For eligible charities
Investment Perspectives 2012
Section 1: 2012 Outlook
1.1 2012: A year for dividend investing in Asia King Fuei Lee Fund Manager, Asian Equities 6
1.2 2012: A year in Asia Richard Sennitt Fund Manager, Asian ex Japan Equities 10
1.3 2012: A year in global emerging markets Allan Conway Head of Emerging Markets Equities 12
1.4 2012: A year in Europe Rory Bateman Head of European Equities 16
1.5 2012: A year in global bonds Bob Jolly Head of Global Macro 20
1.6 2012: A year in global climate change Simon Webber Portfolio Manager and Giles Money Portfolio Manager 22
1.7 2012: A year in the global economy Keith Wade Chief Economist and Strategist and Azad Zangana European Economist 24
1.8 2012: A year in global equities Virginie Maisonneuve Head of Global and International Equities 26
1.9 2012: A year in global property Jim Rehlaender Global Property Securities Fund Manager 28
1.10 2012: A year in Japan Shogo Maeda Head of Japanese Equities 30
1.11 2012: A year in the UK Richard Buxton Head of UK Equities 32
1.12 2012: A year in UK and European corporate bonds Adam Cordery Head of European and UK Credit Strategies and Sarang Kulkarni European Credit Fund Manager 34
1.13 2012: A year in US bonds David Harris Senior Portfolio Manager – US Fixed Income 36
1.14 2012: A year in the US Joanna Shatney Head of US Large Cap Equities 38
Section 2: Investment themes
2.1 Active commodities versus exchange traded funds and index investments David Mooney Co-Head of Investments, Schroders NewFinance Capital 42
2.2 A dangerous decade for the dollar Barry Eichengreen Professor of Economics at the University of California, Berkeley 44
2.3 Asian bonds: the safe havens of the future? Rajeev De Mello Head of Asian Fixed Income 46
2.4 Economic cycles in emerging markets Allan Conway Head of Emerging Markets Equities, Nicholas Field Emerging Markets Strategist and Abbas Barkhordar Emerging Markets Analyst 50
2.5 Emerging markets investment: exploding the myths Allan Conway Head of Emerging Markets Equities 56
2.6 Global demographics: Canada’s unique position Virginie Maisonneuve Head of Global and International Equities and Katherine Davidson Research Associate 66
2.7 How likely is Germany to leave the euro? Alan Brown Group Chief Investment Officer and Philippe Lespinard Chief Investment Officer, Fixed Income 72
2.8 Sovereign debt crises: lessons from history D’Maris Coffman Winton Centre for Financial History, University of Cambridge 76
2.9 To be or not to be… in China: a global investor’s perspective Virginie Maisonneuve Head of Global and International Equities 78
2.10 Unquenchable thirst? The implications of water scarcity in China Rory Pike ESG Equity Analyst and Rick Stathers Head of Responsible Investment 84
2.11 Why ‘gold plus’ is the way to play the gold rush Paula Bujia Fund Manager, Gold & Precious Metals 90
2.12 Adapt – Why success always starts with failure Tim Harford Economist, Broadcaster and Author 94
The views and opinions contained within these articles are of the person(s) quoted, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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WELCOME TO INVESTMENT PERSPECTIVES 2012
The world economy is much more fragile than it used to be. and Paula Bujia from Schroders’ Commodities Team discussing the
With borrowing down and households trying to reduce debt, different options when investing in gold. Alan Brown, Group Chief
many countries’ GDP growth is significantly lower than any time Investment Officer, and Philippe Lespinard, Chief Investment Officer,
in recent history. Slowing economic growth and the unresolved Fixed Income, gave us, earlier this year, their opinions on how likely
eurozone sovereign debt crisis continue to hang over the prospects it is that Germany will leave the euro.
for financial markets in 2012. We hope that these articles will provide an interesting and
Investment Perspectives 2012 brings together views from Schroders’ informative snapshot of what to expect in 2012 and beyond.
regional and asset class investment experts. In section one, several Finally, we’d like to give special thanks to the Product and
of our global investment managers look to the year ahead in their Investment Communications Team for contributing the articles
markets and give their outlooks for 2012. for Investment Perspectives each year. Please visit
Section two contains a set of articles written over the course of www.schroderscharities.com for a range of relevant articles or
2011 on a number of themes. These include Virginie Maisonneuve alternatively, the Charities team will be happy to assist you with
and Katherine Davidson, from our Global and International Equities any with any specific requests.
Team, on Canada’s unique position in global demographics,
1.1 2012: A year for dividend investing in Asia 6
1.2 2012: A year in Asia 10
1.3 2012: A year in global emerging markets 12
1.4 2012: A year in Europe 16
1.5 2012: A year in global bonds 20
1.6 2012: A year in global climate change 22
1.7 2012: A year in the global economy 24
1.8 2012: A year in global equities 26
1.9 2012: A year in global property 28
1.10 2012: A year in Japan 30
1.11 2012: A year in the UK 32
1.12 2012: A year in UK and European corporate bonds 34
1.13 2012: A year in US bonds 36
1.14 2012: A year in the US 38
INVESTMENT PERSPECTIVES 2012
1.1 2012: A year for dividend investing in Asia
King Fuei Lee Fund Manager, Asian Equities
Chart 1: Dividend returns versus price appreciation
– Dividend return tends to have a stronger correlation with existing economic 1000
conditions than share-price appreciation 900
Dividend return is highly correlated to economic growth
– Companies that have high dividend pay-outs usually experience much faster 800 22.0
subsequent earnings growth than their low dividend-paying counterparts
– Because dividends can only be paid out of real earnings and real cash flow, 600
focusing on dividends helps investors avoid companies with dubious earnings
Asian annual GDP growth (nominal, index number)
500 Dividend return (rhs, fwd 1y, annual, %) of total
– A convergence of global and domestic influences has meant that now is an 400
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 return
opportune time to invest for dividends in Asia.
Amid the upheaval in global financial markets, it is useful to take a step back and re-assess one’s long-term of total
investment strategy. While fears of a cyclical slowdown in China may put many investors off the region, the 100 return
reality is that the bigger-picture trend of stronger economic growth driven by urbanisation, industrialisation 0
and positive demographics will continue to unfold across Asia over the next two decades. Here, we discuss 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
why now is an opportune time for long-term investors to develop their portfolios in Asia through a dividend-
Dividend return Price appreciation
Source: Factset, MSCI, IMF and Schroders, as at 30 November 2011.
Despite the market’s obsession with share price appreciation, historically almost two-thirds of long-term
equity returns in Asia have come from dividends. Unlike share price appreciation – which is affected by a
Higher dividends = higher earnings growth = better corporate governance
myriad of factors including non-fundamental influences such as sentiment and momentum – dividend return
represents actual cash paid out by companies to their shareholders. In addition, because dividends can only Critics of income strategies wonder why they should bother with boring dividends when they are really
be paid out of earnings, which are in turn driven by the economy, dividend return tends to have a stronger lusting after the exciting growth story of Asia. After all, Gordon’s Model tells us that only companies that
correlation with existing economic conditions than share-price appreciation (see chart 1). Investors seeking have run out of growth projects to invest in, pay dividends. Try telling that to the executives at Astra
exposure to the multi-decade Asian economic growth story will do well to pay close heed to the dividends International, an Indonesian motorcycle distributor that has steadily raised its dividend pay-out from
that they are capturing from their equity investments. nil to 45% over the last decade, while growing its earnings more than tenfold.
1 2012 OUTLOOK
Chart 2: Company pay-out ratios and EPS growth Chart 3: Dividend signalling effect in Singapore
Subsequent Real EPS Growth (%) Cumulative EPS response
50 After a surprise increase in
dividend payout, EPS continues
30 20.0 to grow for the next four years
A positive relationship exists
-30 between the level of dividend payout 10.0
and future real earnings growth
25 35 45 55 65 75 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58
Payout ratio (%) No. of months following surprise increase in dividend payout
Source: Factset, IMF, MSCI and Schroders, as at 30 November 2011. Source: Lee, King Fuei. 2010. An Empirical Study of Dividend Payout and Future Earnings in Singapore.
Review of Pacific Basin Financial Markets and Policies 13, Issue 2: 267-286.
The real world is a very different place from theory. Because managers of companies have better In a region laden with corporate governance landmines, focusing on dividends when investing in Asia
information about their future prospects and loathe cutting dividends, they will often only pay high dividends has the benefit of helping investors avoid potential blow-ups. By returning excess cash to shareholders as
today if they are comfortable that their expected earnings in future are strong enough to sustain the high dividends, companies avoid the temptation to squander that money on value-destructive investments, while
pay-out. This is also why, in practice, companies that have high dividend pay-outs usually experience much subjecting themselves to more stringent levels of stakeholder scrutiny when they next tap the markets for
faster subsequent earnings growth than their low dividend-paying counterparts (see chart 2). Academics funds. Because dividends can only be paid out of real earnings and real cash flow, focusing on dividends
coined this phenomenon the ‘dividend-signalling effect’. Our research shows that this dividend-signalling helps investors avoid companies with dubious earnings, as these companies are unlikely to have the actual
effect is particularly strong in Asia, and can last as long as four years in markets like Singapore (see chart 3). cash required to make dividend payments. Owing to these factors, companies with strong dividend
pay-outs tend to possess higher corporate governance standards in Asia.
With high dividend-paying companies having stronger future earnings growth and better corporate
governance, it is little wonder that, over the last twenty years, high dividend-yielding stocks have
outperformed both the market and low-yielding stocks in Asia. That said, the benefits of investing for
dividends are not unique to Asia. Studies have shown that in the US and Europe, dividend-investing
strategies also outperform. However these benefits seem to manifest themselves strongest in Asia,
with the Asian strategy delivering returns several times that of their global, US, Japanese and European
counterparts over the last decade.
INVESTMENT PERSPECTIVES 2012
Chart 4: Dividend yield by region Chart 5: Asian market dividend yield versus deposit rates
Dividend yield (%) 6.0
0.0 Australia New Zealand Hong Kong Singapore China Indonesia Taiwan Korea Malaysia Philippines Thailand
Asia Pacific ex Japan World US Japan EMEA Latin America Europe
MSCI Dividend Yield Domestic Deposit Rate
Source: Bloomberg, Factset, MSCI and Schroders, as at 30 November 2011.
Country China Hong Kong Singapore Malaysia Korea Taiwan Thailand Indonesia Philippines
De Fact Exchange Crawling Pegged Managed Managed Free float Managed Managed Managed Free float
Now is the time to invest for dividends in Asia Rate Policy Peg float float float float float
A convergence of global and domestic influences has meant that now is an opportune time to invest for Source: Factset, MSCI, Schroders, International Monetary Fund, 2008. De Facto Classification of Exchange Rate Regimes
and Monetary Policy Framework. As at 30 September 2011.
dividends in Asia. In addition to boasting the strongest economic fundamentals in the world, the region also
has one of the highest dividend yields globally; second only to Europe where the unfolding debt crisis Until monetary policies in Asia are altered so that the low interest rates in the US are not imported into the
continues to raise questions about dividend sustainability (see chart 4). The region also benefits from current region through its exchange rates targeting, the huge divergence between Asian dividend yields and
low interest rates, as a result of Asian central banks pegging, or managing, their exchange rate policies domestic interest rates represents a unique opportunity for investors to enter the dividend-investing strategy
against the US dollar. at little opportunity cost. As shown in chart 5, investors now get to receive regular dividend payments from
Asian corporates that far outstrip the interest rate payments that they would otherwise have received on their
bank deposits, while continuing to participate in potential future share price appreciation – a clear win-win
situation (if there ever is one in the world of finance!).
“Despite the market’s obsession with share price appreciation, historically almost two-thirds of
long-term equity returns in Asia have come from dividends.”
Our research shows that the current environment represents one of the best times to adopt a dividend-investing
strategy. Just as the strategy underperforms in the period leading into a bubble climax (i.e. when the market
discards fundamentals and chases hope), the strategy outperforms very strongly for an extended period of time
after the crisis as the market repents its past mistake of ignoring fundamentals. This was true at the end of the
Asian crisis and after the technology bubble, and continues to be the case following the 2008 credit crisis.
In fact, we believe the Asian crisis fundamentally changed the regional corporate landscape, and was the catalyst
for the current dividend trend (see chart 6). Undoubtedly, the corporate restructurings that followed the crisis led
to higher corporate profitability, burgeoning cash flows and low debt levels which have given rise to the higher
dividend pay-outs we see today.
1 2012 OUTLOOK
Chart 6: Percentage of stocks with dividend yields higher than cash rates
Percentage of stocks with dividends yields higher than cash rate Percentage of stocks with dividends yields higher than bond yield
Jan 99 Jan 01 Jan 03 Jan 05 Jan 07 Jan 09 Jan 11 Jan 99 Jan 01 Jan 03 Jan 05 Jan 07 Jan 09 Jan 11
Source: UBS, as at 30 November 2011.
With this longer-term dividend trend continuing to play out and with ample dividend opportunities existing in
Asia, history suggests that, for investors looking at Asia, the dividend-investing strategy has many more
good years ahead.
The views and opinions contained herein are those of King Fuei Lee and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
1.2 2012: A year in Asia
Richard Sennitt Fund Manager, Asian ex Japan Equities
Chart 1: Asian consumption set to rise strongly
– Growth in Asia will continue to outstrip the developed world, and will be Global household consumption
the key driver of global economic expansion Percentage of global household consumption
– 2012 may prove an interesting time for investors to find opportunities in
the market 30
– Asian government debt to GDP is still relatively manageable and there 25
is certainly room for more fiscal stimulus if required. 20
As much as we would like to say that Asian investors will wake up on 01 January 2012 to a world free of
inflation, where export demand has magically bounced back, global growth is soaring, volatility and debt 10
have disappeared, and China has swooped in and saved us all – this simply won’t happen.
The problems of 2011 will follow us into 2012 and, the truth is, we are in for a difficult 12 months. Although
Asia won’t be immune to the headwinds, it is in a better position to withstand them as it continues its shift 0
from an export-driven growth model to a market that is increasingly driven from within. US Japan UK France China India Korea
Source: IFS, CEIC, Citi Investment Research, 31 July 2009.
Home is where the growth is
In a breakdown of global consumption (Chart 1), we see that the US currently makes up more than 30% of
With most analysts forecasting that Europe will slide back into recession in 2012 and the US will remain household consumption, while the main Asia (ex Japan) economies contribute relatively little to the overall
on an economic ‘go slow’ for some time, Asian governments are increasingly appreciating the need to total. The likes of China and India each contribute less that 5% to global consumption, despite a population
mobilise their own consumers. The present downturn has highlighted the unsustainability of Asia’s present of 1.4 billion in China and 1.2 billion in India. With a rapidly growing middle class and rising urbanisation
model as the region simply cannot achieve further growth by relying on 300 million Americans to keep across the region, the potential of the Asian consumer is unparalleled. However, from an investor’s point of
buying their goods. view, this is still a difficult market, and tapping into this potential is likely to be a long-term challenge.
“Asian economies will continue their shift from the current export-driven growth model to a
market that is increasingly driven from within.” “ Valuations have now reached levels that have historically been a good buying environment
for Asian investors.”
What we will see over the medium term are increased efforts on the part of Asia’s governments to steer
their countries away from being a population of savers to a population of spenders. This would include
strengthening social security nets, such as healthcare provision, to enable people to feel confident enough
to spend. Until this happens, economies in the region will continue to rely on developed markets to buy the
majority of the goods they produce.
1 2012 OUTLOOK
Inflation takes a backseat
With signs of protracted sub-trend growth in the West, the likes of China, Hong Kong and Korea will certainly This time a year ago, Asian investors were almost entirely focused on the issue of inflation. The region was
see a slowdown in growth in 2012. Singapore – seen as a forerunner of Western demand because of its simply growing too fast; this was putting upward pressure on rates and threatening to erode economic
heavy reliance on trade – has already said that its economy is likely to suffer a sharp slowdown next year as growth. Although prices in the region are still rising, there are signs that inflation has peaked and global
export orders from developed countries wane. Despite these expectations, growth in Asia will continue to economic events are likely to remain the market’s main concern over the coming year.
outstrip the developed world, and will be the key driver of global economic expansion. However, for now,
One of the fallouts of a slowdown in the outlook for global growth is that commodity prices are likely to pull
exports still matter for this region.
back and, as Asia is a net importer of commodities, it will be a beneficiary of this trend. As a result, we are
likely to see monetary tightening activity ease and, should the global economic environment deteriorate in
Hunting season 2012, Asia is in a strong position to withstand a further slowdown as authorities across the region still have
Asian equities were hard hit by the general flight to safety that characterised the second half of 2011. Risk tools to stimulate their economies. This is in stark contrast to the West – where rates are at rock bottom and
sentiment indicators suggest the region’s markets spent much of the period in panic mode, having seen public finances are stretched. Overall, Asian government debt to GDP is still relatively manageable and there
double-digit losses year to date. Overall, we are seeing a major rebasing to people’s expectations, and is certainly room for more fiscal stimulus if required. Central banks in Australia and Indonesia have already
downward economic growth means that corporate earnings will also need to be revised lower throughout cut rates, while Singapore’s central bank has begun the gradual appreciation of the Singapore dollar. While
the region. this puts Asian economies in a strong position, going into next year, the region does have one potentially big
problem – China.
It’s important to remember, however, that Asia went through its own financial crisis a decade before the
West. This gave companies in the region the chance to shore up their balance sheets, and now Asian
companies tend not to be saddled with too much debt and have decent levels of cash. Despite this,
The China problem
earnings and leading indicators point to further downward earnings revisions over the coming year. The big issue for the region as a whole is loan growth in China and whether the authorities can engineer a
soft, rather than a hard, landing. Here, the biggest concern has been the rapid expansion of credit. As a
In terms of individual economies, estimated earnings in Taiwan have already seen sharp declines. This is
highly managed economy, China’s loan growth has – until recently – come through the banking system.
partly because Taiwan’s corporate sector is highly transparent – with many IT companies issuing monthly
However, since 2008, we’ve seen an explosion in shadow banking – a form of private lending that bypasses
sales numbers – allowing analysts to factor in any concerns earlier than they would for the rest of the region.
the normal channels. Although Chinese authorities have recently announced measures to curb such
While this makes Taiwan an interesting region for investors, from a valuations point of view, we are likely to
activities and bring these loans back onto balance sheets of banks, action has been late in coming and the
see more downward revisions for corporates across the rest of Asia in the early part of next year.
horse has already bolted.
