Unveiling risk

Private clients looking at the year ahead should expect another year of recovery and relatively solid growth, believe their wealth managers. Emerging markets will continue to be the engine of that growth, but they also hide some not immediately obvious risks.

With a global gross domestic product (GDP) expected to grow at 4.2 per cent, developed markets will rise by 2.2 per cent, with the key laggard being Japan, at 1 per cent. Developing economies are forecast to grow by 6.4 per cent, with China’s economy expected to move forward by 9 per cent, according to Morgan Stanley forecasts, largely in line with analysts’ consensus estimates.

“We have been chronically overweight emerging market equities,” states Jeff Applegate, CIO, Morgan Stanley Smith Barney, the global wealth management business born from the joint venture between Morgan Stanley and Citi.

“The call is very simple. You own equities to have a call on growth and the best growth on the planet has been and will continue to be in emerging market economies. Those will be the equities that will do the best in terms of return,” he says.

Inflation dichotomy

Driving global growth is the global middle class, defined as a family with $10,000 (E7,500) or more in income. Already at the start of the century more than half of global middle class lived in emerging markets. By simply trend lining this growth over the next 20 years, the global middle class is going to be dominated by emerging markets, says Mr Applegate.

“It is the emerging markets consumer that is really driving the bus, in contrast with most business cycles in the post second world war period, where the US consumer was doing the driving. The US consumer no longer has the capacity to do that, nor does the US dollar economy. That has important implications for equity selection, and it is one of the key reasons we are overweight emerging economies.”

Academic studies indicating no real correlation between economy growth and stock performance are dismissed by Mr Applegate, as is evidence that GDP growth typically does not benefit listed equities. The only alternative, unlisted companies, do not enjoy such high standards of governance.

“There is a strong relationship between earnings growth and equity returns and earnings growth is pretty closely tied to the GDP growth,” he believes, adding that, broadly, in emerging markets, corporate governance is vastly improved from 10-20 years ago, as has the state of public finances, with a lot of emerging market multinationals showing better profitability than counterparts in developed economies.

The prospect of two-speed markets is mirrored by expectations of “inflation dichotomy” in the world. If developed economies see no inflation issue, in the near-term, the picture is very different in developing markets, with 5.7 per cent inflation forecast. In particular, China’s inflationary threat, leading to monetary tightening, may impact equity performance in emerging regions.

However, this is not yet a real threat that should be discussed when evaluating overweight positions in emerging markets, according to Chris Godding, Emea CIO, Morgan Stanley Private Wealth Management. The alternatives, he says, are slow-growing, debt-burdened developed markets and most investors are very far from having the benchmark allocation of 14 per cent to these emerging economies.

“At the moment, the growth in China seems to be very robust, export growth is still very strong and the tightening policy does not seem to have dampened the growth prospects by too much,” believes Mr Godding.

That said, inflation protection is a must in clients’ portfolios. “For the first time in history, the Federal Reserve is aiming to increase US inflation and being good bankers they will probably overshoot their goal. We want more protection in our portfolios, so we went from an overweight to an underweight [of inflation-linked products] last autumn,” explains Mr Applegate.

While the US pumped $600bn (E450bn) into the economy through a second round of quantitative easing, Europe embraced austerity as a means to tackling its deficits, but the eurozone sovereign debt crisis continues to represent an area of risk.

“If the sovereign debt problem in the euro area continues to accelerate and spins more out of control, it will definitely have an impact, especially on the global equity markets, as we saw last spring with the Greek crisis, when equity markets sold off pretty dramatically,” says Brent Smith, head of multi asset strategies and fund of funds division at Franklin Templeton. “This is something investors should continue to keep an eye on.”

In the United States, which represents 40 per cent of the global economy, the huge fiscal and monetary stimulus has not generated any real uptake in employment. “In the US, a failure to enter some sort of self sustaining expansion could result in a deflationary environment and possibly, a renewed down lag in the equity market,” he fears.

Given the massive amount of fiscal and monetary stimulus, government bond yields are probably too low at this junction of the recovery. Any significant drop in the price of bonds will be a negative for the housing market in the US and Europe, given how closely mortgage rates are tied to government bond yields, he says.

“The markets are volatile and I think it is appropriate that investors try to gauge the risk. It is not necessarily the potential return they have to focus on,” he says.

Chris Godding, Morgan Stanley Private Wealth Management

Risky assets

A focus on risky assets, equities and commodities, characterises the investment outlook at Commerzbank. “Even after the strong rally in 2009-10, we believe there is still some upside left, and we expect around 10 per cent performance for global equity markets in 2011,” says Chris-Oliver Schickentanz, head of investment in the wealth management division at Commerzbank.

