China’s Stock Market Crash: a Speculative Bubble Pops

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China’s Stock Market Crash: a Speculative Bubble Pops

Investors’ appetite for China’s stock market is quickly unwinding. Since the peak almost one month ago the Shanghai Composite Index lost a third of its value. Just like there were no fundamental economic reasons that could explain the earlier steep increase in stock market prices, the current crash has not been triggered by worries about an imminent hard landing. While we would certainly not dismiss this risk as futile and also think growth will slow down faster than consensus estimates, the impact on economic activity looks set to remain fairly modest.

Since the start of the equity rally last summer until its recent peak almost one month ago, Chinese stock prices more than doubled. This sharp upward move always looked suspicious given that economic activity continued its downward growth trend. Looking forward, economic growth in China will continue to decrease from current levels. The fast rise in income levels seen over the past decades (limiting the country’s future catch-up potential), the rebalancing of the economy towards consumption away from investment and China’s rapidly ageing population will all play an important role in this.

Admittedly, this does by no means imply that equity prices should have moved in the same negative direction. First of all, it can be argued that China’s stock market was far from expensive one year ago. Indeed, traditional valuation measures including the price/earnings ratio or the market capitalization of listed firms relative to GDP both suggested in fact the Chinese stock market had become fairly cheap. Moreover, despite slower growth, the rebalancing of the economy is a positive evolution and one that makes future growth more sustainable.

At the same time, however, there were also several reasons to be sceptical, certainly in times when Chinese policymakers are experiencing difficulties in trying to make sure that growth doesn’t slow too abruptly. Importantly, it cannot be denied that a lot of (official state) media attention has been given to the attractiveness of China’s stock market while policymakers were putting further rebalancing measures in place. In other words, Chinese leaders have interpreted rising stock market prices as evidence that their strategy was playing out fine and have not refrained from underlining this. Moreover, the fact that the housing market was struggling at the same time has also helped to drain savings into China’s stock market. All this in combination with the prospect of more capital account openness (including bigger representation of Chinese stocks in global equity indices) has fuelled a speculative stock market bubble.

Since its peak mid-June, the Shanghai Composite Index has fallen by around 32%. Year to date, however, the index increased more than 8%. Over the last 12 months, meanwhile, equity prices are still up more than 70%. The big challenge and difficulty of course is to see what comes next. Authorities are now taking measures to support the equity market. What’s also obvious is that this is proving very difficult, especially when at least a significant part of the money invested is debt-financed. All in all, for reasons explained here, the impact on overall economic activity should remain fairly limited at this point. That said, recent turbulence once again underlines how difficult it is for Chinese leaders to deal with the huge imbalances stemming from the unsustainable credit boom witnessed after the 2008-2009 crisis.

Hans Bevers is economist at Petercam

From ‘Grexit’ to ‘Grin’ But will Greece Grin and Bear It?

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From ‘Grexit’ to ‘Grin’ But will Greece Grin and Bear It?

After a weekend of long and often very bad-tempered discussions within the Eurogroup, the leaders of the eurozone have finally agreed to offer Greece a third bailout, with the European Commission confirming that Greece will benefit from c.€86 billion of financing over the next three years. 

Assuming the steps required in the coming days are met, the immediate bankruptcy of the Greek government has been avoided, and the country will remain within the eurozone. However, the terms of the deal look to be very tough, and the deal will be seen as a humiliation by many Greeks. Given that the ruling Syriza party was elected on an anti-austerity mandate, and that voters rejected a much weaker reform package in the referendum, political upheaval in Greece may now follow. Moreover, there is no debt forgiveness or debt write-offs for Greece, meaning that total Greek debt-to-GDP levels will remain unsustainably high.