Following the market turmoil of 2011, next year may prove an interesting time for investors to find
With authorities having already begun buying shares in some lenders, hopes of a loosening of monetary
opportunities in the market. Valuations have now reached levels that have historically been a good buying
policy into 2012 have intensified. In this respect, we believe the market is jumping the gun. In our view,
environment for Asian investors. However, with fear overriding all other emotions in the market, short-term
Chinese authorities are unlikely to tighten or loosen policy to any meaningful degree as we move into what is
performance is impossible to call. Investors should, therefore, focus on companies with internally generated
likely to be a very nervous year for the market. This means that fixed-asset investment as a percentage of
cash flows, which would help shield them from any short-term turbulence emanating from the global
GDP is likely to remain high. As for the rest of the region, there are no signs of over investment or of any
economy. Longer term, we are confident that from current market levels, there is very good potential to
‘bubbles’ building up. Capital expenditure for sales is at a very low level for the region, compared to history,
make significant gains in Asia.
therefore, there is considerable room for more investment over the coming year. This is good news for
In terms of strategy, income represents a substantial portion of Asia’s long-term total return, and dividend investors – with the will to hold their nerve.
yield strategies continue to be among the strongest performing equities strategies in the region. In 2012, we
are more likely to see companies surprise with higher dividends than expected as the extensive capital- The views and opinions contained herein are those of Richard Sennitt and may not necessarily
raising activities of 2009/10 means that companies can now afford to pay out cash raised. In Asia, balance represent views expressed or reflected in other Schroders communications, strategies or funds.
sheets are strong and pay-out ratios are back to historically low levels which should provide some comfort
for the sustainability of dividend versus earnings.
INVESTMENT PERSPECTIVES 2012
1.3 2012: A year in global emerging markets
Allan Conway Head of Emerging Market Equities
Public debt and fiscal balance as a percentage of GDP for EM and DM in 2011
– In contrast to the developed world, government-debt-to-GDP ratios are Fiscal Balance (%GDP)
relatively low in the emerging world, and fiscal balances are sound Indonesia
0 Peru Korea
– Although economic growth momentum is slowing everywhere, there has China
-2 Russia EM Turkey
been no discernible change in the growth differential between emerging Mexico
markets and developed markets -4 Australia Czech Phil
Germany Euro area
-6 S Africa Poland
– Emerging market valuations discount a lot of bad news, but tail risks remain. Spain France DM
-8 India UK
-10 US Greece
In 2012, the outlook for emerging markets is likely to be sensitive to exogenous macroeconomic
developments – the largest single risk comes from the eurozone, as politicians struggle to save the euro -12
project. However, economic fundamentals in emerging markets remain strong and valuations already -14
anticipate a lot of bad news. Importantly, the structural case for emerging markets remains intact and 0 50 100 150 200 250
even in the event of a break-up of the eurozone we would view any associated weakness in emerging Public Debt (%GDP)
markets as a strong buying opportunity for long-term investors.
Source: JP Morgan, Economics Team estimates, as at September 2011.
Before looking ahead to what 2012 might hold for emerging markets, we need to put 2011 in context.
The first point to address is why emerging markets have underperformed in 2011. Clearly, it is not due to
Moreover, although economic growth momentum is slowing everywhere, there has been no discernible
a deterioration of balance sheet fundamentals. Balance sheets remain extremely strong at the government,
change in the growth differential between emerging markets (EM) and developed markets (DM). In other
household and corporate level, foreign exchange reserve buffers significant, and bank leverage modest.
words, emerging markets have grown at a rate that is around four percentage points faster than developed
As the chart below shows, government debt to GDP is relatively low, and fiscal balances are sound.
markets over the last decade, including during and after the financial crisis.
Explaining EM underperformance in 2011
So if the structural story remains intact, why have emerging markets underperformed in 2011? The main
reasons, in our opinion, were the US dollar, inflation and global growth. From the beginning of the year until
the spring, the US dollar was weakening, which should have been good for EM. However, this was a time
when investors were concerned about rising inflation in the developing world due to strengthening food
prices and robust economic activity, so returns disappointed.
1 2012 OUTLOOK
Then, after a period of stability, the US dollar began to strengthen, reflecting the sharp rise in risk aversion However, over any short-term periods, markets in particular can be highly correlated, especially during
as global growth forecasts came under pressure from the deterioration in the eurozone. US dollar strength periods of financial stress. In the near term, this is likely to continue due to all the uncertainty in the
and weakening growth prospects are bad for EM. So again, EM came under pressure with returns also developed world that has been well documented. Rather than trying to fathom the next machinations
negatively impacted by emerging market debt investors hedging their currency exposure, the overall of European or US politicians, we want to focus on what is actually happening in the emerging world.
negative sentiment towards equities, and general profit taking. Specifically, we will look at current valuation levels and the sensitivity of EM earnings to growth prospects.
First, a simple point about valuations. By any measure, emerging markets equities are cheap. As the
Valuations attractive, but tail risks remain charts below show, compared to history or developed markets, emerging markets are trading on attractive
Where does that leave us? The short answer is at very attractive valuation levels, but vulnerable to 12-month forward PE, price-to-book and market-cap-to-GDP ratios.
significantly elevated tail risk related to exogenous sources, viz. European sovereign debt and uncertainty
GEMs prospective P/E
about US fiscal policy.
Forward Price Earnings Emerging
So, what to do? The first point to remember is that EM economies and markets have clearly decoupled Markets USA World
from DM, but only if one looks over a reasonable time period. As the chart below shows clearly, EM P/E 9.0 11.4 10.7
have delivered much stronger economic growth than DM over the last ten years and much stronger
EPS Growth 12.4 12.4 11.4
stockmarket returns. 18
PE/EPS Growth 0.7 0.9 0.9
GDP and performance
Difference in real GDP Growth (Emerging versus Developed) and Relative Performance Differential (MSCI EM versus MSCI World)
Mar 1989 = 100
4 Jun 94 Dec 96 Jun 99 Nov 01 May 04 Oct 06 Apr 09 Oct 11
3 MSCI EM 12m Forward P/E Average
Source: Schroders, FactSet, IBES, MSCI, data shown to 20 October 2011.
Mar 89 May 92 Aug 95 Oct 98 Jan 02 Apr 05 Jun 08 Sep 11
Real GDP growth differential (lhs) Relative performance MSCI EM versus MSCI World (rhs)
Source: MSCI, OECD, CS estimates, data shown to end May 2011.
Past performance is not a guide to future performance.
INVESTMENT PERSPECTIVES 2012
MSCI EM Price to Book value How sensitive is earnings growth to GDP?
In particular, the 12-month forward PE is 9 times and is based on forecast earnings growth of around
12%. So, a key question to address is how sensitive EM earnings growth is to changes in GDP and what
conclusions can be drawn about the prospects
for emerging equity markets next year.
What is clear is that EM nominal GDP is slowing due to a combination of falling inflation and slowing global
growth. As might be expected, EM sales growth is closely linked to nominal GDP (see chart below). So as
nominal GDP slows, sales growth will come under pressure. Eventually, this will result in a squeeze on
margins, and as a result earnings will come under pressure.
Sales growth versus nominal GDP
Sep 95 Jan 98 Apr 00 Aug 02 Nov 04 Mar 07 Jun 09 Oct 11 20
Source: FactSet, data shown to 31 October 2011. 15
GEM Aggregate index/GDP 5
92 94 96 98 00 02 04 06 08 10
Avg +121% +396% -65%
150 -54% GEM Sales growth (UBS) GEM nominal GDP growth
While earnings growth is not particularly correlated with nominal GDP, the fit with real GDP is much stronger.
Looking at previous cycles, we can see that provided real GDP for the emerging markets stays above 4%,
earnings growth is likely to remain positive (see the following chart).
Dec 88 Apr 92 Jul 95 Oct 98 Jan 02 Apr 05 Jul 08 Oct 11
GEM Aggregate Index/GDP Average +1Std -1Std % moves in the MSCI EM Price Index
Source: UBS, data shown to 31 October 2011.
Past performance is not a guide to future performance.
1 2012 OUTLOOK
GEM EPS growth (trailing 4 qtrs) In short, the near-term outlook for emerging markets continues to be extremely difficult to predict with many
60% different outcomes possible, but all primarily dependent on exogenous macro drivers. Europe remains the
50% single largest risk as European politicians struggle to retain control of the euro project, but the outcome is far
from certain. To quote Churchill: “To build may have to be the slow and laborious task of years. To destroy
can be the thoughtless act of a single day.”
y = 8.9713x – 0.3604 However, by focusing on emerging fundamentals, we can see that a lot of bad news is already priced in to
R2 = 0.64608 emerging market equity prices. Indeed, if there is progress in Europe, we would expect emerging markets
to rally strongly. In the past when emerging markets have been this cheap they have usually rallied 60-75%
0% over the next 12 months. Even under our worst-case scenario, we estimate EM earnings would fall by
-10% around 20% to 30% which would leave the MSCI Emerging Markets index trading at about its long-term
-20% average. Obviously if the eurozone were to break up then all equity markets would almost certainly trade
lower and EM would be no different, but in our opinion it would provide a great buying opportunity for
0% 1% 2% 3% 4% 5% 6% 7% 8% The views and opinions contained herein are those of Allan Conway and may not necessarily
GEM real GDP growth (trailing 4 qtrs) represent views expressed or reflected in other Schroders communications, strategies or funds.
Source: Schroders. Data to end Q2 2010.
The following table shows three scenarios from the Schroders Economics team. Even under the base
case of a eurozone credit crunch, we expect real GDP for the emerging markets will be 4.5% next year.
The ‘muddle through’ scenario should result in emerging GDP growth of 6% and it is only a disorderly
break-up of the euro that would lead to emerging growth of 2.5% and therefore below the critical 4% level,
in our opinion.
Global economic outlook for 2011/12
Base Case ‘eurozone credit Scenario 1 Scenario 2
crunch +QE’ ‘Euro break up’ ‘Muddle through’
65% 20% 15%
2010 2011 2012 2011 2012 2011 2012
Global Growth 4.4% 3.0% 1.8% 3.0% -0.7% 3.2% 3.4%
US Growth 3.0% 1.7% 1.6% 1.7% -0.7% 1.7% 2.6%
GEMS Growth 7.6% 6.1% 4.5% 6.1% 2.5% 6.3% 6.0%
GEMS CPI 5.2% 6.2% 4.5% 6.2% 2.5% 6.0% 3.5%
Global CPI 2.8% 3.8% 2.5% 3.8% 1.9% 3.8% 2.4%
Fed Funds 0.25% 0.25% 0.25% 0.25% 0.25% 0.25% 0.25%
JPY/US$ 83.0 75.0 70.0 74.0 60.0 75.0 80.0
Oil (US$) 87.2 107.3 105.2 97.3 75.2 112.3 120.2
Source: Schroders, November 2011.
INVESTMENT PERSPECTIVES 2012
1.4 2012: A year in Europe
Rory Bateman Head of European Equities
An unwinding of the high correlation in equity markets
– We expect a normalisation of the high levels of equity market correlations we Over the past six months, European equity returns have never been so highly correlated (see the graph
have witnessed recently below). The weakening global economic outlook and deepening European sovereign debt crisis have driven
investors to reduce their equity exposure in an indiscriminate fashion – without distinguishing between the
– As investors become more discerning, we think stock selection will be a key merits of individual companies. We believe that, as investors get used to the prospect of low European
driver of excess returns in 2012 growth, the top down macroeconomic influences currently weighing on equity markets will be less dramatic
than we have experienced of late; leading to much greater differentiation in stock returns going forwards.
– Extremely attractive valuation levels provide scope for an equity market
re-rating back towards historical levels. EuroStoxx50 correlation
Political uncertainty and the threat of a European recession in 2012 leave European equities offering 0.7
excellent value. We ask the question, “Can European sentiment and the political environment get much 0.6
worse?” Why are we asking this question now? Because valuations and correlations are at extreme levels.
Recently, we have witnessed very high correlations between sectors in the market as investors have
aggressively reduced their equity market exposure without differentiating between the underlying companies
– resulting in the very attractive European equity valuations we are seeing today. The current market levels are, 0.3
therefore, providing a rare opportunity for resolute investors to be rewarded handsomely over the longer term. 0.2
Factors to consider as we head into 2012… 0.1 -40%
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct
07 07 07 07 08 08 08 08 09 09 09 09 10 10 10 10 11 11 11 11
26 weeks rolling correlations of 4 week equity returns EuroStoxx50 26 weeks returns (rhs)
Source: Schroders, Thomson Datastream, as at 04 November 2011. Correlation is pairwise for all constituents of
EuroStoxx50 against one another. Data uses the average correlation over a 26 week period of each stock’s four-weekly
return against every other stock. EuroStoxx50 returns are rolling 26 weeks.
1 2012 OUTLOOK
“The point of maximum uncertainty is quite often the best entry point.” Graham & Dodd P/E MSCI Europe1 MSCI Europe 1 year average returns
by starting G&D PE range 1980-2010
Importantly, for Schroders European Equity team, this type of market plays to our strengths. We derive the
bulk of our alpha generation through bottom-up stock selection, leveraging the considerable expertise of our PE x %
dedicated sector analysts. 40 25
From a timing perspective, the point of maximum uncertainty is quite often the best entry point. European 35 20
equity markets are again approaching the September lows as fears surrounding the ability of policymakers 30 15
to deliver a successful resolution to the eurozone crisis have hit the headlines. While we agree that volatility
will continue, we believe that there will be a resolution to the crisis; which will be a positive driver for
European equities. 20 5
Valuation – a key determinant of future stock returns
European businesses are very attractively valued on a number of metrics, both relative to their history and to
other asset classes and regions. While we expect to be entering a phase of relatively low economic growth
in 2012, European equity markets can still perform well, especially given the depressed valuation levels of Feb Feb Jan Jan Dec Nov Nov Oct Sep 10-15 15-20 20-25 25-30 30-35
80 84 88 92 95 99 03 07 11 PE x
late. European equity valuations are near historic lows as a result of the eurozone debt crisis. Our central
belief is that the euro will survive as the repercussions of a disorderly break-up are unfathomable for the Source: Schroders, Thomson Datastream as at 31 October 2011.
global economy. We accept that there is an increasing possibility of a peripheral nation experiencing a
default, but this is largely reflected in valuations; which according to the Graham & Dodd price-to-earnings The indiscriminate sell off in markets has meant that there is still a substantial degree of overlap between value
(P/E) ratio (at <12x) is close to 30-year lows. and quality – providing an exceptional opportunity to invest in high quality stocks at historically low valuations.
“ We think the current market levels provide a rare opportunity for long-term investors to be “Europe continues to offer investors the opportunity to invest in a wealth of unique and highly-
rewarded handsomely on a three-year view.” competitive global franchises which are currently trading at large discounts to their global peers.”
The following charts provide some context in which to consider the potential return opportunity from the
valuation low point we are currently witnessing. Historically, one year average returns for the MSCI Europe
index have exceeded 20%, given a starting Graham & Dodd P/E range of between 10x and 15x earnings
– the position that European equity markets are currently in.
1 A historic long-term measure, based on 10-year average earnings, which tries to strip out the volatility of the earnings. 17
INVESTMENT PERSPECTIVES 2012
What shape are companies in?
Markets have already discounted much of the downside risk with corporate earnings having been Encouragingly, company balance sheets are in relatively good shape following a period of sustained
aggressively reduced on the back of growth expectations for 2012, while the number of earnings deleveraging, and evidence points to robust free cash flow currently providing good support for dividends.
upgrades relative to earnings downgrades are also at 30-year relative lows (see graph below).
Strong stock selection will come to the fore, in terms of identifying quality companies that are able to remain
European one month earnings revision ratio2 profitable through the low growth environment while maintaining a focus on increasing shareholder value.
We would expect selected high quality businesses to be able to offer sustainable cash returns to
shareholders through dividends or buybacks.
Equities also offer attractive yields while, at the same time, allowing for potential capital appreciation.
1.20 Regional dividend yields have reached levels rarely seen before, while bund yields are at near-record lows.
Dividend yields on many European equities are also comparable to the yield available on corporate bonds in
the region, while offering growth potential and an element of inflation protection.
Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
1-Month Earnings Revision Ratio Average Earnings Revision Ratio
Source: Merrill Lynch Global Quantitative Strategy, MSCI, IBES, as at 31 October 2011.
2 The ratio represents the number of analyst upgrades (less downgrades) to company earnings forecasts expressed as a
18 proportion of all estimates.
1 2012 OUTLOOK
In our view, Europe currently offers investors the opportunity to invest in a wealth of unique and highly
competitive global franchises which are currently trading at large discounts to their global peers. The
discounts that are being applied to these stocks ignore the fact that many European businesses generate
sales on a global basis. European companies generate more than 40% of their revenues from the US and
the emerging markets3 and, therefore, clearly benefit from the growth in these regions while being largely
immune to the funding problems of their host region.
European equities are currently experiencing two extremes which we believe will normalise during 2012,
providing attractive investment opportunities for bottom-up stock pickers:
1. Firstly, the abnormally high levels of equity market correlations are likely to diminish, paving the way for
stock selection to be the key driver of excess returns for 2012. As stock selection becomes increasingly
differentiated, this will play to our strengths and provide a real added advantage for us, given our
expertise and sector specialism throughout the European market.
2. Secondly, we believe the extremely attractive valuation levels provide scope for an equity market re-rating
back towards historical levels – providing a rare opportunity for investors to be rewarded handsomely
over the longer term.