Especially in the first half of 2011, the focus is on German stocks, which are believed to continue to strongly outperform, both at European and global level.

“Germany will be top of the class in Europe, and we expect 3 per cent plus growth in 2011. We believe German companies have done their homework, so they are able to live with a slower growth and generate higher earnings growth. We would expect 15 per cent earnings growth for DAX 30 companies and for German equities as a whole.”

The second regional anchor for the German bank will be emerging markets that have clearly underperformed in 2010, particularly China and Brazil.

“Chinese equities performed quite poorly in 2010, but we are very optimistic on the Chinese economy which we believe will grow by 8 to 10 per cent, and that’s a very good situation for Chinese companies,” says Mr Schickentanz. Despite concerns that the new government in Brazil might implement capital control measures, Brazil’s stable growth forecast of 5 per cent plays in its favour. This is also driven by demand for infrastructure investments, fuelled by the football World Cup and Olympic Games events, which the country will host in 2014 and 2016.

Fixed income investments may present the biggest challenge in 2011. “We have seen record low yields for most government bonds in 2010, but yields are rising and we will have to deal with rising yields for the next couple of quarters. This means that it will be very difficult to get a positive performance out of government bonds over the next 12 months,” says Mr Schickentanz, warning that if Greek or Irish bonds can generate positive returns, they are very risky too.

Local currency emerging market debt may however present a good alternative. Many emerging market countries are running surpluses and displaying fiscal discipline and robustness in their financial systems and their currencies will tend to appreciate. “In 2011 you can generate some extra yield and some currency appreciation from emerging market bonds, but we would not expect the same movements we have seen in 2009 and 2010. Profits will not be as huge as you have made over the last couple of years,” believes Mr Schickentanz.

In the fixed income space, what pays off is a strategy allowing managers freedom to manage bond holdings, independent from the benchmark, such as funds that can go negative duration. “Pimco, with its unconstrained bond fund, has really shown they can work with this concept, where they can go short for some selected durations and they can really generate extra performance,” he adds.

With much more liquid emerging markets, and spreads wide and volatile in the developed world, there are more opportunities to play the country selection theme, says Michael Curtin, head of European wealth management business at Mercer. “Over the next year or two there will be more products available in the absolute return fixed income arena, which will be targeting cash plus 2 to 4 per cent. There are smart managers in this space.”

Malay Ghatak, Citi

Playing the currencies

His preferred currencies are the Malaysian ringitt, Indian rupee, Indonesian rupiah and Thai baht. Some of these have appreciated 5 to 10 per cent last year, better than the Chinese RMB which has appreciated by about 3 per cent, although that is the currency to focus on in terms of its movement versus the dollar, explains Mr Ghatak.

Despite wide divergences in the growth and return outlook in different sectors, the performance in assets and markets have been very correlated for the latter part of last year, making it hard to generate performance as a value picker, but this should change in 2011.

Value pickers and long/short type strategies are expected to outperform, because correlation should not really sustain this year, believes Mr Ghatak. “We would recommend investments in high quality hedge fund managers, who are able to take advantage of such market conditions.”

A number of large cap, global companies are sitting on huge pools of liquidity, which, given record low interest rates and yields on cash today, represents a drag on companies’ balance sheet and performance. This will drive them to look for the right opportunity to deploy that cash in the best interest of the shareholders, he explains.

“We expect M&A and restructuring activities to pick up, going into the next 12-24 months. Moreover, deleveraging trends will continue in the developed world as institutions reduce asset levels and improve capital ratios. This again will provide attractive opportunities for investments,” says Mr Ghatak.

Within equities, which together with commodities, should be favoured over government and corporate debt, investors should focus more on dividends than capital growth, recommends Bill O’Neill, CIO at Merrill Lynch Wealth Management Emea. “We still put emphasis on quality and the dividend theme is a very big part of the story for us,” says Mr O’Neill. “Dividends count as the lion’s share of the equity market over time.”

Areas such as telecoms, healthcare and the energy sector, which should be dividend paying, are the main focus, but investors should gain some cyclical exposure through base materials. The strong large-cap growth stocks in emerging markets also provide basis for dividend diversification.

“Inflation is the real bug in emerging markets and speaking tactically over the next months or so, they could go through a more difficult period, more than we have seen in the past four or five years and certainly since the crash of Lehmans, but their secular story is still very strong, and they are increasingly driven by domestic themes,” he explains.

One of the interesting stories of 2010, indeed, was the extent to which some of the smaller markets performed well on the back of the consumer theme and infrastructure, while Bric countries produces relatively lower returns. This trend is likely to continue in 2011, says Mr O’Neill.