The future for global markets

The panel

Jerome Booth - Head of research at Ashmore Investment Management

Thierry Creno - Head of portfolio management, FundQuest, BNP Paribas Investment Partners

Alec Letchfield - Chief investment officer of HSBC Global Asset Management's UK private client business

Serge Ledermann - Chief investment officer and global head of asset management, Banque Heritage

Rich Nuzum - President and global business leader, investment management business, Mercer

Emerging markets have been consistent in providing high returns to investors throughout the financial crisis. Which countries are you looking at in 2010?

Jerome Booth: Different emerging countries are going to be attractive depending on the asset class. There are also different global scenarios as well as local policy and other factors to consider. Closed economies such as Brazil, India and Indonesia may be safest in the worst environments. Commodity producers may benefit from both benign scenarios and infrastructure booms expected across emerging markets. Open manufacturing exporters in the developing world may be most vulnerable to a US or European meltdown, but they remain safer than developed markets. It is important not to focus on a few countries but be able to change portfolio shape according to conditions.

Thierry Creno: In 2010, we are concentrating our emerging markets investments in Asia and eastern Europe and are underweight on Latin America. We consider eastern Europe, especially Russia, to be more attractively valued.

Asia offers a well-diversified market where domestic demand should continue to increase despite rising interest rates and attractive currencies. This is the growth engine of the world and we are comfortable in seeking exposure there.

Alec Letchfield: Looking at emerging markets, we are increasingly positive on China. The property market has already responded to the tightening measures taken earlier this year and the outlook for inflation is improving with falling commodity prices. This, added to the emergence of domestic consumption as a driver of gross domestic product [GDP] and of stock performance, gives greater balance to the Chinese economy.

Brazil was regarded as highly susceptible to excessive levels of inflation. We believe these concerns to be overdone from the perspective of commodity demand, specifically oil and iron ore. Further, the domestic economy is far more robust, with strong trends in domestic investment and credit growth driving sustainable economic growth.

Serge Ledermann: Emerging markets have been the place to be for investors over the past 10 years. Whereas developed equity markets have produced negative returns - since they started the decade on a high - emerging markets have demonstrated a very good mix of positive characteristics such as low valuation, disinflation forces, higher economic growth and better company management.

Rich Nuzum: Our dynamic asset allocation model, which operates based on a three- to five-year time horizon, is currently suggesting a neutral weight to emerging versus developed markets. However, on a strategic, long-term basis, we do generally advise those of our clients with a longer-term investment horizon to overweight the emerging markets by up to two times their relative market capitalisation. We are conscious that emerging markets tend to have a high beta relative to the developed markets, and this is factored into our dynamic positioning of neutral rather than aggressively overweight versus the long-term strategic target.

Are some countries facing asset bubbles?

Mr Creno: If any emerging market bubble does occur, it will probably be restricted to a single country or sector - such as Chinese real estate - and not be widespread. The structural positive factors supporting emerging markets are well known. Even so, they are not fully immune from what's happening in the global markets. Therefore, outperformance of emerging markets should be less significant going forward, making stock-picking (alpha generation) a more important factor.

Mr Letchfield: China has topped the list of concerns over asset-price bubbles in 2010. The aggressive lending growth carried out by the banks fuelled sharply rising property prices and the Chinese authorities have felt the need to limit the banks' ability to provide mortgages. The reason this is not a bubble is that Chinese buyers put significantly more cash into housing purchases so household leverage levels are not excessive. Structural urbanisation trends are so strong that the need for more housing is acute. The price increases causing the concern have been focused in cities such as Beijing and Shenzhen and the tightening measures are already having the effect of forcing prices down in these areas.

Mr Ledermann: Some asset bubbles may appear - we think one may be the real estate sector in China - but broad-based signs of this do not exist. Growth in emerging markets will be negatively affected by the expected slowdown that will soon appear in the developed world so we are focusing on areas that exhibit a profile of balanced growth between the external sector and domestic growth, Brazil and most Asian markets, for example.

Mr Nuzum: We believe so. But unfortunately, asset bubbles are, by definition, only apparent after the fact. We continue to pursue diversification across developed and emerging markets, across large, mid and small capitalisation stocks, by investment style, and as a multi-manager also by active investment approach. We believe active managers are well positioned to attempt to identify and hopefully outperform over the long term amid recurring asset bubbles.

How are your asset allocations changing and how much of it focuses on emerging markets?

Mr Booth: We do not know how the US and European credit crunch is going to develop. The main scenarios are known, though, and our portfolios are positioned so as not to be caught out under any scenario. A total of 100% is in emerging markets, and in our multi-strategy approaches the main variations are going to be between fixed income and equity - depending on short-term global risk factors, and within fixed income between dollar-denominated and local currency debt. Corporate debt and special situations are offering a lot of value too, while we anticipate investment booms in some emerging markets in both infrastructure and real estate.

