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| MoneySense - Winter 05/06 |
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2005 was another year of strong global economic growth, low inflation, double-digit growth in corporate profits and above average returns from real assets such as equities, property and commodities. Despite a steady rise in interest rates and a major oil shock, the benign inflation environment and structural demand from pension funds for fixed interest assets forced yields lower with the result that bonds also produced above average returns. The conundrum for investors was why bond yields remained so low despite strong economic growth and rising short-term interest rates. The answer reflects the globalisation of trade and financial systems which is prolonging the business cycle. The competitive pricing benefits arising from free trade are well known - less well recognised is the impact of the proliferation of financial instruments which allow less restricted and more cost effective movement of capital resulting in reduced risk premiums and exceptionally low volatility. Together these trends have provided abundant liquidity and, so far at least, a self-correcting inflation mechanism whereby goods and services are realigned to the lowest cost supplier with minimal government or central bank intervention. An example is the almost symbiotic relationship between US consumers buying Chinese manufactured goods in exchange for China stockpiling US dollars/bonds. At some stage the dollar exchange rate should adjust to reflect America’s imbalances with the rest of the world – there was a small adjustment against the renminbi in 2005 but against other currencies it strengthened on cyclical factors such as interest rate differentials and demand for dollars to pay for oil. The
US was again the major contributor to global economic growth with
real GDP of 3.7% exceeding expectations despite oil rising 40%
to a peak of $70 in August and interest rates increasing from
2.25% to 4.25%. The consumer was the main driver - the US consumption
to GDP ratio surged to a 25 year high of 71%, well above that
of any other developed country. This was made possible by a buoyant
housing market and a 6% increase in core personal income. Other
growth contributors were increased capital expenditure by companies
and higher government spending on defence and healthcare. Rising
corporate profitability pushed the return on equity to a cyclical
peak but this was not mirrored in stock prices - more attractive
investment opportunities elsewhere and the unwinding of high valuations
resulted in the S&P 500 closing at 1, 248 which represented
a 3% gain over the year. Japan was one of the most rewarding regions in 2005 as land prices bottomed out, corporate profit margins recovered and companies became increasingly focused on shareholder returns. The restructuring process was confirmed after the snap election in September provided Koizumi with a landslide victory over the anti-reformers. Japan still has to contend with an end to the zero interest rate policy as well as an aging population and a declining workforce but the corporate law revisions effective from 2006 should encourage more efficient capital allocation. Although sales growth was meagre, margin improvement helped the Nikkei end 2005 at 16,111 – matching the 40% gain from other Asian markets. Europe remains the economic laggard. The aftermath of the Stability Pact, the spike in oil prices and sub-trend growth made for a difficult first half but the news improved as a rebound in exports and a mild increase in domestic demand raised hopes of some economic expansion. GDP growth of 1.7% in the UK was sub- trend and lower than forecast at the start of the year. Weaker conditions were seen across services and manufacturing as well as government spending. Real disposable incomes increased marginally but high real interest rates squeezed the housing market and consumers opted for increased saving over expenditure. Retail price inflation remained around 2.9% but core inflation rose sharply to 2.1%. The bright spot was the boost to exports as sterling weakened. UK equity and bond markets both produced strong gains in 2005. Index-linked outperformed conventional gilts as demand from pension funds seeking to match their liabilities supported long-dated stocks. The FTSE 100 closed at 5,618 – a 17% gain and some 5% higher than the improvement in underlying profits. Equity returns were distorted by exceptional gains from mining and oil and gas with little performance differential among other sectors. Takeovers and bid speculation persisted especially among mid-cap companies which once again outperformed their larger counterparts by a significant margin. The return of capital via share buy-backs reached record levels equivalent to around 2% of total market capitalisation. 2006 will be another year of strong economic growth, at least in the first half. Liquidity conditions remain favourable although they will tighten as interest rates continue to rise in the US and Europe. The oil price is unlikely to collapse but should ease sufficiently to ensure inflation remains benign. Companies are well placed to increase profits but expectations for margin improvements look too high given that returns on equity are already at peak levels. Equity valuations are reasonable, especially against some other asset classes, but gains are likely to be more modest than in recent years. Morgan Stanley Quilter Jan06 ms/Winter-05/06-01
