September 2010; market overview

On the 11th and 12th of October RMB Asset Management held its annual Think Tank for the 11th consecutive year. This time around the setting was Hong Kong, and the focus was on the theme of global rebalancing – essentially the Asian growth story. It was interesting to note how many of the investment professionals that presented across a range of asset classes and geographical regions emphasized the importance of valuations when considering investments. Economic growth certainly plays an important role, but as Hugh Young from Aberdeen illustrated with the two graphs below, strong growth in GDP does not necessarily translate into strong growth in the same country’s stock market.

Source: Bloomberg end Dec 09

In China, top line growth has flowed to stakeholders including government, employees and local suppliers, but not to the minority shareholders. Contrast this with India, where a well-established culture of corporate enterprise going back more than a century, set within a strong legal framework, has enabled shareholders to benefit from the buoyant growth in the economy.

September has historically been the worst month for equity markets, but last month’s improvement in the tone of US economic data has gone a long way to easing fears of a double-dip recession and resulted in strong performance for global equities. In local currency terms the major markets rallied with the United States’ S&P 500 (+8.9%) leading the way. In Europe (+4.3%), the United Kingdom (+6.5%) and Japan (+3.9%) equities also pushed ahead but the weak US Dollar resulted in a stronger performance in markets pegged to the greenback than in these markets. Emerging market equities gained 11.1%, with global developed markets (as measured by the MSCI World index) ending the month 9.3% higher.

Even though the month’s strong equity performance could be ascribed to a fair number of positive economic data surprises, this was more a reflection of a lowering of expectations than a genuine improvement in the data flow. Data across housing, employment and industrial production still points to a lethargic recovery, especially in the US. Despite the headwinds that abound the US should nonetheless avoid a double dip recession. Other news out of the land of the brave and the free is that the second round of quantitative easing (or QE2 as it’s now affectionately known) will in all possibility take place before the end of the year in order to support asset prices. This has pushed down real interest rates in the US, but has not (yet) created a government bond bubble. The yield on the ten year US treasury should roughly equate to the market’s expectation of what the geometric average of the Federal Reserve’s funds rate would be for the next ten years. Historically the real Fed funds rate has been 2.5% on average. In the light of the market’s current long term inflation of around 2%, it seems as if an equilibrium funds rate should be around 4.5%. Given our expectation that short-term interest rates will remain at their current levels for some time we can’t see the Fed rushing to get to this “appropriate” level. As deleveraging is a multi year process and will produce a drag on the economy as debts are repaid, the Fed will have to compensate for this damper on growth by keeping their rates lower than what conventional theory would suggest. If this equates to a Fed funds rate which is consistently one percent lower than during a “normal” economic recovery, it’s easy to see the Federal Reserve keeping rates between three and four percent for most of the next decade. This means that a yield of between 2.5% and 3% on the 10-year government note does not relate to a bubble in bond markets.

Bond markets were somewhat weaker over the month as yields on government bonds in the US, UK and Europe stayed flat or increased, after probably being overbought in August. Global government bonds (as measured by the JP Morgan Global Government Bond Index) gained 2.2%, but this was entirely due to the weakness of the greenback against the Japanese Yen, euro and Pound Sterling. Investment grade corporate bonds held up somewhat better, with high yield bonds in the US (+3.0%) and Europe (+3.2%) benefiting from the improvement in equity markets. Convertible bonds also gained (UBS Global Convertible Bond Index +5.5%) but the valuation anomaly that existed throughout the end of 2008 and 2009 has now been fully priced and the asset class does not look significantly more attractive than a combination of equities and corporate bonds.

The greenback struggled against most currencies, with the euro unexpectedly leading the charge. Talk of “currency wars” abounded in early October as it’s clear that many major economies would benefit from a weaker currency. We think that “war” is a very strong word to describe what’s going on, but the occurrence of periodic tussles would seem to be all but a certainty. The Germans (whose industrial production was up strongly in July and August on the back of a weak euro) have tasted the benefits of a weak currency and policymakers around the globe will surely contemplate currency intervention in order to boost exports and thus aid their struggling economies.

A region where economies seem to be anything but struggling is Asia, as we saw first-hand during the conference. There is a lot of optimism in emerging markets, and investment flows have clearly shown this so far this year as illustrated by the graph alongside. The question from an investment point of view is surely whether this optimism is fully priced into emerging market valuations – we certainly think so. RMB Asset Management’s Chris Mahon explores this in September’s FOCUS section. It’s a time to focus on valuations, and be brave in your allocation of capital, as large short-term market fluctuations are not behind us.