The key points of the deal are as follows:

  • Greece will receive some €86bn in bailout funds.
  • Before legal negotiations can take place, the Greek parliament must approve a range of significant reforms affecting VAT and the tax base, pensions and other areas of the economy. The EU would like the reforms to be approved by the Greek parliament this Wednesday (15 July). This unusual approach is a response to the complete breakdown of trust between the Greek government and their European partners.
  • Certain eurozone national parliaments (most pertinently Germany) will then need to give the go ahead before formal negotiations can begin over the specifics of the new bailout program. This could, in theory, be done by the end of the week, although this may prove to be easier said than done.
  • A €50bn asset fund will be created, chiefly to make sure that privatization commitments are kept. This will be run by Greece but supervised by Europe. Half of this fund will be used to recapitalize the Greek banks.
  • The European Stability Mechanism (ESM) will provide an immediate €10bn to recapitalize Greek banks, which are close to collapse.
  • A ‘haircut’ or reduction of Greek debts will not be offered – i.e. there will be no ‘debt forgiveness’ which the German chancellor Angela Merkel has said is ‘out of the question’. Greece’s debts might be restructured to make repayment a little easier (e.g. by extending maturity), but only after Greece has introduced all of its promised reforms.

What happens if the bailout is not approved by the Greek parliament?

Prior to the deal being announced, the Eurogroup had warned Greece that its failure to enact reforms would result in the suspension of Greece’s membership of the euro.  In the event of suspension, the exact length of the ‘time out’ was not specified, but comments from the German finance ministry suggest it could have been as long as five years. However, this triggered further tension between the eurozone member states, with France’s President Hollande saying that a temporary exit from the euro area was not an option, and that the issue at stake was not simply whether Greece stayed in or out of the euro but ‘our conception of Europe’. President Hollande was supported by the Italian PM Matteo Renzi, while Germany continued to emphasise its refusal to do a deal ‘at any price’.

Wider implications

The key focus in the short term will surround the navigation of the immediate hurdles (Greek parliamentary approval, then German parliamentary approval) and how long the banking sector can continue to provide cash to Greek citizens while emergency loans from the ECB remain frozen. All of these situations are urgent and any hold-up would increase significantly the risk of a messy Grexit scenario. In the bigger picture, in agreeing to support this bailout process, Alexis Tsipras has effectively reneged on all of his party’s pre-election commitments and handed sovereignty for domestic policy to Europe. This comes at a time when the economic situation is likely to deteriorate further in part thanks to the newly-prescribed austerity that he was so vehemently against. Against this backdrop, while the short-run risks of Grexit have declined, the risk that the Greek population begin to question the merits of euro membership must surely be increasing.

The implication for markets has been unclear through much of this saga, as investors have found it difficult to assess the direct costs or benefits of the different scenarios. Following months of indecision and reasons to be cautious, it is perhaps unsurprising to see a stark positive reaction to what is a ‘deal’ full of pitfalls and contradictions. The bigger picture message is perhaps for citizens of Europe who might want to re-negotiate the status quo with the establishment. From a position of weakness before, Greece’s economy now lies in tatters once again, facing the prospect of more austerity and outside control. For sure, Tsipras’ management of the situation could be called into question, but any budding protest parties elsewhere will think twice before taking on the elite.

Opinion column by Martin Harvey, Fund Manager at Columbia Threadneedle

Get Used to Periods of Higher Volatility

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Hay que acostumbrarse a periodos de mayor volatilidad
CC-BY-SA-2.0, FlickrPhoto: Susanne Nilsson. Get Used to Periods of Higher Volatility

At the recent market peak, in late April, holders of 30-year German bunds were enjoying year-to-date returns of 23%. The dramatic reversal since then has entirely wiped out these gains: this is hardly the sort of behaviour one would expect from Europe’s premier ‘risk-free’ asset.

In our view, this phenomenon was caused by a crowd-surge into eurozone deflation/ quantitative easing (QE) trades and then a ‘rush for the exit’, when investors realised just how overpopulated and overvalued these trades had become. Overshooting markets do not always need a fundamental trigger to spark a reversal, but the rise in eurozone inflation in May, when core CPI rebounded to a 1-year high, certainly added some urgency to the unwind.

Morality check

We wonder whether today’s bund investors could learn some lessons from the Japanese government bond (JGB) market of the early 2000s. Having trended lower for more than a decade, 10-year JGBs troughed at 0.4% in June 2003. Even though Japan endured a grim eight-year decline in gross domestic product from that point, anyone who bought JGBs at the yield low in 2003 made just 1% per annum over those eight years and was in loss for the first four years of the trade. The moral of the story is: once economic stagnation is priced in, bond returns can be low and volatile, even if the economy continues to disappoint.