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Investors in the Hong Kong stock market who caught the Spring 1998 boom had reason to be very pleased as 60% returns within two years made for an exhilarating upwards ride. But when, after just two years, Hong Kong joined world markets and plunged into a massive market correction, the good news soon soured. For those who failed to get out in time, annualised return shrunk to 4.9% between 1 May 1998 and 30 November 2005. So what might a canny investor have done to avoid this slump in their fortunes? Portfolio diversification into alternative investments seeks to exploit profit opportunities in both rising and falling markets. Man AHL Diversified Futures Ltd* is an investment product with an impressive record not just as a stand-alone investment but, importantly, as effective diversification away from traditional stock and bond investments. And it is open for further subscriptions. Man Investments, one of the leading independent institutions in alternative investments, has offered this unique product since 12 May 1998. For the seven years’ period since inception, Man AHL Diversified Futures Ltd has delivered on its aim to provide substantial medium- term growth while restricting risk. USD 1,000 invested at inception was worth USD 2,738 at 30 November 2005, a total return of 173.8%, or 14.2% a year, a big improvement of 4.9% annualised return on Hong Kong stocks . The low correlation between Man AHL Diversified Futures Ltd and Hong Kong stocks, of -0.11, highlights the ability of the product to seek alternative sources of return which can provide valuable diversification as part of a traditional portfolio of stocks and bonds. The secret to the product’s success is the underlying AHL Diversified Programme. Using highly sophisticated computer software, it uses real-time price information to trade managed futures around the clock in more than 130 financial markets. It responds quickly to price moves and takes advantage of strong market trends. The scope to invest in a diverse range of markets from currencies to commodities widens profit opportunities and helps to minimise risk. In essence, this is the defining characteristic of top tier alternative investment products – offering return and diversification potential. By seeking and maximising profit opportunities in different markets and varied financial instruments, such products can improve risk return profile in a portfolio of investments. Short-term
performance: Man AHL Diversified Futures Ltd1
Source: Man database and Bloomberg. The performance statistics are calculated on a NAV to NAV basis. There is no guarantee of trading performance and past or projected performance is no indication of current or future performance/results. Compound annual rate of return since inception. Calendar year returns since inception are as follows: 1998 (part-year from May): 21.4%, 1999: 3.6%, 2000: 18.4%, 2001: 15.6%, 2002: 9.8%, 2003: 19.4%, 2004: 4.6%, 2005: 16.1% (from 1 January 2005 to 30 November 2005). Hong Kong stocks: Hang Seng Total Return Index (divendends reinvested). Hong Kong stocks has been used for information purposes only and have different profiles to Man AHL Diversified Futures Ltd. MAN AHL Diversified Futures Ltd ms/Winter-05/06-03 Important
note: The prices of futures, options and other instruments in which the Company may invest may fall in value as rapidly as they may rise and it may not be possible to liquidate the positions in the relevant markets before a loss is sustained. No assurance can be given that the investment objective of any product will be achieved or that substantial losses will not be suffered. *Man AHL Diversified Futures Ltd is authorised by the Hong Kong Securities and Futures Commission (the ‘SFC’) under the Code on Unit Trusts and Mutual Funds as a ‘Futures Fund’ and not as a ‘Hedge Fund’. The SFC’s authorisation does not imply official approval or recommendation. Many investors are hotly debating the prospects for the emerging European equity markets, after these markets posted a spectacular return of 36% year to date* and a cumulative return of 113% over the last three years. Potential investors are wondering if they are too late to benefit from the many opportunities this market offers, whereas existing investors are wondering if the market has peaked and now is the time to take profits and invest elsewhere. We believe the emerging European Equity market will continue to offer attractive investment opportunities over the long term, particularly those markets that are on the far edges of emerging Europe, such as Russia and Egypt. Over the past ten years, market conditions in Eastern Europe have improved considerably; increased economic stability and falling inflation have resulted in a more favourable interest rate environment. Additionally, equity market volatility has also declined significantly and is now far closer to the volatility experienced in the European equity market. Despite their huge success, many of the markets in Eastern Europe are trading at a large discount from their Western European counterparts. Russia is trading at a price/earnings ratio of around 7.2, while Turkey is trading at a price/earnings ratio of around 10**. We believe these markets are in the midst of a multi-year growth cycle. Their economies and markets are quite small. If you add up the GDPs and market capitalisations of Central Europe, Israel, Russia and Turkey, they sum a mere 15% of the European Unions GDP and 6% of the European Unions market capitalisation***. As the graph shows, the strong growth that Emerging Europe has enjoyed relative to developed Europe is likely to continue, albeit at a lower pace.