We expect to be in a low growth environment over the coming year and anticipate continued equity market
volatility. However, we think the combination of low valuations and attractive yields, along with the potential
for capital appreciation (offering some inflation protection in a time of negative real yields), provides a
compelling case for resolute investors to keep European equities firmly in their sights. As discussed, markets
have already discounted much of the downside risk associated with European equities and, from where we
are standing, the potential upside is now looking increasingly appealing.
Should a normalisation in equity markets occur, the importance of strong stock selection will come to the
fore with investors targeting returns at a much more granular level, rather than decisions being dictated by
macro events or asset, sector or regional allocations. In effect, good decision making at a stock level looks
set to define a truly successful manager in 2012.
The views and opinions contained herein are those of Rory Bateman and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
3 Source: Bank of America Merrill Lynch, November 2011, ‘Agreement on earnings haircut’ European Equity strategy, p.2.
INVESTMENT PERSPECTIVES 2012
1.5 2012: A year in global bonds
Bob Jolly Head of Global Macro
Today, savings rates in Japan remain among the highest in the world. While households and corporations
have increased their savings, the government has continued to run an impressive budget deficit.
– The eurozone has to either accept greater integration or agree to abandon Government debt as a share of GDP is now estimated to be around 200%.
the euro project Clearly many similarities exist with the situation in the US, euro area and UK today. These countries
– Structural reform is required, and a deeper integration of fiscal policy a allowed banks to expand their balance sheets aggressively and to lend too heavily to consumers.
The consumers then borrowed beyond their means, driving property prices to levels inconsistent
necessity of success in the euro project with conventional earnings multipliers.
– Considerable bad news is already priced into equity multiples and credit spreads The resulting collapse in, most notably, US property prices and more generally stock prices, was met with
– We continue to find bonds issued by strong companies with cash on their aggressive cuts in interest rates, significant government stimulus packages and capital injections into a
number of, otherwise, zombie banks. With many central banks reaching the zero bound of interest rates,
balance sheet and pricing power attractive.
quantitative easing (a polite form of monetisation) has been widely used in an attempt to ward off threats
of deflation. Government debt has ballooned as a share of GDP.
Some of our mature readers may recall the song performed by The Vapors, a punk rock band from the early “Political progress is likely to be slower than markets would like and while we do not believe
eighties. Their one major commercial success, ‘Turning Japanese’, was probably not an attempt to forecast governments of the eurozone will allow events to push economies over the edge of the
the possible similarities in economic downturn between Japan in the early nineties and the broader Western precipice, the risk remains.”
world today. But can the experiences of Japan – 20 or so years of stagnating growth with persistent
concerns over deflation – be a useful guide for the investment climate facing us today? Can policymakers
avoid another year of turmoil and concerns over recovering from our own asset price bubble? Central bank responses
At first glance, there are clear similarities between the Japanese downturn and the problems faced by most On the surface, this is a near carbon copy of the Japanese experiences. However, one key difference is the
of the US, eurozone and UK today. But there are also key differences, not least policy makers’ response to time between the pricking of the property bubble and the speed of response to the ensuing credit crunch.
the crisis as well as the emerging world’s growing importance for global economic growth and prosperity. Initially, the Bank of Japan felt constrained in its ability to adopt the more unconventional measures by
the country’s high levels of nominal savings. It was concerned about the risk of a steep rise in inflation,
Japanese parallels destroying the real value of savings. The ruling political party was also concerned about the state of
Let us briefly start with the similarities: government finances. As soon as it felt growth was returning to trend, it tightened prematurely and dragged
the economy back towards recession. The drag caused by Japanese banks hoarding cash and failing to
Japan’s downturn followed the bursting of the bubble in overinflated property and stock prices. This was lend was felt for six or seven years, before a bank bailout was organised.
caused by lax lending standards in the Japanese banking system. The result was ‘zombie’ banks hoarding
liquidity and the Japanese consumer saving aggressively, leading to economic stagnation and over- While the policy responses to Japan’s problems are very similar to authorities’ response to the 2008 credit
leveraged banks. To boost growth, the Japanese authorities invested heavily and initiated a number of bank crunch, the speed of response is a key difference. Deflation is not entrenched, and while consumers are
bailout packages. However, after witnessing declines of up to 60% in land and stock prices, Japanese rightly living within their means, they are not driving their savings ratio ever higher.
companies and households adopted a more cautious attitude to spending.
1 2012 OUTLOOK
Where next? Investment conclusions
Two debt crises are never the same. Today, we face considerable uncertainty over the eurozone’s response to Markets do not like uncertainty. Political uncertainty is likely to remain high throughout the Western world,
the concerns markets have about the solvency of nations’ finances in Spain and Italy, among others. The US but events in the Middle East continue to add to the uncomfortable environment we find ourselves facing.
political system is a year away from a national election resulting in both sides of the political spectrum playing
However, while the equity multiples and credit spreads of before the credit crunch are clearly an
politics rather than sound economics in response to an elevated level of both debt and unemployment.
inappropriate period to use to calculate market equilibrium, considerable bad news is already in prices.
What is clear is that overspending by governments has to be brought under control. Two irrefutable facts
We continue to find corporate bonds issued by strong companies with cash on their balance sheet and
have to be dealt with:
pricing power attractive.
First, we are living considerably longer, existing retirement ages were set before medical advances extended
Government bond yields of countries with their own exchange rate are anticipated to remain extremely low.
our life expectancy. We will have to work for longer before retiring. Government finances are under
Assuming progress can be made on the further integration of European members of the euro, at some point
increasing strain by the need to pay for the growing retired population in part because their medical
the likes of Italy and Spain will offer good value.
expenses continue to increase. Means testing of healthcare is likely to be introduced at some point in the
not too distant future. However, political progress is likely to be slower than markets would like and while we do not believe
governments of the eurozone will allow events to push economies over the edge of the precipice, the risk
Second, an increasing divergence in expected growth has to reverse. While the West has accumulated too
remains. We continue to trade our portfolios more tactically as volatility remains high.
much debt, the developing world has increased its wealth considerably. Asia and the developing world in
general have in the last decade built up considerable trade and current account surpluses. The cause is The views and opinions contained herein are those of Bob Jolly and may not necessarily
twofold: first, a seemingly insatiable appetite of Western consumers for Asian-produced goods; second, represent views expressed or reflected in other Schroders communications, strategies or funds.
the preference of some Latin American, but more importantly Asian, currencies to maintain a competitively
pegged exchange rate with the US dollar. Some rebalancing of the world’s demand will be achieved by
consumers in the US and the southern European countries spending less but also a move toward freely
floating exchange rates in the developing world.
What is in store for 2012
For 2012, we expect progress in a number of areas;
The eurozone has to either accept greater integration or agree to abandon the euro project. The problems
faced today in Europe are largely caused by growing divergence in expected growth rates made unsustainable
by a narrowly defined union of currencies with a common interest rate. Structural reform is required, and a
deeper integration of fiscal policy a necessity of success in the euro project. Without it, the rifts will grow, and
the problems become more acute.
While the required reforms may be unpopular, markets and sound economics will force policy makers into
the required adjustments, although the progress may be slower than markets desire.
Elsewhere, central banks will continue to adopt unconventional measures, quite probably in increasing size
and regularity, to reduce the impact of tighter fiscal policy and a deleveraging of both bank and household
Asian currencies will most likely continue to appreciate, perhaps not at the speed with which the US
administration, among others, calls for but for their own domestic reasons, such as reducing high inflation
and increasing the purchasing power of domestic consumers.
INVESTMENT PERSPECTIVES 2012
1.6 2012: A year in global climate change
Simon Webber Portfolio Manager and Giles Money Portfolio Manager
– Energy efficiency investments will lead the way and we expect OLED Last year’s forecast: positive momentum is likely to continue given very fast pay-back periods.
televisions to start the next TV technology revolution Fearful consumers, cautious companies and cash strapped governments have driven structural growth in
– Consolidation in renewable energy companies will provide opportunities for energy efficiency industries this year. These cover a range of technologies that are some of the cheapest
ways to reduce energy consumption and carbon emissions. The trend is set to continue into 2012: because
very attractive returns of the current economic environment, we would strongly favour those solutions that require no explicit
– Natural gas will continue its ascent into becoming the most important fossil subsidy and have compelling paybacks with high visibility.
fuel globally for power markets.
A TV revolution
Within the energy efficiency theme, the TV industry is on the cusp of one of its biggest ever changes.
Climate change may have been off the front pages this year, but data continues to show that we are facing A TV that is thinner, lighter, better quality – and about 50% more efficient has been created. Based on
dangerous climate change this century. 2010 was officially the warmest year on record, and with 2011 organic light emitting diodes (OLEDs), the technology unleashes huge creative and practical potential such
throwing up an array of ‘climate-linked’ crises, it will not be long before the issue returns to the forefront. as transparent screens and screens that can be bent, twisted and even rolled up. Critically this can save
In the meantime, business confidence to invest in new climate change solutions is increasing and will significant amounts of electricity and uses far less material in its construction.
continue to do so through 2012. OLED TVs are currently not competitive (Sony’s 11” OLED TV costs $3,500) but the company that achieves
This year has so far seen three times the usual number of $1bn+ weather-related disasters in the US. lower manufacturing costs first will enjoy a huge advantage over its peers, supernormal profits and share
It has brought the deepest drought for 60 years in the Horn of Africa, Thailand’s worst floods for half a gains. Samsung Electronics appears ahead in the race and believes it will have a commercially viable 40”
century, and severe droughts in northern Europe. OLED TV out by 2013 and perhaps even earlier.
These are just a few examples of the extreme weather-related events witnessed this year. While no single event
can be directly attributable to global warming, the combination of events highlights the negative impact climate
change would have if left unchecked. Data released this year showed that global CO2 emissions reached an Last year’s forecast: 1) a modest improvement in global power prices; 2) consolidation
all-time high in 2010 despite slowing economic growth and carbon efficiency improvements. among European renewable equipment producers; 3) Asian equipment companies to
suffer domestically and begin to attack foreign markets; 4) solar to disappoint.
The latest report from the International Energy Agency concluded that ‘rising fossil energy use will lead to
irreversible and potentially catastrophic climate change.’ It warned that the world has five years to avoid
severe climate change. The imperative for governments and businesses to limit and mitigate the impact Green mergers
of climate change will therefore be as important going into 2012 as ever. With this in mind, we review the Renewable energy has remained extremely subdued, with wind and solar disappointing. The industry has
outlook for the key climate change themes. suffered from over-capacity which has squeezed margins and dented profits.
“The imperative for governments and businesses to limit and mitigate the impact of climate This has laid the conditions for a major M&A cycle. It is already underway with a record number of
change will be as important going into 2012 as ever.” announced deals in the first quarter of 2011 (over 140 compared to a quarterly average of 96 in 2010).
This will gather pace in 2012, unless valuations and multiples improve. Therefore, while fundamentals
are extremely bad at the moment there is scope to build into the darkness before the dawn.
1 2012 OUTLOOK
Nuclear fallout Sustainable transport
The defining moment for the renewable and nuclear industry was the Fukushima nuclear crisis, caused by Last year’s forecast: sustainable transport will continue to be very attractive with fuel
the Japanese earthquake and tsunami in March. There was an immediate shift in public attitudes towards efficiency and emissions regulations tightening fast.
nuclear power. Germany announced intentions to phase it out and other countries such as Japan are
Emissions regulations will continue to propel the sustainable transport industry forward in 2012.
re-visiting nuclear strategies.
There are two paths to meeting these targets: improvement of existing internal combustion engines
However, with the crisis now under control, we expect a less emotional debate to develop. Given the and tyres, and brand new power train technologies such as electric vehicles and fuel cells. Of these
climate change demands facing governments, nuclear energy will continue to play a significant role. two paths, it is more likely that an improvement in existing technology will dominate. New technologies
Despite policy changes in some countries, the impact of Fukushima has been less dramatic than feared. remain simply too expensive and/or impractical.
Of the 570 units planned before the disaster, only 37 have been axed or put on hold and China continues
One example is in the tyre industry. New EU tyre regulation states that from November 2012, all tyres must
to drive the sector forward.
be labelled according to their fuel efficiency (tyre resistance consumes 20% of fuel today), wet braking and
With new nuclear on the back foot, renewable technologies are likely to find increased favour. external noise. Japan introduced similar regulation in 2011, and the US and South Korea are expected to
Indeed, in order to compensate for suspending Japan’s nuclear new-build, HSBC estimates an extra follow shortly. This provides strong opportunities for investors. Tyre companies such as Michelin and
renewable capacity of between 1.75-3.5GW per annum would be needed between 2011 and 2030. Bridgestone produce low rolling resistance tyres which offer one of the most appealing cost-per-unit
That is two to three times the current 2011 renewable forecast for Japan. reductions of CO2 emissions. Bridgestone believes that over the past two years the proportion of
‘environmental tyres’ they sell has risen from virtually zero to 40%. Even better, these tyres command
“The defining moment this year for the renewable and nuclear industry was the Fukushima a 10% price premium.
nuclear crisis. With the crisis now under control, we expect a less emotional debate to
develop and for opportunities to emerge.” We therefore project a very healthy and growing market in 2012 for sustainable transport solutions.
Low-carbon fossil fuels Environmental Resources
Last year’s forecast: modest improvements in gas prices. The longer-term outlook for natural Last year’s forecast: the environment will remain supportive of high and rising agricultural prices.
gas to remain strong.
As in 2011, next year will see demand for agricultural produce continue to increase as the global population
2010 was a bad year for natural gas markets in the US and 2011 has been no different. We do, however, grows, and rising income in emerging markets prompts dietary changes.
have good reasons to be more positive in the longer term.
It is estimated that between 2001 and 2014 the global population will increase by 16% which will require
Regulations from the US Environmental Protection Agency on emissions will be enforced in the next two a 30% increase in grain yields to support this. While demand is increasing, available productive land is in
years, and are already impacting coal power plant retirements. The regulations threaten up to 30% of the decline, yield growth is declining and there is growing competition from the biofuel industry for feedstock.
US coal fleet with accelerated closure because of the economics of fitting older plants with new technology.
The changing climate is adding its own pressures. While yields have increased since 1980 due to improvements
Furthermore, the US gas market has not, until now, been able to participate in the export market. This is
in agricultural practices and plant breeding, the effects of warming have exerted a drag on improvements.
now changing, exposing the US to much higher global gas prices.
A 1ºC temperature increase above optimum lowers grain yield by 10%.
With US gas prices much lower than oil prices, and with gas becoming the preferred fossil fuel in most
Tight global inventories for many key crops therefore leave the agricultural system vulnerable to further
major economies, there is plenty of scope for rising demand to support prices.
disruption. As prices look set to continue to increase over time, this provides opportunities for investors
The picture in international gas markets is much more positive. Robust Asian demand for liquefied with exposure to the value chain of this sector.
natural gas (LNG) coupled with Japanese nuclear outages has pushed the LNG market back into balance.
Japan in particular has significantly tightened the global LNG market with what one would argue is a The views and opinions contained herein are those of Simon Webber and Giles Money, and may
recession-proof extra 9-10 metric-tons per annum of demand. This, coupled with supply disruption in not necessarily represent views expressed or reflected in other Schroders communications,
Australia, leaves us positive on seaborne LNG for 2012. strategies or funds.
“Fearful consumers, cautious companies and cash strapped governments have driven
structural growth in energy efficiency throughout this year given compelling returns.”
INVESTMENT PERSPECTIVES 2012
1.7 2012: A year in the global economy
Keith Wade Chief Economist and Strategist and Azad Zangana European Economist
Lessons of 2011
– Global growth is set to slow further in 2012 largely as a result of the euro The world economy is much more fragile than it used to be – a direct result of the 2008 financial crisis.
crisis. On the positive side, two factors should support activity in 2012. A lingering effect of this crisis is that borrowing is down and households are still trying to reduce their debts.
The first is a fall in inflation, which will support household real incomes When the world economy gets hit by a shock in this environment, be it an earthquake in Japan or a big
increase in energy and food prices, it has much more power to disrupt, pushing down growth and forcing
leading to stronger consumer spending. The second is the strength of the the economy closer to recession.
corporate sector; companies have stockpiled cash and built up profits. Before the financial crisis, central banks could respond to negative shocks and stabilise the economy by
– However, Europe is entering a serious recession and will weigh on growth cutting interest rates to boost borrowing and spending. The power of central banks has been drastically
elsewhere. Euro policymakers should redouble their efforts to find a reduced and without this stabilising effect, growth is more vulnerable to shocks. Commodities play a much
more important role now than they used to, as do governments. We have seen a shift in power from central
solution to the eurozone crisis: make the EFSF viable or get external help. banks to politicians, and fiscal policy and regulation have much more of an impact on markets now than ever
QE is probably the lesser of two evils when compared to a euro break-up. – something that’s not necessarily a positive thing.
– The two places where investors will find value are in the credit markets, Politicians, especially European politicians, with opposing ideas and backgrounds, really have struggled to
particularly in the US high yield market where companies are in quite strong come to any real type of agreement on how the eurozone crisis can be resolved. There’s been a growing
conflict between the weaker peripheral economies like Italy, Spain, Ireland, Portugal and Greece, who are
financial shape, and the equity markets, but on a very selective basis. opposed to more stringent austerity measures, and the stronger economies such as Germany, Austria and
the Netherlands who will have to pick up the bill when these weaker economies can no longer meet their
The story of 2011 has been one of gradual slowdown, initially, due to temporary factors such as the
Japanese earthquake and the pick-up in inflation resulting from rising commodity prices, which squeezed
real incomes and weakened growth. As we finally started to see more encouraging data from the US and Global growth prospects
Asia, a bigger problem emerged – the eurozone debt crisis began to spiral out of control. 2011 is coming to As we go into 2012, two factors should support growth. The first is a fall in inflation; this is already beginning to
an end with the eurozone heading into a serious recession in 2012 and facing a fall in GDP of 2%, something come through and will support household real incomes leading to stronger consumer spending. The second is
that is likely to have a knock-on effect on the wider European region, including the UK and to a lesser extent the strength of the corporate sector; companies have stockpiled cash, built up profits and are running surplus
the rest of the world. cashflow at a record rate of 3% of GDP. Business investment has been on the increase, albeit cautiously, with
a 17% increase seen in the third quarter of 2011 and we think this trend will continue. If the corporate sector
steps up job creation, something we have seen tentative signs of, then this will also help support growth.