Furthermore, when we look at the eurozone today, we see an economy that is recovering, not stagnating. Consensus forecasts for 2015 growth have been rising for six months and inflation forecasts have been rising since February. Looking ahead, we expect more of the same as the impact of euro weakness, lower oil prices, easier credit conditions, and diminishing fiscal austerity kick in. Even though European Central Bank QE will continue to exert downward pressure on eurozone bond yields well into 2016, economic recovery is now emerging as a force that will act in the opposite direction.

Growing pains

Although bunds have seen the biggest swings this year, all the major government bond markets have followed the same pattern, with Q2 shaping up to be the worst quarter for sovereign bonds in almost 30 years. As is the case with eurozone bonds, the recent sell-off began as an unwinding of Q1’s euphoria, but more recently, has begun to reflect improving economic data, particularly in the US. 

 

Peer pressure

Following a disappointing start to 2015, US data have significantly improved over the last few weeks. A number of key series – retail sales, payrolls, job openings, consumer confidence, and homebuilder surveys – have surprised to the upside, suggesting the economy is regaining momentum and pulling away from Q1’s soft patch. We think this trend will continue in coming months, prompting the US Federal Reserve to raise interest rates before the year is through and keeping upwards pressure on US bond yields.

We see the recent sell-off in government bonds as largely correcting Q1’s overshoot. If our base case scenario of continued global recovery is realised, we do not expect to see Q1’s yield lows again during this cycle and think yields will grind higher in H2. Higher yields will not necessarily undermine risk assets if they reflect improving economic conditions. However, investors would do well to take note of Mario Draghi’s recent comment: “Get used to periods of higher volatility”.

Paul O’Connor is Co-Head of Multi Asset within the Henderson Multi-Asset team.

Fresh Volatility But Renewed Confidence

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Nueva volatilidad, pero confianza renovada
CC-BY-SA-2.0, FlickrPhoto: Edward Dalmulder. Fresh Volatility But Renewed Confidence

Fresh volatility on bond and equity markets and- toa lesser extent- in currency trading is not all that surprising. Market volatility had been abnormally low for months as investors piled into the same strategies dictated by the ECB’s massive quantitative easing programme. Two events disrupted the calm; higher-than-expected inflation in Europe which officially marked a sharp reduction in deflation risk (and therefore visibility on the ECB’s QE campaign) and concerns over default risk in Greece or Grexit as talks got bogged clown.

Concerning fixed income, faced with bond market volatility, investors had been reassured by the ECB’s flexibility following comments from Benoít Coeuré that the bank could take advantage of swings to accelerate bond buying. But then Mario Draghi said investors would have to get used to volatility, thereby reducing hopes the ECB would try torein in market pressure. As a result, yields on the 10-year German Bund jumped 80bp between April 20 and June 9 or enough to undermine European equity markets.

At the end of April, we moved to an underweight position on European government bonds as they had become extraordinarily expensive. But the extent of the subsequent fall has led us to turn neutral. Even after this correction, European bonds are still expensive but it seems a done dealthat the ECB will stick to its quantitative easing calendar until its official end date of September 2016. This means that with negative yields on some bond market segments, there is justification for bonds to remain expensive. And generally speaking, we believe it is still too early to position portfolios for the end of quantitative easing. Moreover,  we would not be surprised to see other ECB interventions ifyields should  rise further as the bank wants to keep real rates neutral to negative to shore  up the recovery. Against this backdrop, it makes more sense to remain neutral.

On the equity side, if the bond market correction has in fact come to an end, equity markets should rally. In so far as credit spreads remained rather stable as yields rose, the risk of equity markets being contaminated needs to be put into perspective. Earnings expectations are trending higher in the eurozone and in Japan with fewer and fewer downward revisions in the US, UK and emerging countries. And after the weak spell at the beginning of 2015, the US economy is likely to rev up again, thereby facilitating the incipient recovery in Europe and Japan. We expect upward earnings revisions to continue and help equity markets move higher. We had underweighted UK equities ahead of the elections there but a certain degree of stability has returned and we have turned neutral on the market. The thorny issue of the referendum on whether to stay in the European Union will return to centre stage next year but it is still too earlyto position portfolios to reflect this risk. All together, these developments have led us to increase European equity ratings and equity ratings as a whole.