Focus: The days of emerging market outperformance are over

Chris Mahon, international strategist, RMB Asset Management International Investors banking on a strong economic performance to underwrite emerging market (‘EM’) returns are taking a leap of faith that is not justified either by history or by the current valuations, argues Christopher Mahon, International Strategist at RMB Asset Management International.

“Better GDP numbers = better equity returns”. This relationship is one of the great leaps of faith that investors make when deciding their regional asset allocation; and the implication is simple: go for the region with the best economic performance. For many investors today, this means channelling investments into emerging markets.

But over the long run the relationship between GDP and equity returns is much weaker than investors might hope.

For example (according to MSCI Barra), of the major developed markets from 1969-2009, the top three fastest growing economies were Australia, Norway, and Spain. Yet real returns from those equity markets were actually worse than equity returns in the slowest growing countries: Germany, Denmark, and Switzerland.

Market analysis

Extending the time frame or including emerging markets doesn’t change the picture. A recent London Business School analysis of stock market returns of 53 countries over 108 years, encompassing both developed and emerging economies, found the most sluggish economies outperformed sharply, posting 12 per cent equity returns, against returns of 6 to 7 per cent for the remainder of the sample.

Both studies show that backing GDP growth in the hope of better equity returns wouldn’t have worked.

To some extent, this can simply be explained by using valuations as a starting point. High growth regions often have even higher expectations built into the price of the equity market, and so are more likely to disappoint. This is most certainly true of emerging markets today which already trade at a premium. High hopes are already built into the price.

In addition to the valuation story, there is another more subtle reason for a weak link between GDP and equity performance: equity issuance.

Missing link

To demonstrate this, if GDP has any link to corporate performance, theoretically this link should be strongest and most visible at the sales level. Theory suggests the top line should grow fastest in fast growing economies.

But while this is true for corporate income statements, it does not translate to the ‘per share’ level. Over the last ten years, for example, emerging markets have seen spectacular GDP growth, but sales per share have grown slower than the US.

The difference between the two is mainly due to greater equity issuance, which historically has been very high in the emerging world.

Sometimes the high levels of issuance are underpinned by strong economic rationale: think about the Malaysian food distributor who issues equity to fund his rapid expansion.

Sometimes the high levels of issuance are due to worse corporate governance: think about the Russian oligarch who doubles as CEO for his company, who as majority shareholder votes through fabulously lucrative share options packages.

Premium trade

Either way the impact is the same: as an investor, your shareholding becomes diluted. History suggests investors in emerging markets should expect much more issuance than in the developed markets – even in boom times.

Currently EM trades at a premium to developed markets. Believers in EM will claim this is due to higher margins and faster sales growth. Is the premium plausible?

Right now, the MSCI Emerging Market Index trades at a 12% to a 22% premium (depending on the metric) to its developed market peer, the MSCI World Index.

This is not far off 2007 when it traded at a 15% to 36% premium. History shows us that was too much.

Our own analysis suggests that if you believe the EM GDP story, you could just about justify a 10-15% premium, but not more.

Market timing

The time to buy was ten years ago when it was trading at a 25-35% discount. But today, whichever way you look at the emerging markets, the valuations are too expensive. This means the days of outperformance for EM are over and the days to be overweight EM are behind us.

Put simply, relative to developed markets, emerging markets are an asset class priced for perfection with no margin for error to a long term investor. Expecting EM to continue to outperform is at the very least, optimistic

RECENT MANAGER MEETINGS

RECENT MANAGER MEETINGS

AMUNDI ASSET MANAGEMENT
Christopher Morris has moved to Amundi Asset Management as a Senior Global Fixed Income Manager, alongside Anne Beaudu, who is moving across to London from Amundi’s Paris office. Morris was formerly Head of the IMF’s Monetary and Capital Markets Department in London and was a lead author in the fund’s annual Global Financial Stability Report.

Anne Beaudu has been appointed as a Global Fixed Income Manager, and is moving across to London from Amundi’s Paris Office. She was formerly at Credit Agricole Asset Management, whose merger in Amundi completed on January 1.

James Kwok has been appointed as Head of Currency Management in London at Amundi Asset Management. He was formerly a Currency Manager at Societe Generale Asset Management, the other predecessor form of Aumdi.