Encouragingly, the US economy has started to show signs of growth, although we expect this revival to be
temporary given the deterioration in the eurozone, which will impact world trade in 2012. We also do not see
congress allowing much extension of this year’s fiscal stimulus. In response we expect the Federal Reserve
(Fed) to launch a third round of Quantitative Easing (QE) by spring 2012.
1 2012 OUTLOOK
Key risk to recovery
The two headwinds on global economic recovery are fiscal tightening and the euro crisis. As governments evidenced by the sell-off in peripheral bond markets. We are already seeing the early signs of a credit
try to get their budget deficits into better shape, a tightening of fiscal policy has been taking place globally. crunch, which will continue to evolve into 2012. A number of large eurozone banks are struggling to raise
This tightening will continue to have a negative effect on growth but it’s really a question of how the finances on the capital markets and are heavily reliant on liquidity from the European Central Bank (ECB).
economy reacts to that tightening. The second, and notably larger, risk is the uncertainty surrounding the The other major area of concern is the rate at which Italy continues to raise money, a rate that is
eurozone. If the eurozone, which represents a quarter of the world economy, goes into a prolonged unsustainable long term. By our estimation, Italy will need to raise €275 billion in 2012 to repay maturing
recession this will have a big impact on global growth. debt, interest payments and to pay for public services. Should Italy get into difficulty, the EFSF, standing at
“ We have seen a shift in power from central banks to politicians, and fiscal policy and regulation €250 billion, currently falls short and would need to be increased drastically in order to bail out a sizeable
have much more of an impact on markets now than ever – something that’s not necessarily a country such as Italy. It can continue to raise money from the markets at high interest rates while the ECB
positive thing.” can continue to buy Italian debt and try to cap yields. However, neither is sustainable and would certainly
lead to an almighty credit crunch.
Fiscal headwinds Either the eurozone continues along the current path (where Italy is likely to run out of funding options) or
Germany has to give way on QE. Giving the ECB unlimited firepower, in other words a license to print money,
2011 has been a very difficult year for the UK, with tax increases as well as spending cuts biting the real
should drive down bond yields. Germany has so far been against any QE, fuelled by worries that the
economy. We are expecting a 0.5% fall in GDP in 2012 as the UK heads into its second year of austerity.
eurozone will lose any remnant of fiscal discipline left within its peripheral member governments. In our view,
Although it should be less dramatic than we saw in 2011, fighting the fall-out from the eurozone crisis, which
a more likely solution will be support from the IMF along with some QE, which should stabilise debt markets,
will undoubtedly impact exporters and the banking system, ensures 2012 will be a bumpy ride. Tighter
especially for Italy, and should slow the pace of contraction in fiscal policy leading to a less severe recession
lending from banks will eventually feed through into the household sector, further fuelling the likelihood of a
than we currently expect.
recession in the UK. There are signs that the UK government is easing up a little, for example, it’s allowing
infrastructure projects to be brought forward, which should ease some of the pressure on growth. Thinking through these scenarios should make euro policymakers redouble their efforts to find a solution: make
the EFSF viable or get external help. QE is probably the lesser of two evils when compared to a euro break-up.
In the US, the debate between Republicans and Democrats about how much support to provide to the
economy is very difficult to call but at the present time it looks as though there will be a tightening of policy,
even though it’s an election year. Opportunities and threats
Across the eurozone there is a lot of fiscal tightening already built in. There have been changes in political One of the concerns that investors have at the moment is that China will suffer a ‘hard landing’. We don’t
leadership across most of peripheral Europe, most recently in Italy and Spain, so it’s very much a case of believe that’s going to be the case; inflation is now beginning to come down in China and that will relieve some
waiting to see what the new leaders do next, but certainly in the case of Spain, which has already embarked of the pressure on household incomes. We could see quite a strong slowdown in China’s property market but
on reasonable levels of tightening, there may not be too much more that can be done. the authorities are offsetting that by investing in affordable housing. Meanwhile, the rest of the Chinese
economy seems to be performing reasonably well, so we expect a slowdown rather than a ‘hard landing’.
“ We are already seeing the early signs of a credit crunch in the eurozone, which will continue to
evolve into 2012. A number of large eurozone banks are struggling to raise finances on the One thing that’s very clear is that interest rates are going to remain very low throughout the whole of 2012;
capital markets and are heavily reliant on liquidity from the ECB.” we don’t expect any rates rises from the Bank of England or the Fed in 2012. In this low growth environment,
investors are going to have to continue the search for yield. The two places where investors will find that are in
European debt crisis the credit markets, particularly in the US high yield market where companies are in quite strong financial shape,
and the equity markets, but on a very selective basis. Companies that are low beta, cash generating and
At the heart of the eurozone’s problems is the divergence between members; we are seeing a two-speed
paying strong dividends should offer attractive returns in 2012.
Europe where the core is faring reasonably well but the periphery is in recession. Greece is entering its third
year of recession and Spain and Italy are joining it, but we are no closer to seeing a resolution to the crisis.
The views and opinions contained herein are those of Keith Wade and Azad Zangana, and may
Markets’ initial reaction to the ill-fated rescue package announced on 27 October was positive, however as not necessarily represent views expressed or reflected in other Schroders communications,
events unfolded it became apparent that the door was, for the first time, left open for a break-up of the euro. strategies or funds.
With support from China jeopardised by Greek PM Papandreou’s calls for a referendum, the European
Financial Stability Facility (EFSF) was not increased in size and the eurozone has been unravelling since,
INVESTMENT PERSPECTIVES 2012
1.8 2012: A year in global equities
Virginie Maisonneuve Head of Global and International Equities
Adjusting to the ‘new normal’
– 2011 was the year when the European ‘party’ ended; whatever the One of the underlying causes of the crisis of confidence has been a reduction in global growth expectations.
outcome of the most immediate crisis facing the region, there is likely Tighter fiscal policies in the developed world are being employed to help deal with excessive debt and
to be fundamental change facilitate deleveraging. This is very much in line with the ‘new normal’ environment, in which developed world
growth is muted and emerging market growth is robust. This theme (‘Supercycle’) continued to influence the
– Global markets will continue to adjust to the ‘new normal’ where global global operating environment this year and, along with our other two key themes of climate change and
growth is shaped by deleveraging in many parts of the developed world demographics, will be just as instrumental next year.
and the impact of emerging market growth “ With companies postponing business decisions, the risk of a recession in Europe next
– The US election cycle in 2012 and the ability of China to manage its year increases.”
slowdown in growth will also be key to the global economy. Looking into 2012, we believe volatility will remain going into the first quarter of next year as the markets
gauge the resilience of the European and global financial system, and how it will cope with potential
It has been a momentous year for the world economy with events moving at a remarkable pace. additional shocks. There will be three main causes for the continuing volatility: first, the future of Europe;
Fragmentations in the world order have emerged along social and economic fault lines, and the second, the US elections; and third, the nature and effect of the slowdown in Chinese growth.
economic and political landscape looks markedly different from this time last year. At the same time,
the long-term trends that are shaping the global economy are as important as ever heading into 2012. A new age for Europe?
In Chinese ‘Wei Ji’ means both challenge and opportunity. 2012 will most likely be a ‘Wei Ji’ year!
Clearly, what happens in Europe will be key. The inefficiency of the political structures and implementation
2011: a year of sovereign weakness tools at the leaders’ disposal, as evidenced by several attempts by the EU to promote bail-out packages,
makes visibility extremely poor. Nevertheless, it is time for Europe to ‘find its way’ and deal with the
2011 was the year when the European ‘party’ ended. The problems created by having a monetary union economic consequences of unclear leadership.
without a fiscal union, compounded by strong structural divergence in the region, have unravelled. What was
hoped to be an isolated problem in Europe’s ‘periphery’ has spread to engulf the entire region in a crisis that Whatever the outcome of the most immediate crisis facing the region, there is likely to be fundamental
threatens the Eurozone’s very existence – in its current form at least. change, and possibly a new age for Europe. In Italy, at the time of writing as the new government under
Mario Monti is established, the yield on the government’s 10 year notes is fluctuating around the critical 7%
The burden of sovereign debt has not been confined to Europe. In July, political gridlock about raising the US mark. If the situation in Italy deteriorates further, given its size it will be a very strong test of the willingness
debt ceiling almost forced the world’s largest economy into a technical default and prompted S&P to strip the and ability of EU nations to remain united and moving – or not – towards a more integrated fiscal and
country of its coveted AAA rating. Although a deal was struck in time, the difficulty for politicians to lead in such political union. This will be the true test of the ‘faith’ that Europe has in itself.
an environment on both sides of the Atlantic triggered a damaging crisis of confidence in the fragile markets.
We cautiously expect Europe to carve a new path for itself: our assumption is that it will be a continuous
This crisis of confidence has developed despite the fact that, as we move into 2012, the corporate world is effort and that it will take time. We believe at this point that core-Europe has more interest in keeping the
in relatively good shape. Balance sheets are generally healthy among the large companies and cash flows shape of Europe close to what it is today, although we do not exclude the possibility of a ‘two-geared’
are strong. Unlike in 2008, 2011 has very much been a year of sovereign weakness, not corporate Europe. At this stage, though, there are no easy options.
weakness. However, because of the leadership problems on the global stage and with markets pricing in
a weak economic scenario, companies are reluctant to increase spending and start hiring. With companies “It is time for Europe to ‘find its way’ and deal with the economic consequences of
postponing business decisions, the risk of a recession in Europe next year increases. unclear leadership.”
1 2012 OUTLOOK
In any case, the path Europe takes will be paved with the consequences of deleveraging banks’ balance sheets In the developed world, by comparison, the tension between the need to promote growth and the pressure
and slow, if any, economic growth. This deleveraging will limit the ability for many corporations to access capital, to reduce debt, both at a sovereign level and a corporate level, will intensify. For example, in Europe, which is
especially for small and medium sized companies. While many European corporations are cash rich, the in danger of edging back into recession, the need for growth is clearly urgent but somewhat in contradiction
medium-term impact could lead to additional economic retrenchment if it persists. As banks delever in response with the spirit of the current European bailout package targeting fiscal austerity.
to regulatory pressures to bolster their capital positions, this task becomes all the more difficult.
Ultimately, a European solution should include quantitative easing, which might in turn invite a third round of Bright spots will emerge
quantitative easing in the USA and add to currency weakness in key developed markets versus a benchmark Over the last few months, fear has gripped the markets, as evidenced by a strong switch into low beta
like gold. If inflation remains tame, this is not a bad environment to ‘debase’ one’s debt and ‘invite’ a revaluation stocks in September. Given the headwinds and uncertainties facing the global economy, the volatility in the
of some key emerging market currencies. global equity markets will continue. But amid the challenges, there are important bright spots that we expect
to emerge in 2012.
“In the developed world, the tension between the need to promote growth and the pressure to
reduce debt, both at a sovereign level and a corporate level, will intensify.” We see many exciting opportunities for investors in global equities next year. Stocks are currently under-
owned and attractively valued. Furthermore, market volatility will create a stock-picker’s environment:
Political gridlock in the US investors with a medium to long-term focus will be able to find quality companies at very cheap prices.
While US elections are generally entertaining, the split between Democrats and Republicans (by which Japan is now coming back ‘on line’ as it recovers from the devastating earthquake and tsunami in March
we mean the Tea Party movement) has rarely been so sharp. This, in the run up to the November 2012 this year. This will be a boost to global GDP in itself, but equally importantly, it will ease the global supply
presidential election, could create a political gridlock and bring further volatility to the market. We can chain – the disruption of which has been a significant dent to US GDP.
expect to see discussions about the size of the budget deficit intensify as the election season gets going in The environment of slower growth over the next 12 to 18 months should also bode well for inflationary
full. The economic environment in the US, after a strong adjustment since the 2008 financial crisis, is faring pressures overall. It will ease political pressures in countries, especially in emerging markets, that had to
better than in Europe, with growing competitiveness and unemployment plateauing. While consumer maintain tight monetary policies over the past 12 months. This should support our Supercycle theme.
demand remains sluggish, inflationary pressures abating are marginally helping.
Long-term trends are more important than ever
China: when to turn the tap back on?
One trend we see developing that will create investment opportunities is in the area of global competitiveness.
Looking outside Europe, with global growth increasingly relying on emerging market momentum, China’s Some of our work is showing that the US is becoming increasingly competitive: large US corporations have
ability to manage its slowdown at a time of political transition will be as important for the wider global emerged from the financial crisis leaner, more productive and globally competitive, with some US
economy next year as ever. multinationals increasing production in the US.
The pace of growth in China has slowed, but not rapidly. While we are cautious about the short term, we do Given the pace with which macro events are moving currently, and in a world where social and economic
not think its economy will suffer a ‘hard landing’. The overall slowdown comes in response to the recent fragmentation is high, having a long-term focus becomes all the more important to ride out the short-term
sustained tightening measures that the government has used to cool the politically-sensitive rate of inflation. market fluctuations and take advantage of them.
Inflation has now started to fall which should clear the way for carefully targeted easing – especially in the areas
of lending to small and medium sized companies as they have suffered the most from the tightening measures. In our global and international equity portfolios, we maintain our focus on high-quality growth companies,
with visible and sustainable earnings, sound balance sheets and business models, as well as strong
“ We see many exciting opportunities for investors in global equities next year. Stocks are management teams. We continue to pursue companies which, irrespective of the short-term market
currently under-owned and attractively valued.” uncertainties discussed above, are benefiting from longer-term global trends and show strong global
Although the tightening has cooled down part of the economy, it has not had a significant impact on property competitiveness. These include companies benefiting from the mitigation of climate change, growth in
prices which have skyrocketed since the January 2009 stimulus plan. This has led to strong discontent among emerging market demand and demographic trends. These trends will continue to shape the global
many in the country. Furthermore, small and medium sized companies are feeling the crunch of the tightening economy throughout 2012.
policies. Finally, with Europe as its largest trading partner, China is concerned about the potential impact of The views and opinions contained herein are those of Virginie Maisonneuve and may not
the European crisis. With a new leadership team coming in 2013, the current government has the delicate necessarily represent views expressed or reflected in other Schroders communications,
task of fine tuning the shift away from tightening policies but not re-igniting property price increases. strategies or funds.
INVESTMENT PERSPECTIVES 2012
1.9 2012: A year in global property
Jim Rehlaender Global Property Securities Fund Manager
Where are we now?
– There is generally a short supply of ‘bricks and mortar’ property In 2011, markets have been driven almost entirely by perceptions of major macro-economic issues: the pace
investments, while demand for real estate assets by private equity investors of economic activity in the US, the extent to which China is able to engineer a soft rather than hard landing
and institutions remains strong and – above all – the ongoing eurozone debt crisis. The result has been an environment of ‘risk on’, ‘risk off’
market moves, growing risk aversion and a decline in trading volumes. The ride down over the past 12
– These fundamentals are far better than property share prices suggest, months has been disappointing but we believe it will reverse for three key reasons. Firstly, the market
which heavily discount macro-economic headwinds has become ‘over-shorted’ and any turn in market sentiment will force a sharp rally to cover the borrowed
shares. Secondly, property markets are generally in short supply of product, and demand for real estate
– Politics are going to be the dominant theme, particularly in the first half of assets by private equity investors and institutions remains strong. And finally, companies have managed
2012. Any resolution to the current European sovereign debt crisis would their capital much more effectively than they did in 2008 and are well-funded to take advantage of current
be an obvious upward trigger for the global property sector.
Macro-economic concerns mask a stellar property
Today, the disparity between direct property market fundamentals and property securities is as wide as it investment environment
has ever been. The current rate of bricks and mortar development is insufficient to satisfy even moderate
demand levels. Such looming shortages of space would usually lead to potential upside in property-related The critical issues today for the property sector are largely at the macro level, as property markets around
share prices, but this has not happened as equity markets have been solely driven by the macro picture. the world are generally in good shape. Many of our key markets will soon be suffering from a lack of supply
Outside of the US, property securities are oversold by 20% to 30%. We are optimistic that the current as banks and other financial institutions avoid the sector, which greatly impedes the ability of developers to
overriding macro concerns will diminish over the next six months therefore allowing property securities supply current and prospective demand. In addition, investor demand for property has far outpaced supply
to re-rate to more reasonable discounts to net asset value (NAV). and prices have recovered quickly from the lows of 2008. Market fundamentals are far better than property
share prices would suggest, as equity prices heavily discount macro-economic headwinds. In fact, if one
could ignore the media, one would discover an investment environment that is the best it has been in many
years in terms of quality of properties, realistic return assumptions and well-capitalised owner/operators.
1 2012 OUTLOOK
Asia: China and Hong Kong poised to rebound UK: London residential market defies gravity
Low volumes and shorting have exaggerated negative price moves worldwide in 2011, but nowhere has this The residential property market in London remains very strong. London has become the city of choice for
been more pronounced than in Hong Kong and China. Average leverage for property companies in Asia is international investors and it continues to benefit from flight capital. This is great for people who own and
around 20% – lower than in Europe and the US – whilst property share prices trade at an average 50% want to sell, but not so great for those trying to buy. As a result, the average age of a first-time buyer in
discount to NAV. Despite operating in solidly growing economies, the value gap between share prices and London is now 42: this is our primary concern regarding the London market because it means that it is
property company fundamentals is as wide as it was in 2008. In 2009 the value gap was recovered within expensive for businesses to grow and hire staff. On the other hand, London has become the clear winner in
six to nine months after the lows and, albeit assuming the resolution of macro headwinds, it will not surprise the battle to be the primary global financial centre. All of our holdings have reported great numbers in 2011
us to see material positive moves to return to more reasonable discounts to NAV. Recent moves by the – in fact things could not have been much better. There are also legislation changes in the pipeline that, if
Chinese authorities (reducing the Reserve Requirement Ratio by 0.5% in November) signal a reversal of the passed, could make London the trading centre for the European REIT universe. These positives offset our
government’s tightening stance and support our positive view. While we are not expecting the 100% jumps concerns and we remain overweight London.
that we saw in 2008, there is strong potential for significant share price recoveries.