As well as the return of Russo-Ukrainian tensions, political risk is still acute in Greece where talks are dragging on ahead of sizeable repayments to the IMF scheduled for the end of June. We are sticking with our core scenario that a favorable solution will be found as all parties have an interest in reachingan agreement.

Column by EdRAM. Benjamin Melman is Head of Asset Allocation and Sovereign Debt in Edmond de Rothschild Asset Management (France).

The data, comments and analysis in this document reflect the opinion of Edmond de Rothschild Asset Management (France) and its affiliates with respect to the markets, their trends, regulation and tax issues, on the basis of its own expertise, economic analysis and information currently known to it. However, they shall not under any circumstances be construed as comprising any sort of undertaking or guarantee whatsoever on the part of Edmond deRothschild Asset Management (France). Any investment involves specific risks. Main investment risks: risk of capital loss, equity risk, credit risk and fixed income risk. Any investment involves specific risks. All potential investors must take prior measures and specialist advice in order to analyse the risks and establish his or her own opinion independent of Edmond de Rothschild Asset Management (France) in order to determine the relevance of such an investment to his or her own financial situation.

Special warning for Belgium: Please note that this communication is intended for institutional or professional investors only, as mentioned in the Belgian Law of July 20th, 2004 on certain forms of collective management of investment portfolios This notice is also intended only for investors who are not consumers as described in the Belgian Law of July 14th, 1991 on trade practices and information and protection of consumers.

Energy Efficiency: Global Growth Opportunities

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Oportunidades en la industria automovilística: cómo la eficiencia energética está cambiando la forma de hacer coches
CC-BY-SA-2.0, FlickrPhoto: Loremo . Energy Efficiency: Global Growth Opportunities

The Henderson Global Growth strategy, which reached its 5-year anniversary in May 2015, seeks to identify key themes driving world change. One of these is greater energy efficiency. This has been a key theme within the portfolio of the Henderson Gartmore Global Growth Fund for a number of years with holdings well placed to benefit from further government initiatives and technological advances.

The quest for greater energy efficiency is being driven by a combination of factors. Firstly, from an environmental perspective, global temperatures are rising and energy related CO2 emissions are a material contributor to this change. Warmer temperatures are linked to higher incidence of extreme weather, which in turn has a disruptive effect on global food production and water supply.

Energy independence

Secondly, carbon fuels are ultimately a finite reserve and intensity of consumption must be curbed while alternative energy sources are developed for mass use. Additionally, energy independence has become a key topic for governments wishing to insulate their economies from fluctuating commodity prices and supply restraints. Confronting these issues, governments in countries covering 80% of global passenger vehicle sales have set stringent targets for fuel economy or emissions.

Increasing fuel efficiency

In the US, for example, the National Highway Traffic Safety Administration (NHTSA) has mandated that the average passenger car’s fuel economy must increase from around 35 miles per gallon (mpg) today to 56mpg by 2025, and other regions and countries are following suit as shown in the chart below.
 

We believe that in order to meet these government mandated standards, improving the efficiency of the internal combustion engine will be a key consideration for automotive manufacturers for at least the next 10 years.

Smarter engineering

The US Department of Energy estimates that only 18-25% of the energy in gasoline is converted to powering the wheels in the average internal combustion engine powered car, so there is clearly room for gains to be made through smarter engineering.

We invest in companies that manufacture parts and sell technologies which increase the efficiency of the internal combustion engine, and are growing the value of their parts within the car. Stocks currently held related to this theme include Continental, a Germany-based automotive supplier, Valeo, a multinational automotive supplier based in France, along with US auto component manufacturers Delphi and BorgWarner.

Many of the improvements being made by these companies are typically based on proprietary technology, generated through superior engineering and provide the companies with a long-term competitive advantage, which protects their high market shares. The table below shows the positive effects from using various types of car technology on fuel consumption and carbon dioxide emissions.
 

Stock in focus: Continental

We believe the market has undervalued the pace and sustainability of the growth which these auto component companies possess, creating an attractive investment proposition today for our funds.

