The Federal Reserve is likely to start normalising interest rates during the year, but I don’t expect the inflation picture to warrant the sort of aggressive action that would trigger a bear market. If anything, problems elsewhere in the world could keep US policy looser for longer. A lack of wage inflation points to the existence of slack in the developed economies while excess capacity and the structural slowdown in China are keeping commodity prices under downward pressure. The environment reminds me of the 1990s and I am following a strategy that would have worked well over that decade: bullish on US equities, cautious on the emerging markets and sceptical about Europe.

The 1990s saw a prolonged period of disinflationary recovery with Japan playing the role of China as a large industrial economy going ex-growth and the fall of the Berlin Wall bringing excess capacity from the East onto global markets. Against expectations at the time, US growth remained robust, the US dollar was strong and Alan Greenspan’s Fed provided enough liquidity to drive Wall Street to stratospheric levels. Those who think equities are too expensive today should note that the darlings of the 1990s, technology and healthcare stocks, are once again leading the market higher and the fundamentals in both sectors are worthy of upward re-rating if the bull market continues.

The US has been my favourite equity market for the past four years. A strengthening housing market and an end to fiscal tightening are underpinning a solid expansion. The trend in corporate earnings has been consistently strong relative to other regions, particularly Europe. The Federal Reserve is likely to be the first of the major central banks to raise interest rates and this could trigger a period of volatility but, as long as the inflation picture remains benign, the equity markets will come to understand that the Fed will be easing off the accelerator pedal and not slamming on the brakes. And a tighter Fed means US dollar strength is likely to continue adding to returns.

The picture elsewhere is mixed. The desynchronised nature of the global recovery will create opportunities. With China slowing, commodity-reliant emerging markets and developed markets like Canada and Australia with large resource sectors are likely to see poor equity returns and currency weakness. We are also cautious on UK equities in a global context. The resource sector has a large weight, and political uncertainty ahead of the general election in 2015 is undermining the housing-led recovery.

Europe is in a bit of a muddle. Growth momentum has peaked and several countries have moved into outright deflation, but some in Germany see quantitative easing as a bail-out for profligate governments. If the unconventional measures currently in train prove ineffective, European Central Bank President Mario Draghi will need to buy sovereign bonds. A period of market stress may be necessary before policy makers overcome their reluctance. With eurosceptic political parties on the rise, time is not on Europe’s side. I am underweight European equities and short the euro.

Japan is the one place that feels very different when compared with the 1990s and the stock market is a top pick for us. As a commodity importer, Japan benefits from China’s slowdown and its export sector is well-placed for a US-led upturn. The domestic economy is patchy but the authorities are dead set on doing whatever it takes to deliver strong and sustainable nominal growth. To this end, the Bank of Japan has stepped up its asset-buying program and we expect Prime Minister Shinz? Abe either to postpone the October 2015 sales tax rise or offset it with a large supplementary budget. Progress on structural reforms is slow but calling snap elections would give him four more years. Currency weakness is part of the plan and we are short the yen.

I see equities continuing to offer the best opportunities for investors but that doesn’t mean to say there won’t be some tricky moments. Hardly a year went by in the 1990s without a crisis somewhere in the world. Deflationary shocks from Europe or China have the power to unsettle the markets in 2015 but the Fed would adjust policy accordingly and the US recovery would rumble on. Ultimately it is inflation, not deflation, that will end this bull market and there are few signs of it today.

Trevor’s latest investment clock

by Trevor Greetham, Asset Allocation Director at Fidelity

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Past months can be subject to revisions.The investment clock approach generates growth and inflation readings based on past trends and current momentum of lead indicators, to help forecast how the global economy may perform in the coming three to six months. The growth reading sets the relative weighting of cyclical and defensive assets (north-south on the clock diagram). The inflation reading sets the weighting of financial assets versus real assets (east-west).

Financial information comes from Bloomberg unless stated otherwise.

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Fed’s QE exit

We have known for some time that Ben Bernanke has worried about the build-up of risks stemming from investors’ reach for yield which has ultimately stemmed from the Fed’s highly accommodative monetary policy. On the other hand, we also know that Bernanke is fully cognisant of the risks associated with any sudden pick-up in yields from current depressed levels. Indeed, if bond yields were to rise too quickly upon commencement of the exit process, we would expect the Fed to manage the market’s expectations, possibly by pausing, or even temporarily reversing, the normalisation process.