Mr Creno: We see the current aversion to risk as a correction rather than the start of a bear trend. Economic growth and corporate earnings remain on a positive trend, and we don't expect the US Federal Reserve to tighten its policy significantly. We have cut our portfolio's risk profile mainly by reducing the most volatile and liquid assets - equity and commodities. Although we are not yet confident enough to re-enter the market, the next six months should offer opportunities to increase the beta of our portfolio. Emerging markets represent 10% of our equity exposure on average and we could increase this if the conditions merit it.

Mr Letchfield: We are broadly looking to add to risk-asset classes such as equities over the coming months. While we view the issues within Europe as significant, and watch the moderation in Chinese growth carefully, our view is that some of the worst-case scenarios within Europe will not come to fruition and China looks to be heading towards a level of growth that is more than acceptable. Combined with equity valuations that are historically attractive, we see a meaningful upside. Within this, emerging markets remain one of our favoured areas with some of the most attractive growth rates and structural positives. Among the alternative asset classes, we have recently been increasing exposure to both hedge funds and property.

Mr Ledermann: Since the beginning of 2010, we have gradually reduced our allocation to equity markets in our balanced portfolios. This was driven by our concerns such as sovereign debt worries, financial market regulation and growing doubts about economic growth expectations. Since all of those issues are starting to be largely, or already fully discounted by market prices, we envisage increasing our equity allocation during the second part of the year and decreasing the government bond exposure.

Emerging markets play an important role, but not as great as last year when half of our equity allocation was devoted to such markets. Currently, emerging markets represent 20% and 15% of our equity and fixed income allocation, respectively.

Mr Nuzum: Besides emerging market equities, other asset classes we believe offer promising risk-adjusted return and diversification prospects in the medium to long term include emerging market debt, mezzanine debt, active commodity investment (both long and short), private equity secondaries, private debt, real estate debt and insurance-linked securities, including catastrophe risk bonds. Unfortunately, a number of these are relatively illiquid, or require substantial allocations to access on a cost-effective basis. Unlike emerging market equities, not all of these opportunities are necessarily suitable, nor practically available at reasonable cost, to all of our clients.

Which sectors are seeing growth in 2010 and which countries' financial sectors are attractive?

Mr Booth: This changes across countries, but in the longer term we like the domestic consumption growth stories across emerging markets and infrastructure expenditure plays and resources sectors. Specifically in the financial sector, the key is to find banks and companies that are well managed and attractively valued, but also where the macro environment can sustain good returns on equity. So we like banks in Brazil, China and Russia; real-estate companies in Mexico, Brazil, India and China; and capital markets companies, ie: investment banks and bourses in China and Brazil.

Mr Creno: As we are still recovering from the 2008/09 recession, most sectors are providing positive growth this year. This should remain the case in 2011, although to a lesser extent. In developed markets, fiscal consolidation and weaker currencies should help exporting sectors. Domestic demand-oriented sectors in emerging markets should also benefit from this broad rebalancing of the global growth spectrum. With growth likely to be mild, we also tend to focus on quality growth style and visibility, and less so on early cyclical sectors.

With the development of a middle-class and lower-trend inflation over the medium-term, the emerging markets financials sector is probably a better place than the developed one, even if the latter provides more attractive entry points every day. Importantly, emerging market banks have not been affected by the debt crisis.

Mr Letchfield: Many cyclical sectors are forecast to show a strong rebound in profits in 2010 as their profits recover from the earlier recession. We see good growth from many general industrial companies, which are both benefiting from inventory restocking and recovery in end-demand. This has seen an additional boost in countries such as the UK, where currency weakness has been a feature. Typically this would be a short-term view given the cyclical nature of the these industries but, in the UK, there is likely to be a greater level of durability as exporters increasingly take up the baton in light of the indebtedness of the consumer and public sector.

In terms of financial sectors, we would view many of the emerging market financial sectors as attractive in view of the positive demographics as young populations become increasingly wealthy and look to both save and spend more combined with financial systems that, on the whole, are in good shape.

Mr Ledermann: According to leading indicators, global economic growth is about to peak at the moment. Consequently, we are moving from cyclical sectors to more stable sectors such as healthcare, energy and IT. Concerning financials, we have been cautious for quite some time since we believe the sector is about to face stringent regulatory pressures and is still very opaque in terms of balance sheet and revenue generation. Emerging market financial companies are in much better shape and therefore are expected to continue to outperform their developed market peers.

Mr Nuzum: As a multi-manager, Mercer does not currently have a tactical overweight by country or region within the emerging markets, beyond the weights established by our underlying sub-advisors.

Given the current sovereign debt crisis in Greece, how do you expect this to affect returns on sovereign debt?

Mr Booth: It is important to distinguish between the sovereign debt of those countries where sovereign risk has not previously been priced in and has experienced a credit crunch (US and western Europe), and emerging markets. Moreover, investors are increasingly making this distinction. The result will be more flows to emerging markets in the medium if not the short term, not least from emerging market central banks, which are the dominant global marginal investor today.