BARING ASSET MANAGEMENT
Thanasis Petronikolos has moved to Baring Asset Management as a Director of Fixed Income and Currency team, responsible for managing the exposure to Emerging Market Debt and Currencies. He will also manage the asset manager’s new Emerging Markets and Debt Local Currency fund, subject to regulatory approval. He will be based in London and report to Alan Wilde, Head of Fixed Income and Currency. Petronikolos was formerly at RAB Capital.

F&C ASSET MANAGEMENT
Randeep Grewal has moved to F&C Investments as a Senior Fund Manager. He will report to Paras Anand, Head of European Equities. Grewel was formerly at ICAP Equities. Before that he was at Tudor Capital.

Sam Cosh has moved to F&C Investments as a Senior Fund Manager. He will report to Paras Anand, Head of European Equities. Cosh was formerly at BNP Investment Partners.

GEORGE WEISS ASSOCIATES
Brenda Reed has moved to George Weiss Associates as a Fund Manager based in New York. She was formerly a manager of GBP334m Fidelity Global Focus fund. Her responsibilities have passed to Amit Lodha at Fidelity.

GOLDMAN SACHS ASSET MANAGEMENT
Paul Trickett has moved to Goldman Sachs Asset Management as Head of the Global Portfolio Solutions group for EMEA. He was formerly Head of Investment for Europe, Middle East and Africa at Towers Watson.

IGNIS ASSET MANAGEMENT
Mark Lovett has moved to Ignis Asset Management as CIO for Equities. In his role he will oversee more than GBP10 billion of Retail and Institutional Equities. He was formerly at Allianz RCM as CIO for Equities.

INALYTICS
Angus Duncan has moved to Inalytics as Director of Sales. He was formerly at Invest & Give as Head of Distribution.

JAMES CAIRD ASSET MANAGEMENT
Ian Newton has moved to James Caird Asset Management as Special Situations Fund Manager. He was formerly at Cheyne Capital.

Matthew Addison has moved to James Caird Asset Management as Special Situations Fund Manager. In his role he will focus on event driven equities, merger arbitrage, and stressed / distressed debt strategies. He was formerly a partner at Cheyne Capital.

NEPTUNE INVESTMENT MANAGEMENT
Ted Alexander has been appointed Manager of the GBP53 million UK Equity fund replacing Jeremy Smith, following a period of underperformance.

NEWTON INVESTMENT MANAGEMENT
Paul Brain has been appointed as Manager of the BNY Mellon Global Dynamic Bond fund.

OCCITAN CAPITAL PARTNERS
John Candillier has moved to Occitan Capital Partners as Chief Executive. He was formerly Head of Distribution for continental Europe at Nomura.

PGGM
Johan Van der Ende has left PGGM, where he was CIO. His future destination is not yet known.

POLAR CAPITAL
Ming Kemp has moved to Polar Capital as an Emerging Markets Fund Manager. He was formerly an Asian specialist at AXA Framlington.

Neil Denman has moved to Polar Capital as an Emerging Markets Fund manager. He was formerly a Portfolio Manager within the emerging markets team at AXA Framlington.

PSIGMA ASSET MANAGEMENT
Gee Jajodia has moved to Psigma Asset Management as a Business Development Director. He was formerly at Skandia where he worked as a Business Consultant working with IFAs in the wrap market.

Johanna Bitton has moved to Psigma Asset Management as a Sales & Marketing Manager. She will be responsible for the business development and sales team in addition to developing the marketing strategy for Psigma. Bitton was formerly at Skandia.

Lee McDowell has moved to Psigma Asset Management as a Business Development Director. He was formerly has L&G International Ireland where he served as a business development director covering the East, South East and London regions.

UBS GLOBAL ASSET MANAGEMENT
Clemens Reuter has moved to UBS AG as the new Head of Exchange Traded Futures at its global asset management unit, effective February 1. He will report to Martin Thommen, Head of UBS Funds, UBS Global Asset Management in Switzerland, who will continue as interim Head of The ETF business until Reuter’s arrival. Reuter was formerly at Swiss bourse, where he was in charge of the ETF business.

Luke Browne has moved to UBS Global Asset Management as a member of the Structured Solutions team. He will be reporting to Richard Lloyd, Head of Structured Solutions. Browne was formerly Head of Structured Solutions at Insight Investment.

Richard Lloyd has moved to UBS Global Asset Management as Head of Structured Solutions. He was formerly Head of Structured Solutions at Insight Investment.

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Wealth Management Group 2010