said.

Global bonds are a different story, and INGIM expects flat to negative returns in 2011.

While the major European economies are expanding strongly, aided largely by a weak currency and accommodative monetary policy, the peripheral Euro markets continue to be held down by the large levels of sovereign debt and associated funding challenges.

“On balance we believe the combination of improving economic growth and high sovereign debt levels will result in Euro bond yields continuing to head higher in 2011,” said Mr Michel.

Credit best performing sub-sector

Turning to fixed income sub-sectors, INGIM said credit is expected to be the best performing assuming the default cycle pans out as expected.  While underlying interest rates will rise, continued credit spread contraction should see credit perform in a relative sense.

“The rally we have seen in credit markets over the past two years has been strong, supported by improving fundamentals and monetary and fiscal stimulus in the economy.  That being said, there is a sense the rally has overshot the fair value mark and there are few catalysts to drive spreads tighter,” INGIM’s head of credit research, Scott Rundell said.

For issuers, Mr Rundell said offshore markets continue to be more competitive than the Australian bond market with some suggesting several large players are demanding unpalatable spread levels.

“It’s relatively easy for investment grade credit to issue long dated loans or bonds into the US market.  New issuance is likely to be low and we expect few first time local issuers in Australia,” he said.

Global government bond yields on rise

Looking to Australian government bonds, INGIM is expecting limited further tightening in monetary policy in 2011 and now expects government bond yields will remain at or near current levels for the rest of the calendar year. Demand for local government bonds will continue to be dominated by offshore investors.

Despite recent geo-political tensions in the Middle East and North Africa, global government bond yields are expected to continue to rise over the medium term.  US government bonds yields are also expected to continue their upward rise as the market prices in the recovery.

“We’re now seeing ongoing evidence of a broad based economic recovery in the US and government bond yields are set to continue to rise through 2011 as the global economic recovery gathers pace,” said Mr Michel.

World issues cause headwinds

Meanwhile European sovereign debt challenges will continue to cause headwinds for fixed income. In particular, forced losses (or ‘haircuts’) on Irish senior bank debt could create contagion risk to other EU banks, causing the cost of bank funding to spike.

“We also advise monitoring changing bank regulatory regimes and structures as they will impact capital flows and the cost of credit in general,” Mr Rundell said.

Other world factors to watch include Chinese growth and demand for raw materials and the impact of recent events in the Middle-East and North Africa on oil prices.

“The management of many global companies may look to appease shareholders who have experienced negligible growth with capital initiatives aimed at increasing their returns. This could also be a negative credit event,” Mr Rundell said.

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

The post Europe’s reversal of fortunes: core trumps peripherals appeared first on AdviserVoice.

Income-seeking investors will increasingly turn to global equities in 2011, with leading international asset manager Threadneedle forecasting that key international markets will experience double-digit aggregate earnings growth and increasing dividends in 2011.

“For the last two decades investors have traditionally turned to bond markets for income and to equity markets for growth. This is no longer the case. Low interest rates in the Western world and unappealing bond yields are leading investors to turn to equities as a source of income,” Threadneedle Head of Global Equities Jeremy Podger said.

“Corporate profits have recovered strongly over the past 18 months, magnified by operating leverage as a result of cost-cutting undertaken during the downturn.

“Threadneedle forecasts that the UK, European, US and Asian markets will all generate double-digit aggregate earnings growth in 2011. This, in turn, is likely to feed through to a recovery in dividends. Our estimates are for dividend growth of 11 per cent in the UK, 10 per cent in Asia ex Japan and 8 per cent in Europe ex UK in 2011.”

Mr Podger said the broadly-based dividend growth enabled equity income investors to take an increasingly global approach to their portfolios and this had a number of advantages over regional income portfolios.

“Firstly, broadening the investment universe allows investment in best-of-breed companies from across the globe. It also provides the opportunity to gain exposure to fast-growing markets in areas such as Asia, where a number of highly profitable companies are generating robust levels of dividend growth,” Mr Podger said.

Global investing also allows better access to dividend-paying companies in sectors that may not be well represented in regional indices.

“For example, the Australian market offers 119 companies with a market capitalisation in excess of US$500m and a dividend yield of more than 4 per cent, whereas the global market offers 1512 such opportunities,” Mr Podger said.

“This deeper pool of income stocks offers superior scope for outperformance and diversification.”