Interestingly, in his March 1st speech, Bernanke pointed out that if policy rate hikes were implemented too soon this could even cause bond yields to fall. Although he did not explain how, it is our view that one way this could happen would be if an initial rise in yields caused a jump in interest costs, leading to a reduction in disposable income and slower demand for housing.

The 1994 comparison

Of the four rate-rising cycles since 1988, only the 1994 cycle resulted in the US 10-yr yield ending the cycle more than 75bps higher than when the cycle started. Thus only in 1994 did we have a relatively disorderly impact from Fed policy normalisation, with the rate rising cycle resulting in a capital loss on bonds. However, with coupons at 2% or lower, yields rises of 25 basis points or more per year will generate a capital loss.

To be clear, whenever policy rates are normalised, bond yields will go higher. However, that does not mean we will necessarily experience the disorder of 1994. It is difficult to say what the ‘new normal’ for the Fed Funds Rate will be. Assuming equilibrium inflation expectations of 2.5% and an equilibrium real short rate of 1.5%, perhaps 4% is reasonable. The Fed considers the bond yield as decomposed into an expected inflation rate plus an average real short rate plus a term premium. For example, a 2.5% expected inflation rate + a 1.5% real rate and a + 1% term premium, gives a 5% yield. But, it is the speed of the rise that is of critical importance both to investors and the economy. The good news here is that market currently believes it will take more than 10 years to normalise the Fed Funds Rate, implying a slow and manageable rise in yields.

The biggest area of concern for investors will be upward pressure on yields arising from higher inflation expectations as opposed to economic improvement and normalisation. For example, such a situation could arise if the FOMC persisted with a loose monetary stance for too long even as inflation was picking up. While we do not completely dismiss this risk, we feel this is unlikely because the Fed has stated very clearly that it will only unwind monetary accommodation once unemployment drops sufficiently and/or inflation rises beyond its threshold levels. The reference to inflation is key here because it is specifically intended to comfort the market that the Fed won’t allow inflation to become uncontrollable.

Another risk factor worth considering is an increase in the term premium. The most likely cause of this would be a deterioration of the US fiscal situation leading to increasing investor aversion to Treasuries. However, while this is also something that should not be dismissed entirely, we still see few parallels with the 1994 situation, when policy adjustment by the Fed led to a sharp spike in yields in a relatively short time frame. The big difference between now and 1994 is the Fed’s much improved communication with the market. In 1994, yields rose quickly because the market was effectively caught out and surprised by FOMC’s intentions – the FOMC had only recently began to issue policy statements at this time. Today however, we know that the Fed places an immense amount importance on its guidance to the market. Given this, a large rise in yields is only likely if the Fed unexpectedly shifts its stance on how it intends to normalise policy. While such a “blind-siding” in terms of market perception and Fed actions is possible, we think it is unlikely.

The sequence of the exit process is more difficult to predict, because the Fed will want to remain flexible enough to take decisions while the exit process progresses. However, an end to QE will almost certainly be the first step, followed by the winding down of treasury and agency MBS debt that was being rolled over – although this process will take place over the course of many years. As a next step, it’s possible that the Fed raises the interest rate on banks’ excess reserves (IOER) while scaling back the quantity of its reserves via repos (reverse repurchase arrangements) and offering depositary institutions term deposits. Asset sales would be a last resort to reduce the size of the balance sheet – used only in the event that the Fed wants to drain reserves faster than it currently anticipates.

Trevor Greetham, Asset Allocation and Investment Solutions Director, also commented: “Over the longer term, it is natural for bond yields to rise during an economic recovery and this isn’t usually a problem for stocks as long as the rise in yields is orderly. That said, the debate around QE exit is premature. US data has been weak and lead indicators are rolling over. Meanwhile, US headline CPI is 1% and falling. This data is more consistent with easing than tightening.”

By David Buckle, Head of Quantitative Research, Fidelity Worldwide Investment

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This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment.

Prior to making an investment decision, retail investors should seek advice from their financial advisers. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

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The first round was caused when banks and other highly leveraged financial institutions could not be certain of the value of complex financial instruments linked to sub-prime US housing obligations. This second round is based on uncertainty surrounding the value of eurozone sovereign debt, a far more widespread asset with a critical role as a “risk-free” asset in the global banking system. In 2008, the threat of bank runs was stopped by government intervention; now we are seeing a crisis of confidence in European sovereigns that will require equally forceful action.