For example, Continental, which the fund has a weighting in of approximately 1.7%, has strong market positions across its powertrain division with a broad portfolio of engine parts from turbochargers to start-stop technology, geared towards increasing fuel efficiency and reducing emissions. Based on our investment criteria, Continental is attractive on a number of measures:
 

German efficiency

Continental also has one of the market-leading tyre brands and currently trades on 14 times 2016 estimated earnings*. With a rapidly improving balance sheet and strong cash flow generation, investors in Continental have benefited from recent capital growth, as shown in the chart below, as well as a healthy return of cash. We see further upside based on the company’s high exposure to the secular growth areas of carbon dioxide reduction, active safety and in-vehicle infotainment (systems in automobiles that deliver entertainment and information content).
 

Ian Warmerdam is Director of Global Growth Equities and lead manager of the Henderson Global Growth Fund, the Henderson Gartmore Global Growth Fund.

 

The Sweet Spot of Equity Investing

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The Sweet Spot of Equity Investing

It seems the jury is still out over the future direction of the US equity market. Not even a month ago the S&P 500 index flirted with all time-highs, prompting the bulls to wonder if investors really could be the beneficiaries of a seventh successive year of share price gains. Up until then the bears appeared to have had the upper hand – cue recent downward revisions to Q1 GDP numbers, softer than expected retail sales in April and the havoc wrought on company results from a stronger dollar.

I’d counter this pessimistic sentiment. While exporters were hit in the Q1 results season (and yes 45% of S&P companies are overseas earners) domestic companies fared relatively well. Regarding softening GDP numbers, we bulls prefer not to talk about output but national aggregate income which, for the first quarter, registered 1.4% annualised growth. Economists still think there’s no reason for the US not to register 2.5%-3.0% growth in the second quarter annualised.

For me it seems as though we are still in the sweet spot of equity investing. The risk of the US Federal Reserve tightening has been kicked a little bit further into the long grass and, if the IMF has its way, is likely to stay there for some time to come. Yet raising rates is a sign that the economy is not only off life-support but recovering well in the process.

So let’s focus on what we know so far. Knock-out non-farm payroll numbers for May aside, if ever there was a sign of confidence returning to the US economy it’s in the escalating value of M&A deals. In May alone these totalled a staggering US$ 243bn, which if this rate continues could well top 2007’s record. If management didn’t believe the economy was stable they wouldn’t be committing such large amounts of cash to buying other businesses, surely?

And corporates are right to be optimistic. The US economy is one of just three to experience self-sustaining growth in 2014 – the other two being India and the UK. Corporate margins are nearing 50 year highs and, unlike many, I see no reason for them to revert to the mean given the double tailwinds of a fall in oil prices and advances in technology. So while optimistic on the economy, my only real concern is that the rate of corporate investment spend needs to increase. Companies are still in the ‘let’s return cash to shareholders’ mind-set, rather than ‘let’s invest in plant and machinery mentality.’

Unsurprisingly, given the concerted actions of central bankers to drive down bond yields and whip up demand for equities, risk appetite has increased substantially from its October 2014 lows, with investors favouring growth stocks over value. Although, as most US equity investors will know from bitter experience the rotation from growth to value styles and back to growth could change anytime soon.

The recent correction in global bond markets suggests that point may not be too far away. While style volatility has been less pronounced in the US than Europe that’s not to say it doesn’t exist. Watch this space. The trick is, as ever, to keep alpha returns diversified.

Ian Heslop, Head of Global Equities and Manager, Old Mutual North American Equity Fund.

Let’s Talk about Work

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Let’s Talk about Work
Foto: Jesse Acosta. Hablemos de trabajo

I may be a recovering workaholic.

Have your loved ones, friends or colleagues ever confessed to being workaholics? Perhaps, but I doubt it was viewed as a real addiction; at least, compared to a drug addiction that would warrant an intervention. Yet now that I have faced my demons, I have a completely different perspective on the matter.

We are trained to communicate openly regarding just about everything except our excesses in the workplace. The Japanese are one of few cultures that seem to address the problem of overworking head-on.  In Japan, a salaryman, an office warrior, is praised for his achievements but also told to be careful. Working too hard can lead to Karōshi, which in Japanese literally translates to death from overwork.