“ While we are not expecting the 100% jumps that we saw in 2008, there is strong potential for
“If one could ignore the media, one would discover an investment environment that is the significant share price recoveries.”
best it has been in many years in terms of quality of properties, realistic return assumptions
and well-capitalised owner/operators.”
US: a safe harbour
Property company fundamentals have vastly improved since 2008. Companies have recapitalised and
Europe: opportunity in an unfashionable region dividends are well covered. Regulations require US REITs to increase their dividend payments by 10-15%
Any resolution to the current European sovereign debt crisis would be an obvious upward trigger for the in the coming year. A dividend yield of 4% from US REITs compares very favourably with 2-year US
European property sector, which is currently trading at an average 25% discount to NAV on a 5% dividend Treasury yields of 0.22%. This factor will continue to support US REITs in 2012.
yield. Our NAV calculations are conservative and assume no rental growth for two years, no economic
Whilst there is only modest upside in the US market, US REITs are a solid safe harbour for the moment
recovery, and ascribe no value for development or re-development. Given that our favoured companies
and provide a decent source of income. With a 4% dividend yield and 4-6% capital appreciation we
are running at a vacancy rate of 4-5% we do not assume a loss of tenants, but we also do not assume
project an 8-10% return over the coming year.
any growth. In contrast to 2008, there is significant transaction data to support our valuations. Moreover,
there is abundant private equity and institution capital waiting on the side lines; it is hard to find good deals
and investors must pay up if buildings are fully leased. We project a one year return of up to 20% from Health warning
European property securities as they recover the lost ground that has been oversold.
Such positive return forecasts must come with an inevitable health warning. Fears of a European collapse
have been responsible for the bulk of the pressure on property securities in 2011. If the acceleration in the
“ We are optimistic that the current overriding macro concerns will diminish over the next six
eurozone debt crisis is not arrested and banks lose confidence in one another then we are back to where
months therefore allowing property securities to re-rate to more reasonable discounts to net
we were in 2008. In Europe a structure that will save the euro and keep the region from falling back into a
potentially dire recession is vital, as failure would have serious repercussions around the globe. It follows
that the largest risk to our predictions is that the situation deteriorates before its get better.
The views and opinions contained herein are those of Jim Rehlaender and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
1.10 2012: A year in Japan
Shogo Maeda Head of Japanese Equities
Valuations at multi-decade lows
– The market is trading at a multi-decade low, and valuations look more Attractive valuations seem to be a recurring theme in many markets at the moment. The case for Japanese
than attractive, short-term economic dynamics are improving and public valuations is particularly strong; if we benchmark overall market valuations to after the Lehman collapse in
2008 and 2009, Japan is discounting quite a pessimistic scenario. We believe that this leaves potential for
investments are flourishing
a re-rating to come through in 2012.
– In addition, supply chains are improving and enhancements from In addition, we are hopeful that 2012 will be a year where some of Japan’s competitive global industries,
production and public expenditure will provide a stimulus for 2012 such as autos and electronics, will really take the spotlight and generate positive returns for shareholders.
– However, concerns over the macro environment such as the yen, politics,
nuclear power and the global economy remain Corporate fundamentals
The earthquake and the subsequent problems, such as the rising costs of energy and higher taxes,
– Nevertheless, as we say goodbye to a traumatic year for Japan, we will accelerate the shift of Japanese companies’ overseas. Over the past ten years, Japanese companies
look forward to taking advantage of the attractive valuations in 2012. have been steadily increasing the proportion of capital expenditure abroad at the expense of domestic
investment. These investments have been fruitful and the Asian business grew to account for over a
quarter of total earnings in 2010 for large industrial companies. A growing number of firms have become
2011 has presented Japan with more than its fair share of trauma, particularly the devastating Tohuku committed to broadening their operational sphere into rapidly growing emerging markets, particularly in
earthquake in March. Prior to this, returns were quite respectable for the Japanese stockmarket. However, China and Southeast Asia. At the same time, Japanese firms have consistently reduced financial leverage
events were unexpected by all. No one expected to see the market flirting with its level of 30 years ago, and and its net debt-to-equity ratio is currently below 0.5% – or about half its level ten years ago for the 400
investors certainly did not anticipate a one-in-a-thousand year earthquake, a nuclear leak, flooding in Thailand large listed companies in the NRI400 index (by the Nomura Research Institute). Free cash flow has been
which has caused supply chain issues and disrupted production, or such prolonged agony in the eurozone. used to raise dividends and buy-back shares. Despite the instability in global financial markets, the three
So where do we go from here? Well, they say “when you think you are down, smile, because the only way is largest banks are expected to report near record-high earnings for the current fiscal year. Recognising
up” – and there are many factors which indicate this. The market is trading at a multi-decade low, so valuations that the global backdrop has indeed deteriorated over recent months, creating greater uncertainty over
look more than attractive, short-term economic dynamics are improving and there will be an increase in public the earnings outlook in 2012, overall company fundamentals are solid and deserve much better valuations
investments over the coming few years. However, a number of uncertainties in the macro environment in than those currently given.
2012 remain, such as the yen, politics, nuclear power and the global economy. But, as we say goodbye to a
traumatic year for Japan and welcome the New Year, we seek to take advantage of the attractive valuations.
1 2012 OUTLOOK
Public investment Nuclear power
The outlook for public spending is a very positive one. Supplementary budgets – extra funding by authorities The nuclear power issue is one that is unique to Japan, and could perhaps pose a risk. Pre-Fukushima,
to stimulate growth in the Japanese economy – will bring quite a large boost to public expenditure over the nuclear power was close to a third of total electricity generation. That third is comprised of 55 reactors, only
coming quarters, and part of the budget will be used to keep the yen’s price in check. So far we have had 20% of which are currently operational. Some of the 80% that are not being used were impacted by the
two budgets, and we are about to have a third. About this time next year we expect that the boost from earthquake or the tsunami, but the majority have undergone regular inspection and have not been restarted
public expenditure will peak, and enhancements from production and expenditure will provide a stimulus, because of opposition from local governments. The 20% that are working are due to be inspected between
almost independently from what is happening elsewhere. This is great news for Japanese investors. now and spring next year. In the worst case scenario, if those 20% are shut down for maintenance and do
not restart, there will be extreme supply problems. This is a risk which we must bear in mind for 2012;
The yen however it is a worst case scenario and Mr Noda seems to be more pragmatic in how he is approaching
the issue which should work in the country’s favour.
The yen is a depressant and continues to rise as we draw closer to 2012. However, this cannot be construed
as a new challenge for Japan and it can be overcome. Global and Japanese export volumes usually track The views and opinions contained herein are those of Shogo Maeda and may not necessarily
each other quite closely; at the time of the Lehman collapse, global and Japanese export volumes went in represent views expressed or reflected in other Schroders communications, strategies or funds.
the same direction but Japan’s fall was much more rapid. This time round Japanese exports have fallen off a
proverbial cliff but global exports have not, which is a very clear indication that the issue is to do with supply
and not demand. As run down industries such as auto manufacturing and consumer electronics are rebuilt,
we are almost guaranteed a few very strong months of production, almost irrespective of what happens to
Considering the revolving door of Japanese Prime Ministers, typified by the 12 living former leaders, it is
easy to fall into the trap of treating politics in Japan as a trivial matter. But politics are crucial in terms of
confidence in the economy. While Mr Noda, who replaced Mr Kan in August 2011, has taken a conciliatory
stance in managing the relationship with opposition parties, some of the fundamental issues remain
unresolved. This leaves a mixed forecast for 2012 however; we are encouraged by Mr Noda’s recent
initiative to start the negotiation for Japan to join the multi-national free trade framework known as the
Trans-Pacific Partnership, despite strong opposition from some of his own party members.
“ We are hopeful that 2012 will be a year where some of Japan’s competitive global industries
will really take the spotlight and generate positive returns for shareholders.”
INVESTMENT PERSPECTIVES 2012
1.11 2012: A year in the UK
Richard Buxton Head of UK Equities
The macro environment still dominates
– The biggest driver of returns next year is likely to be a positive uplift in risk Although investors hope that 2012 sees the fading of such dominant macro influences in favour of
assets as and when the acceleration in the eurozone debt crisis is arrested stockpicking, it is likely only to be some lessening of the macro uncertainties that will provide the initial
catalyst for greater dispersion of returns within the market. As the eurozone sovereign debt crisis has
– We do not expect a severe contraction in UK economic activity – but more deepened, the likely outcomes have become increasingly binary, hence the reluctance of investors to
of the same: growth effectively flat prejudge the outcome. So subdued has investor sentiment become that any sense that the slow motion
and self-fulfilling run on confidence in European banks and sovereign states is arrested will provoke an
– From today’s valuations the next ten years should provide double-digit real extreme positive reaction in markets.
returns, despite the economic headwinds we face.
No support from earnings revisions…
Throughout 2011 equity markets have been either ‘risk-on’ or ‘risk-off’ – driven solely by the macro picture. Looking at it another way, in 2009 and 2010 the market was buoyed by strong upwards revisions to
The eurozone debt crisis has dominated, putting severe pressure on risk assets. So subdued has investor corporate earnings estimates as growth picked up and benefits of cost reductions flowed through into
sentiment become that any sense of a resolution to the self-fulfilling run on confidence in European banks and profits. In 2011 this support fell away, as earnings met, rather than beat, expectations. Right now, as
sovereign states will provoke an extreme positive reaction from equity markets. expectations for UK and global growth continue to recede, it is probable that earnings forecasts for 2012
remain too high and the next few months will see a continuation of recent downgrades to profit
Of course the market also faces broader headwinds: the fallout from the financial crisis is likely to be with us
expectations. There will be no upward pressure from this market driver.
for several more years as banks continue to deleverage and economic growth remains lacklustre. However,
irrespective of the environment we face over the next 12 months, quoted corporate Britain is in good shape.
Balance sheets are healthy, margins are good, returns on capital are attractive and dividends are rising again. …nor from liquidity
Meanwhile, fund flows into equities slowed throughout 2011 and have now gone into reverse. Inflows are
Risk on, risk off likely to pick up again only when the situation in Europe looks more assured. More positively, monetary
policy tightening is unlikely to be a negative headwind in 2012 with both the US Fed and the Bank of England
In 2011, markets have been driven almost entirely by perceptions of major macro-economic issues: the pace
signalling no such move until well into 2013 – or whenever economic growth is strong enough to withstand
of economic activity in the US, the extent to which China is able to engineer a soft rather than hard landing
it. On the contrary, expect more quantitative easing from the Bank of England in 2012.
and – above all – the ongoing eurozone debt crisis. The result: an environment of volatile ‘risk on, risk off’
market moves, increasing correlation between asset classes, growing risk aversion, an unwillingness by
investors to adopt extreme positions and a decline in trading volumes. Sentiment is all
The only immediate driver of equity returns in 2012 is any rerating of the market resulting from a positive
“If the clouds over Europe lift, the scope for positive returns in 2012 is high.”
resolution to the uncertainty surrounding Europe and the survival of the euro. Call it the equity risk premium
if you want to, or the elusive chimerical ‘investor sentiment’ if you prefer, but the biggest driver of returns
next year is likely to be a positive uplift in risk assets as and when the acceleration in the eurozone debt
crisis is arrested. As with any binary outcome, the reverse will also apply if this does not occur.
1 2012 OUTLOOK
UK economy to continue to flatline Health warning
UK economic activity was near zero in 2011. Some of the headwinds to activity such as this year’s VAT Such positive long-run return forecasts must come with an inevitable health warning. Previous extended
and direct tax increases won’t be repeated and falling inflation should relieve some of the squeeze on real periods of little real return from UK equities have lasted 13, 16 and 21 years, so we could face a few more
incomes. The Olympic Games and the Queen’s Jubilee should be modestly positive for activity. But public years yet of ‘good years, bad years – not much progress’. Given the headwinds to growth we face, this
spending cuts will still bite, with further public sector job losses just as the pace of private sector job creation seems highly plausible. Equally, whilst ten year returns from a 9x valuation have historically been very
is slowing. A recession in Europe, which looks unavoidable, will hardly be positive since it remains the UK’s positive, previous bear phases have typically ended on a price/earnings ratio of 6x. Again, it is easy to
biggest export market. On balance, we do not expect a severe contraction in activity but more of the same: envisage a further crisis in the next few years which does provoke a final lurch down in stockmarkets to
growth effectively flat, modestly either side of zero. In other words, a sluggish environment that feels generationally attractive valuation levels.
recessionary irrespective of whether the statisticians tell us that it is or not.
Corporate health supportive for 2012
Debt reduction and bank deleveraging – long-term headwinds Finally, it is worth emphasising that irrespective of the sluggish environment we face in 2012, quoted
Whilst we do not envisage a sharp contraction in the economy in 2012, it is important to remember three corporate Britain is in good shape. Balance sheets are healthy, margins are good, returns on capital are
years on from the financial crisis of 2008 that its shadow will hang over us for several more years yet. attractive and dividends are rising again. Many companies do have growth opportunities outside the UK in
History suggests at least six years is needed for banks to work out losses from previous crises – and this is faster growing geographies such as Brazil or Singapore, or in industries such as power and energy. If the
the biggest yet. Irrespective of one’s view on the wisdom or long-term consequences of tackling a problem clouds over Europe lift, the scope for a rerating driving positive returns in 2012 is high despite the difficult
of too much indebtedness in the Western world with central bank money-printing, it is clear that what has outlook for the UK economy.
been called the post-war debt supercycle has reached a turning point. Governments, banks, individuals and
nation states are having to retrench and this means economic activity will be low. As a result, growth is more The views and opinions contained herein are those of Richard Buxton and may not necessarily
vulnerable to shocks and, with regret, short-term equity returns will remain volatile and subject to ‘risk on, represent views expressed or reflected in other Schroders communications, strategies or funds.
risk off’ shifts in mood.
Valuations extremely supportive for long-term investors
After over a decade of no capital return from investment in the UK equity market, investors are
understandably disillusioned. But ten years ago the market stood on a price/earnings ratio of 24x. Today,
it trades at a valuation of 9x earnings. Crucially, starting valuations are the key to future returns – not the
economic backdrop. From a 24x multiple ten years ago, one would have struggled to make money from
equities even if the macro-economic environment had been a panacea. If history is any guide, then from
today’s valuations the next ten years should provide double-digit real returns, despite the economic
headwinds we face.
“Ten years ago the market stood on a price/earnings ratio of 24x. Today, it trades at 9x.
Crucially, starting valuations are the key to future returns – not the economic backdrop.”
INVESTMENT PERSPECTIVES 2012
1.12 2012: A year in UK and
European corporate bonds
Adam Cordery Head of European and UK Credit Strategies and Sarang Kulkarni European Credit Fund Manager
What does this tell us about credit in 2012?
– Risk assets are stuck in a doom-boom cycle – There are clearly more uncertainties in the UK and eurozone today than there ever were in the past,
– There are clearly more uncertainties in the UK and eurozone today than and they are closer to home
there ever were in the past, and they are closer to home – Sentiment will be the key short term driver, rather than fundamentals, and is likely to shift frequently
– Liquidity will be abnormally low and volatility will be abnormally high in 2012, and as fund managers,
– Sentiment will be the key short term driver, rather than fundamentals, we will need to make this work for us and not against us.
and is likely to shift frequently
Our outlook for 2012 is characterised by more questions than there are answers.
– Liquidity will be abnormally low and volatility will be abnormally high in 2012.
We have laid out many of the relevant questions below. Many of these questions are highly political issues;
the answers will be determined by politics, and the nature of politics means we have little chance of coming
Risk assets are stuck in a doom-boom cycle at the moment. The natural dynamics of the political up with definitive answers in advance.
process drains market confidence and creates more fear and speculation than normal about the
health of the real economy. For us, the challenge for investment in 2012 will be to invest well in an environment in which the range of possible
outcomes is far greater in number and far harder to identify and quantify than we have been used to in the past.
What can break the cycle? The UK and Europe of 2012 will probably not be the UK and Europe of the decades up to 2007, and in 2012
more than ever the ability to make decisions in the midst of genuine uncertainty is the skill that will be tested.
– A co-ordinated sovereign bond buying programme could contain bond yields, but may or may not
prevent weak growth. It would, however, give the market confidence that the weaker sovereigns will
be supported as they work their way through their debt burdens Sovereigns
– The lack of liquidity may indeed force investors to take longer term views, and low yields in core 1. Cycle of downgrades: As yields rise, funding becomes more difficult and this leads to downgrades and
government bonds and cash may eventually push them in to risk assets, including corporate bonds, higher yields. Could a credible bond buying programme address this?
or at least slow down the pace of selling 2. Austerity plans: Austerity plans have been approved in most countries, and deleveraging is going to be
– If there is an acceleration of the sell off, prices may then better reflect what investors see as the possible a very slow process, particularly with low growth. Would the stronger economies force austerity at the
worst case outcome, and risk assets may see greater demand. expense of growth?
3. ECB Buying: The ECB’s buying programme always has a positive effect on the market, even though the
It seems like investors are currently hoping for the first option, preparing for the third and resigning ECB is a reluctant buyer. The ECB’s proposed limit of €20 billion a week is large enough to meet all of
themselves to the second. Italy and Spain’s refinancing needs for next year. Can the ECB be persuaded to do more?
4. EFSF: The EFSF is the closest we have come to a eurobond, however the market disagrees and the
EFSF remains unfunded. Could this be the vehicle for greater international co-operation where the US,
China and others buy EFSF bonds?
1 2012 OUTLOOK
5. Eurobonds: The current willingness and ability to launch a eurobond are limited, even though this quasi 1. Earnings: Estimates for future earnings remain relatively optimistic, equities seem priced for a
transfer union is what may be needed. Would the treaty change proposed in the mini summit bring moderate recovery, so a profit recession would drive prices down. P/E ratios are approaching
greater fiscal accountability, which may make Germany open to the idea of a eurobond? cyclical lows. Do corporates have the flexibility to cut costs, having done so aggressively in 2009?