Despite this, “a bullish case can be made for 2012,” says Mr Greetham. “It rests on a US-led economic upswing strong enough to offset anticipated weakness in the European economy and it assumes the worst-case scenario of a messy euro break-up can be avoided. US data has been resilient, but as things stand I am doubtful financial contagion from Europe can be avoided.

“Global growth is slowing and a peak in inflation will enable central banks to ease policy with force. However, it will be hard to offset a synchronised slowdown in the European Union, an economic area in aggregate larger than either the US or Chinese economies. Meanwhile, the ability of the US to underpin global activity is constrained by political deadlock over fiscal policy and China is unlikely to fill the gap. Its exports to the developed world are slowing and monetary easing is likely to be incremental with inflation still uncomfortably high.”

Mr Greetham says “we enter 2012 with our portfolios as defensively positioned as we were throughout 2008. One of the key reasons for my caution is I believe policy responses are making the European debt crisis worse. US investors have become used to a sequence of events that sees a market panic elicit a policy response that rapidly triggers a reversal in the business cycle and in stock prices. In earlier times, people called this the Greenspan put. But what if the policy response is the wrong policy response?

“Europe’s problems stem from a chronic lack of competitiveness in the peripheral economies resulting in large trade deficits with the core that markets are no longer willing to finance. Policy makers are addressing the crisis by insisting on ever deeper austerity, by threatening banks with injections of public capital and by hinting that countries that don’t follow the rules can leave the euro. These policies may do more harm than good.”

Mr Greetham suggests “a solution to the problem could come from a policy to rebalance the European economies with the European Central Bank (ECB) intervening to maintain market discipline in the meantime. Trying to restore competitiveness by deflating wages and asset prices in the periphery is doomed to failure when debt levels are so high. It is far better to inflate the core. If policy makers are unwilling to do this, for example by easing fiscal policy in Germany, then a much weaker euro exchange rate could do the trick by boosting German exports to the rest of the world. The ECB could help such a transition by providing unlimited support to cap yield spreads in eurozone sovereign bond markets.”

He notes “a recession in Europe will have an impact on emerging markets through trade and financial channels. European banks are the dominant lenders into Asia where credit growth has been a key driver of economic activity. Emerging markets will probably not be spared from volatility, but a weak global economy in 2012 could provide a good long-term buying opportunity in much the same way as it did in 2008/9. When global growth starts to recover, emerging markets are likely to outperform developed markets by some margin.”
 
As for asset allocation, “moving into 2012, we continue to favour bonds over equities. We remain underweight in commodities, albeit overweight in gold.

“Within global equity markets, we favour the US; the market has relatively defensive attributes and, despite the fiscal deadlock, it is still the most likely to stimulate its economy to protect economic growth and jobs. Economic policy is more pro-growth than in other developed markets, with the Fed willing to take aggressive action when required and the Democratic administration likely to table fiscal stimulus and housing support programs. Swiss equities are also attractive for their defensive qualities, with the currency hedged. We expect a period of euro and Swiss franc weakness and dollar appreciation.

“In summary, investment conditions remain difficult. We expect short violent economic cycles driven by bouts of unprecedented fiscal and monetary stimulus.

“Diversification across a range of asset classes will remain an attractive proposition and there will be lots of opportunities to add value through a sensible tactical asset allocation policy.”
This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investment. This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs.  You should consider these matters before acting on the information.  You also should consider the Product Disclosure Statements (“PDS”) for respective Fidelity products before making a decision whether to acquire or hold the product.  The relevant PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading from our website at www.fidelity.com.au. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Details about Fidelity Australia’s provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website at www.fidelity.com.au. © 2012 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

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Dominic Rossi, Global Chief Investment Officer of Equities at Fidelity Worldwide Investment, said “markets have reacted positively to the intent shown by policymakers, yet my overall view is that the deal is not the game changer investors are looking for. Italy’s 120% debt-to-GDP (gross domestic product) doesn’t look any more sustainable today than yesterday. Europe is destined for a multi-year workout during which economic growth will be very restrained and equities are likely to remain cheap. The path of equities will therefore require better news elsewhere. Earnings growth in the United States continues to surprise on the upside and we may be approaching a policy shift in China. The catalyst for higher equity values lies outside Europe rather than within.”