How do you discuss the topic without getting defensive? How do we know if this is a real problem? Perhaps you are questioning yourself about your work habits while reading this. From personal experience, here are the main areas that have helped me transition into a balanced work style over the past six months, without losing any productivity.

1.  Moderate, Don’t Quit

Out of all of the addictions you could potentially have, this may be one you can enjoy with moderation. As a workaholic, chances are you are a top producer at your company. The problem solver, the yes man, the hero in the conference room. Just remember, being proud of your workaholism also means understanding there is a problem. That is the first step in the recovery process.

2.  Don’t Isolate Yourself

Talk to your friends, family, and loved ones about all aspects of your job.  Understand that it is quite hard for them to understand the day-to-day process and the dedication you have to give to your work, especially if you are a CEO or entrepreneur and the buck stops with you. Communication can help everyone around you understand why you have to stay at the office past nine PM and why sometimes there are last minute deals or negotiations that come up.

3.  Enjoy your downtime 

Figure out where you can spare an hour or two from work from time to time and dedicate it to a hobby or simply spend that time with friends and family. Do anything but take on a new task at work just to be ahead of schedule.

4.  Enjoy your worktime

When there is work to do, put your best effort into it. We all have tough days filled with extra work, and in those you should not have to feel bad about changing plans, about staying late at the office, about having to explain to people why you work so hard. If you have been communicating with everyone around you effectively and you have learned to share your downtime, they will understand when it is worktime.

5.  Get to know your work self

Closing new business, pushing deals through gives me a rush and sense of satisfaction. Seeking these amazing feelings at times results in taking on more projects than I can deal with. I have learned to recognize when I am taking on too much at work and discuss it with co-workers and business partners. You have to find the line between success and excess and seek the perfect medium.

6.  Get where you want to go

More important than any list, have a vision. Find something that drives you not only at work, but also outside during beautiful day-to-day living. For me right now this means not showing up late to my squash games, spending holidays with my family, and attending birthdays and weddings of loved ones, but at the same time not feeling bad if I have to miss one because a real work emergency comes up.

In the future I hope not to be late when picking up one of my children from school, and I hope to be part of a family whose love and support make us a team.

I love my job but know that Karōshi, won’t serve me, my job, or the people in my life. The Japanese also have a word for those who are able to escape the workaholic world – datsurara. This word used to mean dropout, but today when technology makes it all but impossible to unplug and reconnect to the world, datsura describes a healthy new lifestyle that incorporates both entrepreneurship and balance.

Shadow Banking Comes Out of the Shadows

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Shadow Banking Comes Out of the Shadows

The term ‘shadow banking’ was first coined in 2007 to describe parts of the financial intermediation process conducted outside of the commercial banking system. It encompasses all non-bank credit intermediation and spans wholesale markets-based finance (such as certain types of investment funds and securitisation vehicles, as well as activities such as securities financing transactions) and alternative lending channels.

The negative connotations associated with the name stem from the role of complex, opaque and lightly regulated financing activities in the 2008 financial crisis. Shadow banking was thus seen as a source of systemic risk that required containment.

Seven years later, the shadow banking debate has changed dramatically:  with traditional bank lending constrained by more stringent regulatory capital and liquidity requirements, the focus on shadow banking has shifted from containing risks to enabling capital markets to revive economic growth.

Within this context, a new CFA Institute study on Shadow Banking suggests that nonbank credit in the form of markets-based finance can provide a potential solution to reviving the real economy by helping to channel capital to productive enterprises. However, in order to put shadow banking on a sustainable footing, it is necessary to increase standardisation and simplification of issuance structures, as well as boosting transparency more generally, in order to support investor interests.

The scope of regulation surrounding markets-based finance is already quite broad. In the EU and the US, for example, regulation of investment funds marketed to retail investors is comprehensive, while new rules for money market funds have been established (among other things). In this context, the term ‘shadow banking’ is somewhat misplaced and should not be construed with unregulated activities.

On the other hand, there are other parts of the shadow banking system that are mostly unregulated, such as peer-to-peer lending, microfinance companies, trust-based loan provision, and other alternative lending channels, and it is in this domain that risks to investor protection  are most likely to emerge.