The key drivers of this growth include large foreign direct investment inflows, convergence with Western Europe, pent up customer demand, commodities strength, competitive labour costs and accelerating productivity. We believe a good way for investors to tap into the ongoing growth of the market may be to concentrate on the markets in those countries that are on the fringes of emerging Europe, such as Russia and Egypt. We believe both these markets offer the best long-term growth prospects in emerging Europe. Growth in private consumption demand and strong commodities prices are among the key drivers of outperformance in Russia. Unquenched consumer demand, stemming from the lingering effects of decades of centralised economic planning, is a key driver of the Russian economy, which has on average grown roughly 6.5% per annum since 1999. Also critical to Russia’s macroeconomic strength has been vibrant commodities prices. The Russian investment environment does involve risks, as highlighted by the Yukos affair; however, we think these risks are sufficiently discounted in valuations. The prospects for Egypt are also very promising. The country’s stock market in 2004 was one of world’s best-performing, appreciating 103% in euro terms, and has shown few signs of slowing down in 2005, driven in part by investor enthusiasm over economic and political reform. While countries on the fringes of Central and Eastern Europe offer the best long-term growth prospects, the discerning investor can still find selective attractive opportunities in countries such as Hungary, Poland and the Czech Republic. Many companies in this region are now reaping the benefits of corporate restructuring efforts in recent years. Following the collapse of the Russian market in 1998 and with it the main source of demand for Eastern European exports, companies focused on improving the quality of their products to win market share in Western Europe. Today, leading Central and Eastern European companies have not only built solid market positions in neighbouring Western Europe, but are also well-placed to once again make in-roads into the growing Russian consumer market. Overall,
we continue to see significant long-term value in the emerging
Europe and Middle East region if we can properly manage the
risk in this market. However, volatility will likely remain
a key characteristic of the region’s evolving markets.
We believe a good way for investors to exploit the ongoing growth
of the market may be to concentrate on the markets in those
countries that are on the periphery of the emerging Europe,
such as Russia and Egypt. Pioneer Investments ms/Winter-05/06-04 |
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The reason why Greek Mythology is still relevant today is that it provides lessons on the tragedy of human behaviour which is both timeless and repetitive. One character that appeals is the Greek heroine whose name gave rise to the Cassandra Complex. Having been given the gift of prophecy by Apollo, who had ulterior motives for teaching her, she later spurned her Divine suitor. Although she could foretell the future, Apollo took his revenge such that she would never be believed by her fellow mortals. Without wanting to sound like some smart-alec guru with selective memory just for the good bits, this has been very much the case for my positive forecasts on gold over several years. The thrust of the argument was that over many centuries, governments at war tend to lose all financial discipline in order to win at any cost. The cost comes through a debasement or devaluation of the currency as debts build to pay for the war-effort. When government-manipulated money loses its purchasing power then investors head for real assets such as precious metals. So far, we have witnessed the standard inverse relationship where a weaker dollar boosts the price of commodities generally and gold in particular. Since 9/11, Americans have been encouraged to spend remorselessly thereby sucking in too many imports and leaving a surplus of dollars in the market. The evidence for this is the huge US current account deficit. It would normally have led to much greater currency weakness but up until recently, Asian central banks were willing buyers of US dollars via Treasury bonds. This kept the spin-cycle churning with mass produced money in exchange for cheap imported goods. Things have now changed. Against all expectations (including my own) the dollar has strengthened in 2005. At the same time, the jingoistic but ultimately self-destructive call by US Congressmen to revalue China’s currency is cutting off a vital source of demand for the dollar. So what has given the currency a boost at a time when the big buyers are backing away? There are three one-off factors that are making the dollar burn brightly: like a shooting star it may look impressive and catch the eye but it is only a temporary, final flash. First, the fact the US interest rates have been rising, albeit too slowly, has pulled in a good deal of international capital flows looking for a home. Second, when hedge funds borrowed cheaply in dollars to