Threadneedle said the financial crisis affected companies’ ability to pay dividends, with a number forced to cut or suspend their dividends during the recession as profits came under downward pressure.

At the same time the financial sector, which has been an important source of income over the long term in most equity markets, saw many companies forced to stop paying dividends as a condition of government support packages.

“This situation was an exception to the long-term pattern whereby, unlike deposits and most bonds, the income generated by equity investments has the capacity to grow over time. The short-term factors that disturbed this long-term trend have now begun to reverse and we are entering a new dividend cycle,” Mr Podger said.

PIMCO’s actively managed bond funds continue to outperform both local and global equities though market conditions are set to become challenging for fixed interest as the world economy recovery post GFC gathers pace.

As the market anticipates growth in the US in particular, PIMCO believes short-term rates are set to rise in the global developed world in 2012 with spikes already evident in long-term rates. However, PIMCO believes the changing climate provides scope for active managers to demonstrate their value and act as both an income generator and stabiliser for portfolios.

Peter Dorrian, Head of Global Wealth Management at PIMCO, said actively managed bonds will continue to produce steady returns to income conscious investors in a challenging environment.

“The need for bonds remains essential as the risk rally is likely to run out of steam mid-year,” he said.

“We believe fixed interest has a place in every portfolio, regardless of the economic environment. All investors should retain exposure to the asset class as a diversifier and as an important means of lowering overall portfolio volatility,” Mr Dorrian said.

The PIMCO Australian Bond Fund has continued to perform strongly, outperforming the Australian share market by almost eight per cent as measured by the ASX 200 over calendar 2010. The fund also outperformed over three and five year periods.

The outperformance of PIMCO’s bond funds has also included global markets. The EQT PIMCO Global Bond Fund outperformed the Australian share market over one, two, three and five year periods including a 15.67% return in calendar 2010.

“Over a five-year period, PIMCO’s Australian and global bond funds have comprehensively outperformed the ASX 200. The results show bonds can outperform equities with less volatility,” Mr Dorrian said.

While past returns are no guarantee of future returns, funds such as the Australian Bond Fund and Diversified Fixed Income Fund should continue to provide value for investors.

“In difficult investment environments, active management of fixed interest can help ensure clients’ funds are more effectively administered through superior macroeconomic forecasting, adjusting portfolio duration and strong credit analysis capabilities,” he said.

Key points

• While mainstream global shares may be due for a short term correction, the cyclical recovery still has further to go. Shares are still cheap, confidence in the sustainability of the global recovery is continuing and share market liquidity remains favourable.
• US shares are in the “sweet spot” of the investment cycle and are likely to outperform for a while.

Introduction

Improving confidence in the global recovery has seen mainstream global share markets post strong gains since mid last year. However, many fret that it is unsustainable with high unemployment, high public debt and unsustainably easy monetary policy hanging over advanced countries and emerging markets increasingly subject to inflationary pressures.

Cyclical recovery has further to go

While, as always, there is lots to worry about, our assessment is the cyclical recovery in shares is panning out broadly as expected and has much further to run. After a major bear market ends the recovery in shares often goes through several stages: an initial rebound during the first year, a period of correction or consolidation in the second year and then a continuation. This is illustrated in the table below for Australian shares which shows strong average gains in the first year, typically poorer performance in the second year and then strong gains in the third year.

Post bear market recoveries, Australian shares

Source: Bloomberg, AMP Capital Investors

So far so good with the correction in share markets last year being consistent with this pattern. Of course, markets don’t always follow a precise 12 month pattern, but if history is any guide this would suggest strong returns over the next six to 12 months. More fundamentally, the broad cyclical backdrop for shares and other growth trades remains fundamentally positive.

First, share valuations are still attractive. The forward price to earnings multiple for global shares is 12.9 times which is well below longer term averages for the low inflation period. Similarly, the forward price to earnings ratio for Australian shares is 13 times compared to a longer term average of 14.6 times. Emerging market and Asian shares are only trading on 11 to 12 times forward PEs.

Source: Thomson Financial, AMP Capital Investors

Second, while some of the heat is starting to come out of emerging countries, leading indicators for the US, Europe and to a lesser degree Japan have moved back up after a soft patch mid last year. This is evident in business conditions indicators as shown in the next chart.