The renewed interest in shadow banking coincides with the European Commission’s policy initiative to establish a ‘Capital Markets Union’ (CMU).  The objective of CMU is to tackle the barriers to the flow of capital in Europe and diversify sources of finance for companies. The initiative comes against a backdrop of weak economic growth and concomitantly accommodative central bank policies. With constrained bank lending, expanding the pool of capital available to European companies is arguably more important than ever. In this context, shadow banking can play a pivotal role in unlocking capital markets and better connecting investors with the financing needs of the economy.

To realise the potential benefits from shadow banking, policymakers must tackle product and market fragmentation within securitisation markets by incentivising more simplified, standardised issuance structures, as well as implementing a more robust framework regarding the use of collateral associated with securities financing transactions. By doing so, shadow banking can support a variety of investor needs and enhance the efficient functioning of the financial system.

EMD: Take Pride, Not Prejudice

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EMD: Take Pride, Not Prejudice

After weeks of continuing turbulence in global bond markets, investors are once again asking themselves “where next for fixed income markets?”There is, even among some seasoned fixed income investors, something of a tendency to see emerging markets in terms that we believe to be too simplistic. Over the last decade we have seen the rating agencies, the markets and now the average person realise that the traditional developed markets are not the bedrock that they historically have been and neither are emerging markets the basket cases that some have characterised them as.

Indeed, the World Bank classifications of low, middle and high income (of which emerging market countries are generally regarded as being in the bottom two, and developed market countries in the top) now place countries such as Chile, Poland, Uruguay and Russia in the high income category.  Similarly, from a default risk perspective, the team at Old Mutual has identified over 12 emerging market countries for which the credit default swap (CDS) market indicates a lower risk of default than Spain and Italy.

It is relatively easy, on the face of it, to see why misperceptions about emerging markets have arisen. A good example can be found in a comparison of Italian and Czech government bonds. In the early 1990s, Italian government debt was rated AAA, while Czech debt was rated BBB.

Yet it was not always thus, and in some respects this disparity was an accident of history, with the Czech Republic having found itself on the “wrong” side of the Iron Curtain, a fact that weighed on the country’s sovereign rating long after the fall of Communism in Europe. The onset of the Eurozone crisis saw Italy’s rating steadily deteriorate, so that it is now BBB-, while the Czech Republic’s rating has risen to AA-.  The key reason for this exchange of places is illustrated by two simple statistics: Italy’s debt-to-GDP ratio is 134%, while the Czech ratio is 44%.

It is a remarkably similar story for Greece and Turkey, with the later generally viewed as an “emerging” market, while Greece was considered a “developed market”.  Greece is now rated CCC+, with 175% debt-to-GDP, while Turkey is BB+ and has a 37% debt-to-GDP ratio.

What may surprise some investors is that these examples are not isolated ones, as borne out by aggregated figures: on average, emerging market countries have a debt-to-GDP ratio of 35%, versus 95% in developed market countries. This pattern only looks likely to become further entrenched, given consensus forecasts for the next five years that indicate emerging market economic growth should outstrip that of developed markets by some 3.5% per annum (Source: Bloomberg: weighted average, net debt, 2013 full-year GDP).

Enlightened investors are increasingly recognising the diversity of the emerging market debt asset class.

There are approximately 190 countries in the world, of which some 25 are developed. This leaves 165 countries that are potential emerging market investments.  The picture is similar in the currency markets: there are essentially 12 developed market currencies, and over 80 different emerging market currencies.

A key tenet of investment management is finding different sources of alpha.  Given QE in the US, Japan, UK and now Europe, correlations in G7 markets are at very high levels.  Emerging markets are generally less correlated due the differing levels of credit quality, monetary stance and political risk.

Indeed, within emerging markets we have seen a significant rotation: China’s economic picture has been deteriorating, although its growth rate still seems attractive on a relative basis. Meanwhile, India’s new reformist government is undertaking significant changes, which in turn are feeding into the economy and inflation expectations.  India’s growth rate is likely to overtake China in the near future.

For investors, this only increases the importance of taking idiosyncratic positions. The challenge is to identify the markets that really are attractive, implying that there should be attractive opportunities for active managers to add value.

Aside from arguments about how misunderstood emerging markets are, and how much diversity they offer, perhaps the most persuasive of all from an investor’s perspective is their long-term return prospects.