invest overseas for the so-called carry trade, the effect of rising rates created a loss-making situation that had to be reversed. This is known as short-covering where investors scramble to reverse a trade, clear their borrowing and minimise losses. Finally, there has been a tax break for US corporations to repatriate profits but this expires at the end of 2005. This gave rise to a further flow of funds back to the States. Just as the aligning planets were seen as a portent of doom in Greek Mythology, we now see a series of events coming up for 2006 that paint a negative picture. First, while the handover of Federal Reserve chairmanship is usually good for equities in the 3 months prior and 1 month after the change, markets have traditionally underperformed once the honeymoon is over. We should therefore be wary about equities going into March 2006. Second, the US consumer and government are so sodden with debt and liabilities that any significant rise in interest rates will topple both the property market and the economy. Finally, the pressure on China to revalue may well be the final push that sends the dollar into devaluation mode. Instead of exporting deflation to the USA, strengthening Asian currencies will import inflation. A recent Federal Reserve announcement explained that they will no longer publish M3 money supply data; a figure that is scrutinised constantly by their European counterparts at the ECB. This is a very clever move because while the Fed appears conservative by raising rates the truth is they are swamping the economy below the surface with printed money. Some market participants understand that these factors are inflationary. This is why the gold price has broken through the $500 level and US bond yields are rising. It would also appear that gold is emerging as a currency in its own right because it is no longer a hostage to the fortune of the dollar. Gold should be looked on as an insurance policy for one’s paper assets and not an investment in its own right: it should therefore not be traded but left well alone. Toby
Birch |
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US equity markets performed in lacklustre fashion in 2005. Ongoing interest rate rises by the Federal Reserve ensured that the US Dow Jones finished the year in negative territory. Moving ahead, the prospects for US equities appear relatively good in the first half of 2006. Although the Federal Reserve is on course to continue raising interest rates, market expectations point to no more than one (or at most) two further increases, so overall liquidity available for investment should be reasonably supportive. With markets now less concerned about interest rates, the prospects are for a bigger focus on company earnings, which should be largely positive, at least for the first quarter of the year. However, at this stage, we are only cautiously optimistic about US equities. Key factors could constrain upside, including a fall in US home sales (particularly after the rapid rise in house prices seen in recent years). As a result, a highly selective approach to equity allocation remains the best way forward. One of the best ways of pinpointing value is to adopt a quantitative solution that is able to recognise and mechanically exploit valuation distortions among US stocks. A key advantage of quant solutions is that they are entirely computer driven, with no human decision making in stock selection. As a result, there is no emotion involved, meaning that the twin evils of greed and fear, which do so much to compromise conventional stock picking, are removed from the equation. However, the last few years have seen the market flooded with quant solutions and it is not always easy to single out which offer the best value, so we list below some key points to bear in mind when making your choice. An established track record, demonstrable through either performance statistics or rigorous back testing, is perhaps the most obvious pre-requisite. However, beyond that, we would suggest the key factors to bear in mind are (i) comprehensiveness, (ii) transparency and (iii) responsiveness. With regard to the first point, a quant solution that is programmed to select from a wide universe of economic sectors translates into a diversified approach, thereby reducing risk. This is an especially important point, bearing in mind that equities per se tend to perform in a more volatile fashion than bonds. A solution that places limits on exposure to any one sector is of further help in diluting risk. With reference to the second point, information about key variables should also be available. An approach that takes account of company growth, stock price value, profitability and cash flow parameters is one which has much to recommend it. Finally, it is also worthwhile sourcing a quant product that is able to respond to changing market conditions. In particular, a solution that is able to adjust its holdings at least three or four times a year is preferable; otherwise, there is a risk of being superseded by market developments. Ashok
Shah |
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