Mr Creno: Uncertainties over risk-free assets is an important headwind for all asset classes. But, once the crisis passes, we could see a trend towards both convergence and differentiation. We see possible convergence between developed and emerging markets' sovereign debts, because although some credit default swap levels have been well-publicised recently, local regulations usually still make a difference between so-called risk-free sovereign debt (developed countries) and risky (emerging market) sovereign debt. We see differentiation developing between developed markets' sovereign debt, which would create an important new factor in the management of a developed market sovereign bond portfolio.

Mr Letchfield: Returns on sovereign debt have already been dramatically impacted by the crisis in Greece. In Europe, countries with high fiscal deficits and debt-to-GDP ratios witnessed their own government debt markets being hit in April, while the core eurozone government bond markets have benefited from a flight to quality. Now the European Financial Stability Facility has been put in place, there is a chance that markets will wish to test its sustainability by adding pressure on other fiscally weak countries - developments in Spanish government yields will be worth watching as a good indicator of the sovereign debt crisis.

Progress on drastic fiscal tightening implementation in sensitive countries will also determine the direction of the sovereign crisis. European economic growth will remain below trend for a while. However, bonds issued by the core European countries are starting to be expensive from an economic backdrop point of view. It is very difficult to forecast where the sovereign crisis will lead, but volatility will remain a constant feature in eurozone government bond returns.

Mr Ledermann: The current environment highlights the fact that the 'usual (sovereign) suspects' are the not the same as before, ie: Asia and Latin America, but rather are found increasingly among the developed nations. There is little contagion to the emerging world so far. The danger here is that the EU does not get its act together and that this crisis drags along, inducing a 'lost decade' for growth, as has occurred in Japan since 1990.

The main consequence is the deflationary nature of the current debt crisis and, hence, a low-interest-rate environment for a prolonged period as well as a premium for quality borrowers. The balance of preferences in terms of sovereign debt has shifted from core-developed markets to a mix of developed and emerging market debt.

Mr Nuzum: While some individual countries are facing difficulties, sovereign debt in general has been little affected, and despite the problems in Greece it has still proved to be a good defensive investment when risky assets weaken. The global capital markets appear to generally agree with our assessment that most emerging debt markets are not exposed to the same dynamics as Greece.

Within emerging markets, most governments - clearly not all, but most - learned valuable lessons from past emerging market debt crises. While there are clear exceptions, most emerging market governments have generally established enviable levels of fiscal balance, have amassed substantial foreign exchange reserves, and have made strong progress towards matching up the currency exposure of their assets and liabilities so they appear much less vulnerable to another debt crisis.

What is the best balance between sensible regulation and robust measures to prevent another crisis?

Mr Booth: The key issue is avoiding systemic risks in the banking sector through proper macro-prudential regulation. This is not rocket science or new - we just neglected to do it for the past couple of decades in the developed world.

If there is one regulatory principle which needs to be ingrained in this industry it is that, when someone loses money, they cannot argue as a legitimate defence that everybody else made the same mistake. Otherwise we are going to get more moral hazard, more herding and more surprises, which cause systemic problems in the future.

Mr Creno: Once the new rules are clear, we expect the markets to adapt as they have always done. More regulation could be negative overall, especially if it affects the profitability of the financial sector. But if it focuses on transparency and leverage control instead of forbidding any particular type of activity, it could achieve a well-balanced outcome.

Mr Letchfield: The appropriate balance between sensible regulation and robust measures is one that enables the financial system to continue functioning efficiently while allowing funds to be allocated optimally, but which at the same time prevents bubbles and excesses developing leading to the creation of systematic risk to the broader economic system.

The impact of new regulations on markets depends on whether regulators can achieve the right balance between addressing the structural issues highlighted by the credit crunch but without being so draconian as to prevent financial companies earning sensible returns on their equity.

In the short-term, with much of the planned regulation still in the discussion phase (with Basel III, for example, unlikely to be introduced for a number of years), this undoubtedly adds a layer of uncertainty, which will weigh on markets to some extent.

Mr Ledermann: Since there is no collective, corrective action being taken from the industry, the regulators have been forced to step in. Regulation will be more international, coordinated and very prudent. This will translate into less leeway for non-transparent, off-balance sheet, and highly leveraged activities. Access to credit and leverage will be more difficult. The price to pay will be potentially less liquidity in the marketplace and more collateral required from all participants. The consequence of poor risk management is a more ring-fenced financial services industry.

Mr Nuzum: We note that throughout recorded history, there have been financial crises for as long as there have been financial markets. Clearly there are lessons to be learnt from the global financial crisis, suggesting some reform is desirable. We believe a 'choice' between 'more' versus 'less' regulation is, for the most part, a false choice.

If there were a choice between a regulatory regime that would seek to 'prevent another crisis', at the cost of less efficient global capital allocation and a lower rate of long-term economic growth, versus a regulatory regime that would not prevent occasional crises, but that would ensure more efficient global capital allocation over the long term, and a higher rate of long-term economic growth, we believe our clients' investment portfolios, and our clients' ability to ultimately afford to pay against their liabilities and other financial objectives, would likely be better served by the latter regime.