Trevor Greetham, Director of Asset Allocation, at Fidelity Worldwide Investment, said “the European Union leaders surprised positively after the squabbling of recent days but were low on detail on the critical point of leverage for the bail out fund to backstop Spain and Italy. We may have to wait until November for specifics of possible BRIC/IMF (Brazil, Russia, China, India / International Monetary Fund) involvement alongside a partial insurance scheme for primary issuance. The critical test will be what happens to the eurozone economy. Provision of liquidity goes hand in hand with further austerity in the periphery with Italy now the focus. Meanwhile, if the United Kingdom experience is any guide it will be hard for national regulators to prevent banks deleveraging their balance sheets now forced public capital injections are threatened.”

Richard Skelt, Fidelity portfolio manager, said “the agreement lessens the risk of systemic shock once the agreed mechanisms are in place, and markets are responding positively to this. Looking out beyond the immediate relief rally, a number of headwinds remain. There is a continued policy emphasis on austerity at the expense of growth within Europe which will create a drag for the southern European countries particularly, and the measures imposed on the banking system are also likely to be negative for credit and growth. The longer term path for equities will be determined by the economic cycle globally and less so by political activity in Europe.”

Eugene Philalithis, Fidelity portfolio manager, said “I think the package makes significant progress in terms of the various bank funding and liquidity channels, although some details still need to be resolved.  The proposals to leverage the European Financial Stability Fund and expand its scope are also positive for sovereign funding liquidity. The agreement on the bank recapitalisations is also a significant step forward, the intention of governments being to prevent banks meaningfully shrinking their balance sheets through selling assets or cutting off the supply of credit to the economy.

“Anecdotally, I had a meeting with a bank loans manager this morning who mentioned that banks will most likely dispose of non-core assets, such as infrastructure loans and possibly commercial real estate, while keeping the corporate book largely untouched as it is performing well and pays more than their cost of funding.  But the supply of new credit to the economy could still be hampered, which is likely to be negative. The statement made it clear that private sector Involvement in Greece is a special case, and it will remain to be seen whether the markets accept this and contagion is prevented.  But even with a 50% haircut in Greek government debt, the debt:GDP ratio is expected to fall to 120% by 2020, hardly providing an immediate solution to the solvency problem. 

“Concerns still remain with the lack of detail on implementation for some of these schemes, but there is another meeting in early November where more detail may be provided. Finally, the commitment to enshrine fiscal prudence within national legislation means more austerity is on the horizon for Europe, which leaves the European Central Bank as the only solution for growth.  Without looser monetary policy growth prospects in Europe do not look bright. I think we will see a relief rally in equities and bank debt, as well as peripheral bonds (excluding Greece), and a stronger euro potentially, but at some point the economic fundamentals may overwhelm the initial optimism, so I will take a cautious approach to adding risk.”

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Paul Taylor, Head of Australian Equities and Portfolio Manager of the Fidelity Australian Equities Fund

“Markets are nervous, sceptical, cautious and scared and for very good reasons. We have a European sovereign debt crisis, a huge US debt issue, worrying US economic growth, slowing global growth and concerns that China may reign in growth too hard and go straight past the soft landing scenario and head directly into a hard landing. Further depressing the market is the thought that the sovereign debt issues in Europe and the US are likely to be with us for a prolonged period of time – major readjustments like these take a long time to play out.

“Having made all those depressing comments any potential bright spots or glimmers of hope tend to get drowned in the over riding gloom of the current market sentiment. There is some good news in the US reporting season which is generally better than expected on both revenues and costs and I believe that China is much better positioned than market fears would suggest. The simple fact that Chinese policy is trying to lower growth to a more sustainable level and control inflation already means that they are in a stronger position than the rest of the world which is struggling to achieve any growth. The worse the rest of the world gets the higher the likelihood that China will at least halt its monetary tightening policy. China demonstrated through the global financial crisis (GFC) that it will act very counter cyclically and step up and invest when the rest of the world is struggling and they may well take the same approach again as global growth slows.

“What does all this mean for Australia? It means that with the sovereign debt issues in Europe and the US we are in a lower growth world. As the world undertakes de-leveraging this will have a negative impact on global growth and Australia as a small open economy will be negatively impacted by lower world growth.