6. Greece: Greece will impose losses on private sector bond holders and may continue to generate 2. Balance sheets: By and large balance sheets are pretty robust, with the ability to meet short term
negative headlines. Is this yesterday’s story? Or is the issue of Greece’s exit from the EZ/EU going to rise liabilities as they fall due. With large cash balances, would corporates see debt/stock buybacks as
up and create further chaos and disruption? the most effective use of cash?
7. Italy/Spain/France: New governments in Italy and Spain have done little to contain yields yet. 3. Ratings: Although most corporates have robust balance sheets, ratings may come under pressure
Domestic demand should be strong but there may be limited demand from the international community if the sovereign gets downgraded. Most European corporates are geographically diversified.
for these countries’ bonds. Would year end rebalancing and profit taking cause a rally, as these names Can corporate ratings decouple from sovereign ratings?
are large parts of benchmarks?
8. Ireland/Portugal: Implementation of austerity plans seems to be on track, though they are not yet able Banks
to access markets independently. Would a successful resolution of Ireland/Portugal serve as a workable 1. Funding/Liquidity: Central banks, deposits and natural deleveraging are continuing sources of funding.
template for the larger countries? Is the ECB likely to reduce liquidity to the banking sector when markets are impaired?
9. USA: Another downgrade may be possible if the budget process drags on. The US does not seem to be 2. Capital: There are concerns about their ability to raise capital for the June 2012 deadline set by
actively addressing the extent of its sovereign debt, but there seems to be plenty of demand for it. Would the the European Banking Authority, but most banks have plans in place. With the equity markets weak,
US launch the next round of quantitative easing (QE3) and possible QE4, QE5 etc if a recession threatened? will banks have enough options to avoid sovereign bail-outs?
10. UK: Right place, right time! Deleveraging plans need speeding up, but opposition is growing. Current 3. Profitability: With trading profits and commission income falling, and charge offs rising (but that may be
plans seem to be focused on using the balance sheet strength to promote growth. Can the UK decouple mitigated by some sort of forbearance), bank profitability may be under pressure. Will any bank be able
from Europe? Or is it just being given the benefit of the doubt for now? to survive if the EU stops supporting the sovereign bond market?
11. Euro breakup: A breakup could mean default for some sovereigns and their banks, but could solve the 4. Liability Management Exercises (LMEs): Spreads on subordinated bank bonds have reached a level
over leveraging problem overnight. Hence, international support for individual sovereigns may be lacking where it’s now attractive for banks to buy back their own debt and book a gain. Could LMEs take away
until the issue of the euro is resolved. What would it cost a weaker sovereign to leave the euro? the selling pressure on subordinated bank bonds?
12. The new Deutsche Mark: It would be the world’s safe haven currency, making German exports 5. Ratings: Ratings may come under pressure as the agencies modify their methodology to remove the
uncompetitive. Can Germany afford to leave the euro? ratings uplift from sovereign support. Would a wave of downgrades spur banks to do more LMEs?
The Economy Market Dynamics
1. Growth: Expectations of growth are being lowered to reflect the impact of the sovereign crisis. Does a 1. Demand for risk assets: Uncertainty will reduce demand for risk assets up until the time when
protracted period of low or no growth necessarily lead to a deep recession? valuations reflect the worst case scenario, or until the need for returns start overriding fear. How wide do
2. Inflation and base rates: Output gaps remain large and commodity prices are coming off their highs. spreads have to go to push investors from government bonds into corporate bonds?
Base rates are to stay low over the medium term. As low inflation or even the risk of deflation arises, how 2. Liquidity: Highly institutionalised markets such as corporate bonds will suffer from a lack of liquidity as
long will the ECB remain a reluctant dove? all counterparties work to a shorter investment horizon and intermediaries continue to reduce risk limits.
3. Money supply: The velocity of money will remain low until central banks find a way of bypassing the Is ‘buy and hold’ the new style of active management?
banks and getting cash directly to borrowers. Can more schemes like the UK’s Credit Easing improve 3. Valuations: High yield is already pricing in three quarters of the credit losses suffered in the worst five year
the access for corporates? period in history (the second leg of the Great Depression). Investment grade credit spreads are consistent with a
4. Employment: Will remain under pressure, particularly with public sector retrenchment. Wage growth mild recession but are not yet pricing in a 2008 type scenario. However, the correlation between equities and
will be subdued as a result, making Europe more competitive. Can falling wages in G7/EU bring more credit makes credit vulnerable if earnings disappoint. Can investment grade, high yield and equities decouple?
production and services onshore?
The views and opinions contained herein are those of Adam Cordery and Sarang Kulkarni
and may not necessarily represent views expressed or reflected in other Schroders
communications, strategies or funds. 35
INVESTMENT PERSPECTIVES 2012
1.13 2012: A year in US bonds
David Harris Senior Portfolio Manager – US Fixed Income
– ‘Value versus volatility’ sums up the conflicting goals of bond managers in The first factor is the broad recognition that debt expansion will not be the large driver of economic growth
2011, and 2012 should be similar in many respects as it has been for the past several decades. The 2008 financial crisis forced corporations and then
consumers to tighten budget belts. Federal and local governments picked up much of the slack at first,
– We still see good value in corporate bonds and some securitised sectors enacting a whole host of spending and incentive measures to jump-start growth with the expectation that
– Treasuries, and most government bonds in general, are unattractive as past patterns of consumption and job growth could be coerced. Whenever growth softened too much,
it seemed the government would be there to provide support.
anything except a safe haven vehicle
The first serious blow to this view came this summer when very weak Q2 GDP of just (1.0%) was released
– We will continue to invest in strategies based on our fundamental research, along with revisions to Q1 that removed nearly all forward momentum (GDP revised from 1.9% to 0.4%).
but to often express these views in smaller scale to reduce the impact from That this news came on the back of substantial fiscal and monetary stimulus, stimulus that was set to expire
adverse market movements. in the coming months, was most disappointing. That it was released during the heat of the contentious,
and now famously derisive, federal budget debate rammed home to optimistic investors that government
support would not be riding to the economic rescue any time soon; at least not with the same force
‘Value versus volatility’ pretty well sums up the conflicting goals of bond managers in 2011, and 2012 of past stimulus packages. Any doubts were put to rest in late November when Congress failed to reach
should be similar in many respects. There is enormous uncertainty facing investors next year and many of any agreement at all on a near-term stimulus package in exchange for longer term spending cuts or
the factors that prompted sometimes violent price changes this year are set to continue in the new year, revenue improvement.
and a new group of catalysts will join the list.
What this means for the US bond market is that economic growth faces a formidable headwind in
Questions about fragile economic growth in the US will be accompanied by even more contentious political reduced government expenditures, even if a last minute stimulus package is produced for 2012. Between
debate on what, if any, combination of tax reform and spending rationalisation might control the US federal 2008 and 2011 the surge in government spending has effectively offset the increase in consumer savings
budget deficit, and this will no doubt be complicated further by the November presidential election. and reduction in corporate leverage, holding gross national debt about constant, but at the expense of
Consumer finances in the US remain fragile, with many households still squeezed by low job creation, stronger growth.
negligible wage growth and a housing market still searching for a bottom. European growth is headed for
recession and the chance of the downturn spreading to North America via the financial system will be a “There will be plenty of opportunity to generate good returns as long as short-term market
large risk for early next year. disruptions are accepted as another source of adding value and volatility does not cause
investors to discard their fundamental research.”
But beyond the attention to economic trends, there are two new factors that came to the forefront in late
2011 and which are set to influence investments throughout 2012. Indeed, it appears the collective bond
market had a series of epiphanies in Q3 that should frame investment activity for some time to come,
and these factors are by no means isolated to the US.
1 2012 OUTLOOK
Will 2012 be different? Investment themes for 2012
Can we expect a different dynamic for 2012? There are some reasons to be optimistic. Consumers have Our investment themes still point to good value in corporate bonds and some securitised sectors.
built up a small savings cushion to dip into, up from around 1% in 2005 to 5% at the beginning of 2011, For US portfolios, the lower end of investment grade and the upper end of high yield, the BBB to BB rated
though the overall savings rate is still very low in comparison to all but the last decade. Job growth should area, offer the best combination of yield premium, credit improvement and spread tightening potential.
also pick up as cost cutting has left businesses with little room to expand without more hiring. Job gains
Allocations into similarly rated emerging market corporate bonds are also attractive. Industry and security
are still likely to be modest compared to the number of jobs lost during the downturn, and cost pressures
selection within corporates will continue to emphasize businesses with positive free cash flows and
will remain fierce and upward wage pressure will also be weak.
management taking a prudent approach with company finances. With so much uncertainty the margin of
On the whole, the structural impediments that have held back growth during the last few years – consumer error for companies is thin too.
debt, housing, business cost pressures – are past their worst but are largely still in place, and are now
Within mortgage backed securities (MBS), low coupon GNMA-issued securities offer very good yield with
accompanied by serious fiscal headwinds. While there is plenty of evidence to support our long held view
low refinancing risk. Better yet, they are relatively immune from manipulation of refinance programs and
that economic growth will be historically very weak, the imbalances that are often a precursor to recession
credit availability, and so are a good stable alternative to low yielding government securities. Non-agency
are not present, so a dip into negative growth is not part of our base case for next year. That said, the
securitised issues may play a larger role next year, though only after there is better certainty on the policy
margin for disappointment is so thin that recession remains a significant risk.
front. Municipal securities, often overlooked by many investors, may also provide good value next year as
state and local governments move to address fiscal issues at different paces. Treasuries, and most
Politics trumps fundamentals government bonds in general, are unattractive as anything except a safe haven vehicle. Low yields offer
The second factor the market’s been introduced to of late is that political policy pronouncements will little protection of a serious policy error or loss of confidence in the US.
often trump economic and credit fundamentals. As with the realisation about the impact of deleveraging
on growth, summer 2011 proved a watershed period. In addition to the US budget debate, European Portfolio strategy
policies meant to contain the escalating European debt crisis dominated headlines during the summer.
While the net outcome has been, and will likely be, more government bond purchases and various forms of As for overall portfolio strategy, we are not abandoning our longer term themes because of the uncertainties
austerity to curtail deficits, the regular shifts in official policy and constant speculation about the next shift created by more creative fiscal policies or the rapidly changing political landscape. Instead, we recognise
has overwhelmed the economic impact. Even as it now appears a more lasting solution may occur in 2012, that the persistence of these factors next year will keep markets much more volatile than normal but that
Europe should be a very large source of uncertainty and volatility next year. investment opportunities will abound. There will be a trade-off between expressing a strong view based on
long-term value and the need to preserve portfolio principal against the potentially violent short-term swings
Adding to the US and European debt policy are the many more localized policy changes meant to help that come as unintended consequences of otherwise well-meant policy changes.
stimulate growth but which distort the investment landscape. One of the better examples is in the mortgage
market where amendments to the HARP (Home Affordable Refinance Program) have combined with the Our response is to continue to invest in strategies based on our fundamental research, but to often express
Fed’s existing and possible future quantitative easing programs to overwhelm the importance of these views in smaller scale to reduce the impact from adverse market movements. We will often seek out
fundamental drivers of value. complementary strategies that may provide lower correlation or act as hedges during periods of higher
volatility. Also, policy-driven deviations will themselves create frequent opportunities for shorter term
A special comment should be reserved for monetary policy which has been unconventional for more than strategies that take advantage of temporary dislocations and balance longer term strategies.
two years. Further quantitative easing is very much still on the table for next year if growth falters and other
changes such as amendments to inflation targeting language are possible. That said, monetary policy will Given the economic and political uncertainty next year, 2012 has the potential to be at least as frustrating
continue to seek to offset the effects of fiscal drag, though we do not expect a meaningful boost to growth for bond investors as 2011 was. But there will be plenty of opportunity to generate good returns as long as
and unintended consequences such as inflation need to be monitored closely. short-term market disruptions are accepted as another source of adding value and volatility does not cause
investors to discard their fundamental research. Prudence dictates finding the right balance between the
two: ‘Value versus Volatility’.
The views and opinions contained herein are those of David Harris and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
1.14 2012: A year in the US
Joanna Shatney Head of US Large Cap Equities
Looking back at 2011
– US companies should provide modest earnings growth even in a difficult The US had its fair share of negative attention in 2011. However, despite a 20% correction mid-year, the
macro backdrop. Our base case reflects modest revenue and margin market has muddled through the increasing risk of recession, the pending constraints of federal spending
cuts, political wrangling, a debt downgrade and the European sovereign debt crisis – and is currently trading
expansion, but if economic growth proves more challenging, we expect
around 5% below its 2011 starting point.
capital redeployment to protect total return
The correlation between individual stocks’ performance in 2011 has been near record highs, as concerns
– Valuations are low relative to history – other developed markets might be over the macro-environment have prevented a more discriminate focus on company fundamentals. While
cheaper, but carry higher risk and companies have fewer levers to pull if 2012 – an election year – could be riddled with worries about ‘more of the same’, there are positives on the
corporate front, and we expect moderate earnings growth against low expectations.
economic challenges worsen
While we recognise the macro challenges that lie ahead, we are hopeful that investors will begin to focus on
– Instead of just focusing on macro events, we are hopeful that fundamentals the companies with strong fundamentals and attractive valuations, allowing the market to finally break out of
will prove strong enough to break the correlation story of 2011 the correlation story of 2011.
– Relative to other developed markets the US is well-positioned for moderate
GDP growth and has longer-term competitive advantages. Moderate earnings growth in 2012 against low expectations
GDP growth expectations have been cut over the past several months, but US economic growth is still
expected to be strong relative to other developed economies. We believe that earnings growth of at least
US companies are well-positioned to drive earnings growth against a backdrop of uncertainty in 2012, as 5%-10% is the most likely outcome next year. While this is down considerably from the bounce-off-the-bottom,
they achieve revenue growth above GDP, with room for margin expansion. Additionally, capital redeployment double-digit growth rates experienced by the S&P 500 since March 2009 – we view this as ‘good enough’
can serve as a backstop for returns if the macro headwinds prove more negative than we currently forecast. against a backdrop of very low expectations.
Over the longer term, we believe the US can deliver higher equity returns than other developed markets as a
result of its corporate strengths – as well as three positive secular themes: innovation, increased competitive Looking beyond the short-term and barring a significant double-dip recession, we continue to believe that
advantage, and population growth. US companies are fairly well-positioned over the next few years as they have multiple ‘levers’ to pull in order
to drive earnings growth:
1. US companies have been able to increase revenue at a faster rate than gross domestic product growth
over the past three years
2. Capacity utilisation is very low and should help margins improve with higher volumes – cost containment
remains a theme
3. Cash redeployment should help bolster overall shareholder returns through higher dividends and share
repurchases. If revenue growth were to fall short of expectations, we could see companies become more
aggressive on acquisitions and cash redeployment to protect overall returns.
1 2012 OUTLOOK
Valuations are attractive – relative to other developed markets ‘Growth’ is as American as apple pie
Over the past twenty years the S&P 500 has traded in a range of 10-20X forward earnings, with an average Competitive advantages and longer-term structural changes should support US growth relative to other countries:
of 13.7X. Our view of 5-10% earnings growth next year implies a price/earnings ratio closer to 12X. While
Innovation – while trends are evident on a global basis, many of the world’s largest, most recognizable brand
other developed markets may offer short-term cheaper valuations, the flexibility of US corporations in driving
names – and most innovative companies (Apple, Google and Amazon) reside in the US. This provides a
earnings growth (the levers noted earlier) combined with the long-term secular growth drivers of innovation,
solid foundation for organic revenue growth and expands the breadth of investment opportunities for our
competitive advantage, and positive demographics, make the long-term earnings stream and total return
profile for US equities more attractive than most other developed markets.
The competitive landscape has shifted for US companies: firstly a falling dollar has helped lower the
A brief outlook on politics – lots to do, but not sure it will get manufacturing cost base of the US, which has finally begun to capture investors’ attention. A longer-term
trend has been that over the last twenty years productivity growth has averaged 1.7% per annum,
done in an election year surpassing Europe and Japan. Today, a US employee is 1.2X and 1.4X as productive as European and
While election years often bring good news for markets, this is not a foregone conclusion. We see 2012 Japanese employees respectively.
as a year of few decisions, which may be a negative, but is already partially reflected in the current market
Demographics – in contrast to other developed economies, the US still has real population growth which
valuation. As we look into next year, it is likely that fiscal spending will be a drag on GDP growth – by at least
should support the long-term growth of the economy and help it deal with some of its challenges, such as
100-200 basis points. Questions will remain about fiscal cost reduction – we see this as a post election
the housing market overhang. This trend is being driven by both a positive birth rate and immigration.
decision (2013). The extension of some of the tax packages that were reworked in late 2010 is also unclear,
but we could get greater clarity around these negotiations in the next few months. The US is also in the
The views and opinions contained herein are those of Joanna Shatney and may not necessarily
midst of implementing substantial regulatory changes across the financial and healthcare industries, and
represent views expressed or reflected in other Schroders communications, strategies or funds.
greater clarity around rules and structural change could help us become more optimistic overall.
Unlike many other developed markets the US is able to deal with some of its fiscal challenges in two ways:
– The Federal Reserve has a dual mandate – not just stable inflation, but also maximum employment. This
means that in a slow growth situation it may attempt to ease monetary policy further. It can still expand its
balance sheet and continue to implement creative solutions like ‘Operation Twist’ to stimulate the economy
– There is potential for further fiscal stimulus, but we are not assuming much happens aside from the
extension of tax cuts that prevents the fiscal drag from surpassing the 150 basis point level in 2012.