Source: Bloomberg, AMP Capital Investors

In fact, the US is leading the charge on this front. The US ISM business conditions indicators are about as strong as they ever get. Corporate profits are up strongly and this is boosting business investment. Various labour market indicators point to a big resurgence in jobs growth and unemployment is already falling. Finally, US consumers are starting to feel more confident again and this is boosting retail sales. Similarly in Europe, strength in Germany is more than offsetting weakness in peripheral debt troubled countries. So there is good reason for confidence in the sustainability of the global recovery.

Third, the liquidity backdrop for shares is very positive with: easy money in the US, Europe and Japan;  cashed up corporates starting to undertake takeovers and share buybacks and boost dividends; and individual investors starting to switch back from bonds to shares. At the moment the latter is particularly noticeable in the US with the record inflows into bond mutual funds of recent years now starting to flow back out into equity mutual funds. Given the size of the bond inflows in recent years this might have a way to go before it is complete. If history is any guide and share markets do continue to rise then the same is likely to become evident amongst Australian individual investors.

In fact the US and northern Europe are arguably in the classic “sweet spot” in the investment cycle – with rebounding growth and surging profits but plenty of spare capacity such that inflation is not really a problem and central banks can keep interest rates low and money easy. This period in the cycle is usually very positive for shares.

The US is in the “sweet spot” in the investment cycle

Source: AMP Capital Investors

Finally, there are no signs of the excesses that normally mark the end of cyclical recoveries in shares. Inflation is still benign in advanced countries and even in emerging countries it is mainly reflective of higher food prices, not excessive demand. Prices for assets such as shares and property are still far from being overvalued.

But what could go wrong?

Essentially there are four main areas of concern.

Firstly, there is a risk of a short term pull back in shares. Many technical indicators suggest US shares are overbought and measures of short term investor optimism are at levels that often precede corrections. However, while there is the risk of a consolidation or a 5% pullback, the positive fundamental outlook outlined above suggests any short term dip should be seen as a buying opportunity.

Secondly, longer term structural issues clearly remain in major advanced countries. The threat remains from very high public debt levels, still fragile household balance sheets, ongoing issues in the US housing market and poor demographics. However, our assessment is that while these are likely to be medium term constraints for major advanced countries they are unlikely to cause a blow up in the next year or two;

• Europe seems prepared to do whatever it can to stop its debt problems spreading. And the US is having no trouble financing its budget deficit.
• Household balance sheets in the US remain worrying but rising share prices and the fall in household debt ratios mean they are becoming less fragile.
• While the US housing market is still a threat, rising home sales suggest it has found a floor and in any case the significance of housing activity in the US economy is half what it used to be.
• Finally, demographics are certainly poor and will be a long term constraint in major advanced countries, but this is a very slow moving event.

Thirdly, worries about inflation and growth in emerging countries could start to weigh on major share markets. Asian and emerging market shares generally have had a bad start to the year reflecting the need for monetary tightening in response to inflationary pressures. Basically Asia and other emerging countries are further advanced in their economic cycle (see earlier chart) and so have less spare capacity and less justification for very easy monetary conditions. As a result, monetary tightening is required to take monetary conditions back to neutral – as has already occurred in Australia – and this is seeing emerging markets go through a period of under performance relative to the US and Europe. This is likely to continue for the next six months or so, but with underlying inflation in these countries a long way from getting out of control and policy makers already responding, a hard landing is unlikely in the emerging world. Nor does it change the favourable strategic outlook for Asian/emerging share markets.

Finally, the eventual reversal of easy money policies in the US, Europe and Japan and easy fiscal policy in the US will likely cause gyrations in share markets. However, this is unlikely to be a major issue for markets until later this year at the earliest or more likely through next year. Excess capacity in the US, Europe and Japan suggests underlying inflation is likely to remain benign for some time heading off the need for a quick return to more normal monetary conditions in these countries.

Concluding comments

The cyclical recovery in global shares has further to run, but with Asian and emerging markets further advanced in their economic cycles and US shares still in the “sweet spot” in the investment cycle, the next six months or so may see further short term outperformance by US shares. Australian shares are likely to be in between: monetary tightening in Asia may act as a short term constraint on Australian shares but with monetary conditions already normalised in Australia and the RBA ahead of the curve, Australian shares are likely to continue to benefit from the positive lead flowing from US shares.