“However while we are in a lower growth world this does not mean everything is low growth, it means on average we are low growth but within this average we will see some real pockets of growth. These pockets of growth will include China and a range of emerging economies. Australia will continue to be a beneficiary of its complementary economy with other emerging economies like China.

“With investors so cautious and sceptical they are implying that not only are we in a low growth world but that every market and every company is low growth – and that is the real opportunity in the market at the moment.

“We have seen very significant compression of valuations between markets as well as stocks within markets as investors become very sceptical about growth for all markets and companies. The Australian market is currently very attractively valued at about 10-11x price to earnings ratio and a 5% dividend yield. This sort of valuation is very attractive from an absolute perspective as well as relative to Australia’s own history. The Australian market has historically traded at between 14-15x price to earnings ratio. It is hard to see the Australian market re-rating from 10-11x back to 14x-15x over the next 12 months while these macro black clouds remain, so the market’s performance will likely come from the market’s earnings growth and dividend yield. It is very realistic to expect Australian market returns of 10%-15% over the next 12 months from dividends and earnings growth even without a valuation uplift.

“I think the really interesting point over the next 12 months will be the differentiation at the individual stock level. The pockets of growth in the market will provide a real opportunity to differentiate those stocks with significant growth opportunities. In a low growth world those stocks with growth opportunities will likely be bid up by the market as they become rare assets.

“As valuations are compressed the market is not differentiating between those companies with growth and those without growth. When we look back through history these sort of periods prove to be great long-term investment opportunities into great quality companies, with strong balance sheets and management teams, excellent growth opportunities and attractive valuations.”

Martha Wang – Portfolio Manager of the Fidelity China Fund

“Although China is not insular from recent world events, the sustainable domestic demand fundamentals driving the long-term growth and given the current attractive valuations against regional peers and versus long-term historical averages should provide ample grounds for fund flows back into China. “Given the domestic focus of my portfolio the impact from this incident would be less than other export oriented portfolios.”

Trevor Greetham, Director of Asset Allocation at Fidelity

“I see the US credit rating downgrade as bad news, but not for the obvious reasons. To me the ratings agencies are inadvertently playing a pernicious role in worsening the global policy response to the private sector debt crisis.

“They, along with the IMF, are encouraging governments to tighten fiscal policy when it is very hard to ease monetary policy effectively as an offset due to the zero lower bound for interest rates in the case of the US and UK or the one-size-fits-all ECB rate in the case of peripheral Eurozone countries. In addition, with almost all developed economies now tightening, export growth cannot offer the cushion it might to a country embarking on cut backs in isolation.

“Fighting the current crisis with additional austerity measures could be self-defeating. If growth weakens there will be negative consequences for tax revenues, private sector debt dynamics and financial stability.

“The credit agencies might argue they are not responsible for the broader implications of their actions. It is widely accepted that they were instrumental in creating the financial crisis in the first place due to the AAA ratings they placed on flawed structured products. As much as they are able, governments should probably ignore them. US regulators have already issued guidance saying US banks should continue to treat Treasuries as AAA. Taking things a step further, governments should not abandon the option of short term fiscal stimulus. Cut backs that create recession serve no purpose – not even to reduce government debt.”

Nick Price, Portfolio Manager Emerging Markets

“Given the political and currency frictions, it is highly likely that governments may have to resort to inflating away their debt problems.

“This bodes well for resource stocks, and especially those with assets less exposed to the economic cycle. We are already seeing this, with a number of the gold stocks recently reporting significant improvements in cash-flow generation on the back of recent rises in the prices of precious metals. If there is further monetary stimulus, this effect may well become more pronounced.

“In stark contrast to the cash constrained economies of the West where state funding is under pressure, we are also seeing opportunities present themselves in the developing markets where money is actually flowing into public sector systems, such as healthcare and infrastructure.

“This is exhibiting itself in the form of superior earnings growth rates in these segments, where the recent market falls are presenting stocks with superior fundamentals at increasingly attractive valuations.

“Against the backdrop of the recent declines in equity markets over the last few days, we have been using the opportunity to increase our holdings in those high quality stocks that can continue to generate free cashflow and pay an increasingly attractive dividend yield. Even the stocks with the best fundamentals are being impacted on an intraday basis, despite the fact that many of their fundamentals are proving stronger than ever.

“We regard the current environment as a real opportunity to buy some really good businesses at some great prices. This is exactly what we have been doing over the last few days.”

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