2.1 Active commodities versus exchange traded funds and index investments 42
2.2 A dangerous decade for the dollar 44
2.3 Asian bonds: the safe havens of the future? 46
2.4 Economic cycles in emerging markets 50
2.5 Emerging markets investment: exploding the myths 56
2.6 Global demographics: Canada’s unique position 66
2.7 How likely is Germany to leave the euro? 72
2.8 Sovereign debt crises: lessons from history 76
2.9 To be or not to be… in China: a global investor’s perspective 78
2.10 Unquenchable thirst? The implications of water scarcity in China 84
2.11 Why ‘gold plus’ is the way to play the gold rush 92
2.12 Adapt – Why success always starts with failure 94
INVESTMENT PERSPECTIVES 2012
2.1 Active commodities versus exchange
traded funds and index investments
Written in January 2011 David Mooney Co-Head of Investments, Schroders NewFinance Capital
Indices and ETFs do not reflect spot commodities prices
Increasingly investors have sought access to commodities through the use of passive strategies and There is no investment that can be guaranteed to track a spot price and recent experience establishes that
Exchange Traded Funds (ETFs) tracking commodity indices. However, in this asset class ETFs can be the normal commodities total return indices are unreliable when it comes to tracking spot commodities
limited in tracking indices and providing effective exposure to the commodities they are supposed to track. prices, yet it is spot prices that often form the basis of investor concern, for example, when investors hold
We believe that utilising active discretionary approaches to gain commodities exposure provides a significant commodities as a bulwark against inflation.
opportunity to generate superior returns with a more attractive risk profile than using ETFs or standardised
index investments. There are numerous reasons to hold this point of view, and we have arrived at our DJ-UBS spot index versus DJ-UBS (TR) index
conclusions along a number of lines of reasoning. 200
Put simply, we believe that active management generates far higher returns, and active programmes will 160
significantly outperform their benchmarks on a net of fees basis. In many other asset classes, academic
research and the daily experience of investors have suggested the superiority of a ‘passive’ or index 140
approach to trading. In the case of commodities markets, however, academic research is rare and the
common experience is of active outperformance.
What makes commodities different? For a start, these markets are less ‘efficient’ in a number of ways. Experienced
practitioners may have more ready access to market critical information. Execution is crucial, and experience 80
may count in this sphere as well. Finally, investors are not the only participants in the markets and commercial
participants may have different motivations. A commercial buyer may be prepared to lock in forward prices at 60
a high price to reduce uncertainty. This may leave an attractive trade open to parties willing to absorb risk. 2005 2006 2007 2008 2009 2010
Risk management DJ – UBS Spot index DJ – UBS (TR)
Source: Schroders, data to 01 December 2010.
Active managers generally manage risk. When markets are particularly volatile or prone to sudden moves, active
managers may choose to mitigate that risk. Standard index investments track indices such as the Dow Jones UBS
The major indices reflect the return of an investor who holds a long position in one of the front three futures
(TR) index or the S&P GSCI (TR) index, and these indices are particularly vulnerable both to volatility and price
contracts i.e. who owns a contract that requires delivery of a commodity in a stated timeframe over the
shocks. When markets are turbulent, they remain in autopilot, with the same positions in the same maturities.
coming three months. Short term events can cause a much greater impact on short-dated futures, and so
The major indices hold their positions in the front of the curve, i.e. for delivery in the next three months, and such contracts are likely to be more volatile than longer dated contracts. The shape of the price curve is
this is also the most volatile part of the curve. Since active management often dictates holding longer dated crucial: when there is persistent contango (when distant delivery prices for futures exceeds spot prices)
contracts where that is deemed to hold the possibility of better returns, it also dampens the day to day then the total returns indices will lag the spot returns indices reflecting the cost of rolling positions.
swings in the value of the investment.
2 INVESTMENT THEMES
Enhanced indices are no substitute for active management
In contango markets therefore, index investors face a constant underperformance relative to spot There are numerous ‘enhanced index’ products offered by financial institutions to address vulnerabilities in
commodities prices. This is clearly mitigated if an active manager can create countervailing alpha standard index offerings. These are variations on a theme with respect to the standard indices.
– that alpha compensates for the costs of rolling contracts.
While we recognise that certain variations may work in certain markets, the weakness of these products is
that most use a single technique to outperform their benchmark. In reality, there are multiple means to
Indices are vulnerable to being arbitraged create superior performance and the choice depends on market circumstance. A discretionary manager
The indices are poorly constructed in being tied to a rule-based approach that dictates in which maturities can use skill and experience to select the means to optimal performance and to the market environment.
positions are held and when positions are to be rolled. Knowing or calculating the roll volume based on
A secondary criticism of the enhanced index approach stems from the risk that these techniques are built
assessment of total invested assets becomes a source of potential revenue for speculators! A programme
on historical data analysis (data mining). Just because a particular approach worked in the past to
that signals to the market that huge volumes of futures in immediate maturities need to be sold and new
outperform an index, that does not mean it will work in the future.
contracts purchased as of close of business on each of five successive trading days runs the risk that
execution will occur at unattractive prices.
The views and opinions contained herein are those of David Mooney and may not necessarily
Flexibility represent views expressed or reflected in other Schroders communications, strategies or funds.
By their nature, ETFs and standardised index products are a ‘one size fits all’ solution while investors may
have limits with respect to volatility or drawdowns and investors may require exclusion or inclusion of certain
markets. Flexibility means that the money manager of an active fund has choices to mitigate risks or to
substitute one component for another.
Neither indices nor ETFs are truly passive
For reasons made clear above, there is a great deal of activity in so called passive indices. A position in a
prompt-dated futures contract has to be rolled if the investor is to avoid the need to buy warehouse space.
Further, indices may be reweighted to reflect shifts in the relative prices of commodities or based on
exogenous factors such as their share of world commodity trade. Finally, the process of rolling is carried
out on a predetermined timetable. With the rules governing the maturity to be held, which will vary according
to the time of the year, and the rules for rolling futures contracts (including cash settled positions), these
indices look more like rules-based trading programmes than anything passive. For sure, it is not possible
to ‘buy and hold’ commodities – the march of time along makes that idea impossible.
INVESTMENT PERSPECTIVES 2012
2.2 A dangerous decade for the dollar
Written in March 2011 Barry Eichengreen Professor of Economics at the University of California, Berkeley
For how much longer will the average Somali pirate demand that ransoms are paid to him in dollars? When From a corporate point of view, US businesses benefit greatly from the fact that international finance is
will Americans cease to be able to pay a taxi driver in their home currency wherever they are in the world? carried out in their home currency. It relieves them of the cost of foreign exchange and the complexity of
And if Iran continues to send aid to Afghanistan, for how long will that support take the form of a bag full of having to hedge against the prospect of exchange rates moving against them. But they face the same
dollar bills dumped on the desk of President Karzai? mixed blessings as their government and their people.
Barry Eichengreen, Professor of Economics and Political Science at the University of California, Berkeley, With foreigners willing to finance the US current account deficit more keenly than they will for any other
expects the dollar to remain dominant in the decade ahead – although, only just. He joined us for the country, Americans can quite easily live beyond their means. If they choose to engage in financial excesses
Schroders Secular Market Forum to discuss the rise and the fall of the world’s global currency. – for example, falling prey to frenzied real estate speculation – foreigners have proved themselves willing to
continue lending and, in doing so, give the US enough rope to hang itself with.
Although last year’s talk of currency war passed off without much bloodshed, the dollar – already bruised
by the effects of the financial crisis and subsequent quantitative easing – left the battlefield with yet another
gnash in its side. Ineffective politics raised severe question marks over the ability of the US authorities to
The dollar and the financial crisis
tackle the burgeoning budget deficit. The arrival of the euro and the ambition of the Chinese mean that the Would the recent financial crisis have happened if our multi-polar global economy was supported by a
global monetary and financial system is moving rapidly towards a multi-polar model, and the dollar must multi-polar monetary and financial system? Almost certainly not, according to Eichengreen. It is, in fact,
make room at the top for its rivals. As we move towards a world where three currencies will simultaneously the mismatch between a broadening global economy and the narrow dollar-centric monetary system that
dominate the system, the bright side, from the dollar’s point of view, is that its rivals – the euro and the allowed the US to leverage itself to the extent that it did in the years leading up to 2007. While the US
renminbi – must overcome their own problems first! economy – as a percentage of global GDP – has shrunk over the last decade, foreigners have supplied
the US with ever-increasing credit, which the American people deployed in such a regrettable manner.
“My characterisation of the financial crisis is that there is a mismatch between the increasingly
multi-polar world economy and a still dollar-centric financial system”
Despite the anxiety currently surrounding the dollar, it remains the only true global currency and derives
great benefit from this ‘exorbitant privilege’. Not only do the US government and its people find themselves
in a position whereby everyone else wants their currency, they also have the unique privilege of being able A brief history: The world’s love affair with the dollar
to borrow in so rampant a fashion they may unwittingly bring the world to the brink of economic disaster. How we got into this situation? After 1870, the US became the largest economy in the world.
Hence, US Treasury Secretary John Connally, in 1971, famously told a delegation of Europeans worried After 1914 it also became the largest exporter. However, it was not until after WW1 that the dollar
about exchange rate fluctuations that the dollar “is our currency, but your problem.” began to move from a position whereby it was barely being used internationally to being the leading
reserve and investment currency by 1924. This view probably runs counter to what we all learned in
school (i.e. that sterling remained the world’s international currency until 1945). However, if you go to
Striking statistics the archives of the major central banks, you will see that most were holding more dollars than sterling
The statistics surrounding dollar dominance are striking. The US is only 20% of the global economy, in 1924. At that point the dollar operated more or less on a par with sterling, until the end of WW2.
however, the vast majority of international business is still done using the dollar. The bank for With the conflict having devastated Europe, the US was the only country with deep and liquid
International Settlements recently released its tri-annual survey of foreign exchange (forex) markets, financial markets, leaving the international community with little alternative but to do business
which showed that 85% for forex transactions worldwide involved the dollar. Similarly, the dollar using the dollar. Half a century on, the global economy plays host to several deep and liquid
represents 61% of identified forex reserves of the world’s central banks. financial markets. Yet the world’s love affair with the dollar endures.
2 INVESTMENT THEMES
Why the world still uses the dollar € The euro
The half century following WW2 has seen the rest of the world’s economies gain ground on the US, but the – Despite concerns about the future of the euro, history has shown that Europe responds to a crisis by moving to
monetary and financial system remains peculiarly dollar dominated. The reason for this can be seen everywhere deeper integration
– from the world of computer operating systems (the near monopoly of Microsoft) to the world of politics – in a – A default by Greece or Ireland will not mean the end of the euro. And restructuring may strengthen the euro
phenomenon called ‘incumbency advantage’. In terms of currencies, if everybody else is using dollars, it makes – Germany has too much invested (economically and politically) to abandon the European project
sense for your business to use the same currency as your clients and competitors. An exporter, for example, – When the reform agenda (including banks, debt, and surveillance) is complete, the eurozone will have a proper
seeking to break into international markets, must signal that its price is competitive and will, therefore, have to monetary union and the euro’s position on the international stage will be secure.
denominate its product in the same currency as everyone else. For the past half century the market has been
characterised by network externalities, which force companies to adopt the same standard as everybody
¥ The renminbi
else in their network. This phenomenon, compounded by the cost of switching from one denomination to
another, meant that – until now – there has been room for only one true international currency. – Dollar dependence is a disadvantage to Chinese corporates
– China will have to surmount some serious challenges to internationalise its currency
“Everybody else is using dollars so what the heck! You continue to use dollars and because you – It will have to build deep and liquid financial markets; and make these accessible to foreigners. It will have to remove
continue to use dollars, everybody else does. Once a standard is widely adopted it tends to get some of the financial restrictions that are integral to its development model. It will have to commercialise its banks and
locked in. However, I would suggest that, in a world of free and rapid information sharing – this establish a rule of law to build investor confidence
argument no longer applies…” – This programme of reforms is moving fast, and could be completed within a decade.
Although the influence of network externalities was compelling in the past, it is unlikely to dominate currency So should we worry?
activity in the future. According to Eichengreen, the notion that importers, exporters and others will want to Ultimately, we should be reassured by the prospect of a multi-currency environment because it will, in the
use the same currency as other importers and exporters – in order to avoid confusing their customers – long term, make the world a safer financial place. There will be a greater convergence between the
holds less weight in a world where everyone has a smartphone that can be used to compare currency multi-polar global economy and the monetary and financial system that supports it.
values in real time. As little as a decade ago, most people struggled to get an up-to date currency quote,
but today the currency converter is one of the top ten downloads from the Apple AppStore. The monopoly power that the US has enjoyed as a result of its place as the only global currency will no
longer exist. As a result, if the US abuses its exorbitant privilege, it will be easier for foreign investors to use
“A teacher of mine at Harvard, Richard Copper, once said: ‘Never allow anyone to give you a alternatives. In Mr Eichengreen’s view, there is no particular problem with the continued existence of
forecast or prediction without also giving you a date!’” reasonable fluctuations between the three international currencies. A sharp or unanticipated fluctuation,
however, would be a bad thing and it is within the interests of the corresponding governments and central
banks to maintain stable policies. As a result, the reserve currency-issuing countries (i.e. the US, the euro
Twenty-twenty area and China) will have to act with more transparency and discipline – which can only be a good thing.
Eichengreen predicts that by 2020 – after almost a century as the world’s super currency – the dollar will
have to make room for its rivals. Ten years from today, the most likely scenario is that there will be three
genuinely global currencies operating – not necessarily as equals – but simultaneously: Biography of Barry Eichengreen
Barry Eichengreen is Professor of Economics and Political science at the University of California,
$ The dollar Berkeley, where he has taught since 1987. He is a research associate of the US National Bureau of
– The main problem the dollar faces is the need for fiscal consolidation at a time of dysfunctional politics in the US Economic Research, as well as research fellow of the Centre for Economic Policy Research in London.
– With spending cuts and tax increases both being such toxic issues, and with elections set for 2012, we are unlikely to He has been a senior policy advisor at the International Monetary Fund, and was the 2010 recipient of
see any ‘adult conversation’ about the budget until the morning after the ballot boxes close the Schumpeter Prize from the International Schumpeter Society. His most recent book is Exorbitant
– Markets will, however, want to see quick action in 2013 and continued fiscal inconsistency is likely to hasten a move Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.
away from reliance on the dollar.
The views and opinions contained herein are those of the Barry Eichengreen and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
2.3 Asian bonds: the safe havens of the future?
Written in September 2011 Rajeev De Mello Head of Asian Fixed Income
Asian bonds have proven to be a rare safe haven in the recent market turbulence. The HSBC Asia local Foreign reserves held by Asian countries (excluding Japan) 2
currency index is up 8.9% this year to 09 September1. There are a number of reasons why we strongly believe 6,000
Asian currencies and fixed income will prove to be a superior store of value for the foreseeable future:
– Asian economies are supported by strong economic fundamentals
– There is strong growth potential in Asia 4,000
– It is a diversified investment universe
– The sector has one of the best risk/return profiles over the last 10 years
– The rise of China. 2,000
Asian economic fundamentals are strong 1,000
The main concern when investors choose fixed income is: “will my principal and coupon be paid?” It is
increasingly difficult to gauge this risk in developed economies that are now suffering under high levels of 0
debt, but in Asia both governments and corporate issuers benefit from large and growing cash reserves. Apr 00 Apr 01 Apr 02 Apr 03 Apr 04 Apr 05 Apr 06 Apr 07 Apr 08 Apr 09 Apr 10 Apr 11
China Taiwan South Korea India Hong Kong Singapore Thailand Malaysia Philippines
Simplistically, there is just over $5 trillion worth of bonds outstanding in Asia which is balanced by just over
$5 trillion in cash reserves. This is a very comforting starting point to consider when looking for a safe store
of value now that previous havens seem rockier.
Strong growth outlook in Asia
Growth prospects are being downgraded across European countries and for the US. This is perhaps not too
much of a surprise considering the large debt burdens that will take a long time to reduce. We have already
demonstrated that Asia has lots of cash reserves so it is no surprise either to learn that economic growth
prospects are commensurately much better. This provides another strong reason to invest in Asian bonds
because Asian institutions will be able to generate even more cash in the future to pay bondholders.
1 Source: Bloomberg.
46 2 Source: Bloomberg, as at 30 April 2011.
2 INVESTMENT THEMES
Global GDP forecasts Asian country characteristics
Global GDP forecasts
Country S&P rating GDP per capita 2010 US$ 10-Yr yield
Singapore AAA 44,375 1.63%
Hong Kong AAA 31,759 1.81%
Taiwan AA- 18,588 1.39%
South Korea A+ 20,546 3.84%
0 China AA- 4,389 3.95%
-2 Malaysia A 8,453 3.65%
-4 Thailand A- 4,676 3.48%
-6 India BBB- 1,347 8.24%
US Eurozone Japan Asia ex Japan Latin America
Indonesia BB+ 3,024 6.86%
2009 2010 (E) 2011 (F) 2012 (F)
Philippines BB+ 2,079 5.97%
Source: BoAML forecasts, as at 12 July 2011. Source: Schroders, Bloomberg, HSBC. 10-Yr yields as at 25 August 2011. S&P Rating indicates the long-term local
currency sovereign debt rating.
Diversified investment universe
One of the best risk/return profiles over the last 10 years
Asian countries are extremely diverse in all aspects, including financial development. The fixed income
universe ranges from safe mature economies like Singapore and Hong Kong to the fast-growing but The combination of factors such as strong economic growth, large cash reserves and diversification has
developing India, Indonesia and China. This diversity offers our fund managers the opportunity to switch meant that Asian bonds have provided the best risk-adjusted performance of all mainstream asset classes
investments according to the overall economic environment and the specific performance of each country. over the past 10 years.
For example, when global concerns are dominating markets, investments can be concentrated in safe
countries but switched easily to seek higher returns.
INVESTMENT PERSPECTIVES 2012
Risk/return across various asset classes The rise of China
10-Yr return 10-Yr volatility The spectacular growth and development of the offshore Chinese currency (RMB) bond market over the
Asset class 3 annualised annualised Return/risk ratio past year has added another potential opportunity for Asian bond investors. As China will continue to play
an important role in world trade, it is only natural that the RMB takes on a larger function in trade settlement.