Since the summer of 2013, emerging market debt has been somewhat out of favour due to expectations of the Federal Reserve’s normalisation of interest rates and its corresponding shock to emerging markets. At the same time, quantitative easing (an extraordinary measure) has led to better returns from developed market bonds than the vast majority of investors had expected.

Looking ahead, we believe monetary stimulus will continue to support developed equity markets, but less so the bond markets. Clearly, the best forecast of future expected return from a bond is the yield.  On this measure, we would argue that quantitative easing has made developed market bonds a virtual desert of opportunity for those investors looking for attractive long-term returns from their fixed income portfolios.

By stark contrast, the emerging market debt universe is so full of opportunities, it more closely resembles a complex jungle – potentially very fertile hunting ground, but not without potential pitfalls.

This is not, of course, to suggest that developed market government bonds have no part to play; indeed, their role as a (relative) safe-haven during periods of severe market stress shouldn’t be understated.

Once again, the figures tend to speak for themselves: developed market government bond yields are 1.5%, with an average maturity of 9.25 years. Meanwhile, local currency emerging market yields average 6.5% (external currency emerging market yields average 5.78%), with a 7.2-year average maturity. 

To some investors, these figures will come as something of a surprise. Recognition is increasingly widespread, however, that emerging market debt is scarcely the esoteric asset class it was once thought of as being. But for those who might have been put off even considering an allocation to emerging market debt in the past, figures like these only reinforce the case for reappraising the asset class.

All data: source: Bloomberg, as at 03/06/15, unless otherwise indicated.

Investments Views by John Peta, head of emerging market debt, Old Mutual Global Investors

Old Mutual Global Investors (OMGI) has no house market view and opinions expressed are the views of individual fund manager(s) as at the time of writing.

Henderson: “We Expect the Dollar’s Trajectory to Be More Volatile Going Forward”

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La trayectoria del dólar será más volátil de aquí en adelante y podría pillar a las divisas asiáticas en el camino
CC-BY-SA-2.0, FlickrPhoto: Philip Taylor. Henderson: “We Expect the Dollar’s Trajectory to Be More Volatile Going Forward”

In the US, in the short term, a strong dollar is positive for interest rates markets given low commodity prices, low inflation, and the falling cost of imports. However, the strong dollar may be undermining price insensitive buyers of government bonds as currency reserve growth slows. We have long argued that there are now fewer long-term buyers of US bonds.

Credit markets: fundamental analysis required

As the dollar rises, corporate earnings in the US could come under pressure. However, a strong dollar also means oil (priced in dollars) becomes cheaper and corporates should benefit from the stronger economy. Obviously, some sectors, such as energy, will suffer from the lower oil price. However, others, including retail, autos and industrials, will benefit from better demand and cheaper input costs.

In EM, a strong dollar should benefit corporations that sell products in dollars but pay costs, such as wages and rents, in local currency. However, regional exchange rate differences versus local competitors, such as Japan versus Asia, are a more important driver for these companies. Given the scale of EM credit growth in recent years, with many borrowing in US dollars, the true scale of dollar-denominated emerging market debt exposure is difficult to gauge. This necessitates greater discrimination as issuers with US dollar liabilities may find it harder to service their debt from local currency revenues if the dollar continues to strengthen.

Currency markets: prepare for volatility

So far the moves in currency (FX) markets, while large, have been relatively orderly. However, as we move further into Phase 3 with forced unwinding of carry trades to reduce risk and the potential for devaluations, events may become more disorderly and FX volatility rise.

Conclusion: risks and opportunities

With economic divergence fading as a driver of US dollar strength, the combination of central bank policy divergence, less currency reserve growth, and the unwinding of carry trades should continue to propel the US dollar higher. However, we expect the dollar’s trajectory to be more volatile going forward; while the majority of the dollar’s recent rise has been at the expense of the euro and the yen, the next phase may see Asia moving into the firing line. The third phase of the dollar’s strength may begin in earnest later this year, with the start of a US hiking cycle a possible catalyst. The environment this will create is certain to be a challenging one but as volatility rises it will also throw up opportunities for investors willing to examine the risks more closely.

James McAlevey is Portfolio Manager of Henderson Horizon Total Return Bond.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.