Asian local bonds 8.7% 6.3% 1.38
Exporters to China that accumulate RMB balances will need to invest. Given this, we believe continued
Asian USD bonds 8.4% 7.3% 1.15 inflows into the RMB market is a secular trend supported by China’s stronger growth prospects combined
with attractive currency appreciation potential. The chart below shows how stable the Chinese currency has
US Treasuries 5.5% 4.8% 1.14
been as the authorities manage the peg gradually upwards allowing investors to take a stable view. We think
Emerging Market Debt 10.2% 9.7% 1.05 the currency will appreciate by 5% in 2011.
Global Government Bonds 7.9% 7.6% 1.04
CNY nominal effective exchange rate and USD/CNY exchange rate
Emerging Market Equities 13.5% 24.1% 0.56
Nominal effective exchange rate trade weighted CNY Exchange rate USD/CNY
Asia ex Japan Equities 11.3% 23.2% 0.49 120 6.3
European Equities 3.5% 20.3% 0.17 115
Global Equities 2.8% 17.0% 0.17 110 6.8
This information above is for illustrative purposes only. Past performance is not a guide to future performance and may not 105
be repeated. 7.3
Source: Bloomberg, Schroders, as at 30 June 2011.
Feb 06 Aug 06 Feb 07 Aug 07 Feb 08 Aug 08 Feb 09 Aug 09 Feb 10 Aug 10 Feb 11 Aug 11
CNY nominal effective exchange rate (lhs) USDCNY exchange rate (rhs)
Source: Bloomberg, as at 26 August 2011.
3 Asset classes represented by the following indices: Asian local bonds – HSBC Asian Local Bond index; Asian USD bonds
– JPMorgan Asia Credit index (chain-linked from 01 August 2006 to old JACI index); US Treasuries – Citigroup Treasury/
Agency index; Emerging Market Debt – JPMorgan Emerging Market Debt index; Global Government Bonds – Citigroup
World Government Bond index; Emerging Market Equities – MSCI Emerging Market index; Asia ex Japan Equities – MSCI
48 AC Asia ex Japan index; Global Equities – MSCI World index; European Equities – MSCI AC Europe index.
2 INVESTMENT THEMES
In summary, we are positive on the longer-term structural story for investing in Asian bonds. After the global
financial crisis, Asia’s stronger growth potential and sovereign balance sheets will attract more global capital,
be it portfolio flows or direct investments. External vulnerability has also been reduced through accumulation
of sufficient foreign reserves and tailored prudential measures to discourage short-term ‘hot money’. Finally,
the rapid growth and development of the offshore RMB bond market provides another area of potential
investment opportunity for Asian bond investors.
The views and opinions contained herein are those of Rajeev De Mello and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
2.4 Economic cycles in emerging markets
Allan Conway Head of Emerging Markets Equities, Nicholas Field Emerging Markets Strategist and Abbas Barkhordar Emerging Markets Analyst
Written in June 2011
Many investors base some part of their investment decision on the business cycle and how it affects US Cycles
markets. They may have in their minds an image of a ‘perfect cycle’ relating GDP growth, interest rates and
equity markets. The perfect cycle would look something like this: Even though this is a paper on emerging markets, we start by looking at US cycles. There are two reasons for
this. The first is that the US has data going back considerably further than any emerging market. It has been
running an independent monetary policy, largely uninfluenced by the rest of the world, for a long time. The
9% E A 20% emerging markets have started to adopt this approach, so arguably the history of US cycles may be more of a
8% 15% guide to the future of emerging markets than their own history. The second reason is that recent emerging
7% 10% market interest rate cycles, including the current one (possibly to a lesser degree) have been heavily influenced
by US policy through the dollar’s position as reserve currency and emerging markets’ foreign exchange policy.
Either way, we will not be able to understand emerging market cycles without understanding the US.
*The definition of ‘recession’ used in this article is the one used by the National Bureau of Economic Research (NBER).
The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is
3% D -10% a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in
2% C -15% real GDP, real income, employment, industrial production, and wholesale-retail sales.
1% -20% US Real GDP YoY and Nominal Interest Rates
0% -25% First, let’s look at interest rate cycles against GDP:
0 12 24 36 48 60
GDP YoY Interest Rates Market YoY (rhs)
A. Recession* starts, rates cut, market already falling and continues. 10%
B. Market starts to rally before last rate cut and some three to six months before end of recession.
C. Strong market rally as economy recovers, rates stay low.
D. Brief hiccup in markets during first rate rise. But growth continues and so does the market.
E. After extended period of slow and steady rate rises, growth becomes ‘frothy’.
Market anticipates next recession by three to six months and falls. 0%
F. Goes back to the beginning and repeats.
But does this picture have any bearing on reality, and how does it fit with the complex world of differently
paced cycles in emerging markets? Right now, the developed world has not started raising rates, but we
have already seen a number of rate rises in emerging markets. Can we make sense of this picture with
reference to history? This paper attempts to answer that question. Recession NOM IR Real GDP YoY
Source: NBER, Bloomberg.
2 INVESTMENT THEMES
US nominal interest rates versus YoY Market
The data seems to fit the expected pattern, with rates pushing up for extended periods of time before they 20% 90%
induce the end of the cycle. One clear effect is the last three cycles have been long ones. There have been 18%
eight recessions over the period (excluding the most recent one). 16%
Months between recession Months from first rate rise to Length
Recession start Recession end end and first rate rise start of next recession of recovery 12%
Aug 1957 Apr 1958 1 23 24 10%
Apr 1960 Feb 1961 -4 110 106 8%
Dec 1969 Nov 1970 3 33 36 6% -10%
Nov 1973 Mar 1975 12 46 58 4%
Jan 1980 Jul 1980 0 12 12 2%
Jul 1981 Nov 1982 5 87 92 0% -50%
Jul 1990 Mar 1991 34 86 120
Mar 2001 Nov 2001 30 43 73
Average 10 55 65
Recession NOM IR S&P YoY
Source: NBER, Bloomberg. Source: NBER, Bloomberg (end-month data).
There are large variations across these cycles. Recent cycles have been long, but so was the 1960s cycle. This chart shows interest rates against year-on-year changes in the S&P 500 index. We see that the market
But the interest rate cycles show more variation than the growth pattern. What is most striking is the change does tend to drop significantly towards the end of an interest rate cycle peak and before the start of a
in the reactions of the Federal Reserve. Prior to 1990, the Fed tended to raise rates close to the end of the recession. But we also notice a tendency for mid-cycle ‘pauses’ where the equity market has a bad patch in
recession. But the last three recessions have been marked by long periods of low interest rates lasting well the middle of a rate-rising cycle.
into the recovery. The Fed has been able to ‘get away’ with this as the period from 1982 has been one of
global disinflation, and prolonged low levels of rates have not generated inflation. It would seem that the Percentage of months in
nature of the cycle, and the recessions, changed after 1982. When market peaks – months When market troughs – recovery when market had
Recession start Recession end before recession starts months before recession ends positive year-on-year returns
There are many reasons for this, but this is not a piece on structural change in the US economy. So, suffice Aug 1957 Apr 1958 13 4 100%
to say, up until 1982 the US suffered ‘classic’ industrial recessions led by slowdowns in industrial output and Apr 1960 Feb 1961 9 4 78%
inventory swings. As the Communist block entered the global workforce and manufacturing reduced as a Dec 1969 Nov 1970 12 5 100%
share of the US economy, cycles depended more on services and in particular on finance. So each of the Nov 1973 Mar 1975 10 3 70%
last three recessions were marked by some sort of financial disaster – Savings and Loan in 1990, the Jan 1980 Jul 1980 -1 3 100%
NASDAQ crash in 2001 and the near collapse of the entire banking system in 2008. A combination of global Jul 1981 Nov 1982 8 4 81%
disinflation and financial rather than industrial recessions has fundamentally changed the nature of the Jul 1990 Mar 1991 1 5 96%
Federal Reserve’s response to recession. Is this change reflected in equity markets as well? Mar 2001 Nov 2001 7 -15 100%
Dec 2007 Jun 2009 2 3 –
Average 7 2 91%
INVESTMENT PERSPECTIVES 2012
Most of the time markets seem to act in the ‘expected’ way, anticipating a recession by 6-12 months and This chart is very revealing about the long-term structural changes in the Chinese economy, but less so in
anticipating a recovery by about three months. The exceptions are the short 1980 recession, when the market suggesting any kind of ‘perfect’ cycle as described in the introduction. Now is not the time to discuss the
peaked just after the recession started, and the 2001 recession where the market bottomed in 2003, during financial history of China, but we can observe from the chart that although there is some cyclicality in the
a deflation scare long after the recession was officially over, but well before interest rates had gone up. early years, with GDP, interest rates and inflation all coming off their peaks of 1993/94 at the same time, the
lags and timescale do not match up – GDP and rates took years to reach their floor and do not seem
The last column in the table shows that the start of the interest rate cycle does not always cause a mid-cycle
connected to markets. Later on, there is even less connection, with interest rates seeming to have no role in
‘pause’, at least in markets – some cycles have no negative 12-month periods at all in between recessions.
the 2007/08 GDP cycle.
So, in summary, the US fits our perfect cyclical framework quite well. Interest rate paths have tended to be
quite orderly, in line with the business cycle, and the markets tend to respond to these cycles with the The normal cyclical rules do not seem to apply to China. In our view, there are two reasons for this. Firstly,
expected lead times. The start of the interest rate cycle can induce meaningful, if temporary setbacks, but China has not had a normal business cycle in the last 20-30 years. Instead it is having a one-off
not always. Since the end of the Second World War, we have not had a severe market shock, or fallback into industrialisation. So the business cycle is a much more long-term structural cycle. Secondly, monetary policy
recession without an interest rate cycle. has been designed to provide the relevant quantity of cheap capital to make this industrialisation happen.
The Chinese have therefore not controlled the economy with interest rates, but instead with quantitative
Emerging Markets controls on the amount of available capital. For example, after the slowdown in 2008, the Government
responded with a huge increase in available loans for infrastructure projects.
In China, the authorities conduct unorthodox monetary policy, and the usual rules of the cycle do not apply.
The US might fit the pattern well, but there is no guarantee emerging markets also fit. For much of recent
history, emerging markets have depended to some degree on capital flows from the rest of the world – they
have been influenced by US monetary policy. In other words, local monetary policy need not have the same
The same is not true for all emerging economies:
effects as seen in the US case. Unfortunately, the data we have does not go back beyond the last two
cycles or so for emerging countries. But it is still worth examining to see how the cycles differ from emerging 150% 45%
to the US and across emerging markets. 130%
Our starting point has to be the largest and most important emerging economy – China. The chart below
contains Chinese real and nominal interest rates as well as GDP changes and year-on-year local market 25%
changes (as represented by the Shanghai A-share market):
250% 10% 5%
100% -50% -15%
-50% -15% LC mkt Nom YoY Nom IR (rhs) Real IR (rhs) Real GDP YoY (rhs)
-100% -20% Source: Bloomberg.
In Brazil we see interest rates impacting on the economy and market in an expected way. After the currency
LC mkt Nom YoY Nom IR (rhs) Real IR (rhs)
crisis and recession of 1998, rates dropped rapidly and the market responded with some strong
Real GDP YoY (rhs) CPI (rhs) performance as the economy recovered. Again, after the events of the 2002 crisis, following the aftermath of
the Argentine default in December 2001 and the 2002 Brazilian election, there was a rapid reduction in
interest rates followed by a rapid market and economic recovery.
2 INVESTMENT THEMES
There have been five interest rate cycles in Brazil since 1998. We use these to define our cycles rather than MSCI EM aggregate interest rates
recessions – all of the cycles were associated with a sharp slowdown in growth, but they did not necessarily 10%
result in negative growth.
Months between recession Months from first rate rise
Slowdown start Slowdown end end and first rate rise to start of next recession
Nov 1998 Nov 1999 15 3
May 2001 Feb 2002 7 5 4%
Feb 2003 Aug 2003 12 6
Feb 2005 Nov 2005 28 11 2%
Feb 2009 Aug 2009 7 N/A
Average 14 6 0%
Source: Bloomberg. -2%
Rates seem to move up about a year after the end of the recession – rather like the US. The difference is 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
that the next recession seems to start soon after. Brazil has had a volatile GDP series over the last 15 years Nom IR Real IR
with lots of short, sharp cycles. Given that proviso however, the Brazilian cycle seems well behaved.
Source: Bloomberg, FactSet
Brazil and China represent two extremes. One has short cycles where interest rates, the economy and
markets seem to follow understandable patterns relative to each other. China has long, slow ‘mega cycles’ After the drop in rates in 2009 we have seen a small pickup more recently, but only to levels associated with
where interest rate policy is largely irrelevant. Most other countries in the emerging world lie somewhere the 2003-2006 expansion phase. In fact, looking at the trend in real interest rates, we can see no increase at
between these two extremes, with some aspects of ‘normal’ cycles but with large deviations due to crises all in the last twelve months. So interest rate cycles are not consistent across emerging markets, but in as
(for example Russia in 1998) or due to the overwhelming effects of external factors. much as rates do matter in aggregate, they are at very low levels.
Nonetheless, we can see some patterns in emerging markets in aggregate. If we look at nominal rates Further signs of emerging cyclicality can be seen by looking at emerging inflation in aggregate. Below is a
weighted by MSCI index weights for emerging countries, we can see the 2007/08 cycle: chart of emerging inflation (weighted by MSCI index weights) and emerging equity market performance
versus that of developed markets:
MSCI EM/MSCI World versus GEMS Headline CPI
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
MSCI EM CPI MSCI EM/MSCI World
Source: Bloomberg, FactSet.
INVESTMENT PERSPECTIVES 2012
In 1997/98 inflation went up as markets dropped. This was during the Asian and Russian crises where sharp S&P 500 performance S&P 500 performance S&P 500
currency devaluation pushed up inflation. But after this, inflation increases are associated with market rises. three months before three months after first S&P 500 performance performance from
Recession first rate rise (measured rate rise (measured from first rate rise to first rate rise to start
This is true in 2002, 2004, 2007 and more recently. So, outside of crisis periods, both markets and inflation Start Recession end from month end) from month end) market peak of next recession
have been driven by strong economic and earnings growth – inflation has not been a driver itself. In other Aug 1957 Apr 1958 6% 9% 37% 28%
words, rising inflation does not, by itself, stop markets from rising. Apr 1960 Feb 1961 -4% 11% 98% 70%
In a broad sense, emerging markets have shown responsiveness to a global cycle – markets, inflation and Dec 1969 Nov 1970 15% 5% 22% 5%
rates moving up over long periods of time, before recession. Nov 1973 Mar 1975 14% 1% 14% 10%
Jan 1980 Jul 1980 16% 9% 13% 8%
US versus Emerging Jul 1981 Nov 1982 9% 6% 129% 128%
Jul 1990 Mar 1991 2% -5% 214% 151%
In the US, interest rates, GDP and markets seem to be reasonably connected. We notice a less strong
Mar 2001 Nov 2001 -4% -1% 40% 34%
relationship in emerging markets. This is not too surprising. Emerging markets have not in the past been
Average 7% 4% 71% 54%
able (or willing) to operate a fully independent monetary policy. Looking at a chart of emerging performance
Average number of months 49 55
versus developed, US dollar and US interest rates we can see that, in aggregate, emerging markets have
been affected by US policy (dollar and interest rates) rather more than their own. Source: NBER, Bloomberg, Shiller.
The table shows markets generally go up before and after the first rate rise, with only two small exceptions
to this rule. They then continue to rise substantially afterwards. Indeed, even if one holds the market all the
way up to the next recession (that is, failing to anticipate it), there are still substantial gains to be enjoyed.
And there are no exceptions to this rule.
In contrast, the MSCI emerging market index was down 12% in the three months in 1994 following the first
90 rate rise after the 1991 recession, and down 10% in the three months leading up to 2004 rate rise – indeed
from peak to trough emerging markets were down over 20% in April and May 2004. These are only two data
points, so we cannot draw a firm conclusion, but on these occasions, the first US interest rate move had a
bigger effect on emerging markets than on US markets.
If we look at emerging markets’ response to their own rate rises, we get a limited picture. Unfortunately there
is minimal data. In modern times, there have been two major cycles – one in the 1990s which ended in crisis
for a number of countries, and the recent one through the 2000s, ending in 2008. Not only is this very little
Log MSCI EM/S&P US Nom IR (rhs) USD REER Inverted
data, it is also a time of huge structural change, so it is not clear that the data means anything. For what it is
Source: Bloomberg. worth, emerging markets have rallied between 20% and 330% with an average of nearly 150% from first rate
rise to market peak. But the average to the start of the next recession is only +25%, showing the severity of
We know the reasons for this – currency ties to the dollar and foreign capital flows. But it clearly makes the 2008 market fall.
calling emerging cycles harder – we have to consider two sets of economic and interest rate cycles.
Indeed, if we look at the effects of the first rate rise in the US on S&P 500 returns, we do not see anything
meaningful. Rate rises themselves are indicative of a continued market and economic growth
phase, not a bar to it.
2 INVESTMENT THEMES
Finally, if we look at the response of the MSCI Emerging Markets index to the US cycle, we get two distinct Where does the current situation fit into this pattern?
answers in recent times:
– The US has not yet raised rates. In recent cycles, the Federal Reserve has been starting the interest rate cycle
Performance from first US at later and later dates after recession. If this pattern is repeated (and given the last recession was the most
MSCI EM performance (matched to US cycle) From first US hike to US market peak hike to next US recession severe, it seems reasonable to assume it will be) then we are almost a year away from the first rate rise.
1990s cycle -12% -34%
– Emerging markets have started to raise rates, but rates are low compared to historical levels. Real rates
2000s cycle 241% 218%
are still around zero, in aggregate.
Source: Bloomberg, NBER. – Inflation is picking up, but this tends to be associated with strong GDP growth and markets.
Emerging markets show the radical difference between the two cycles. The 1990s was a period of robust As a very rough summary, we can use recent history to show what this cycle might be like. Taking the
GDP growth, and strong income growth in the US. Interest rates were generally 2-3% above inflation and the average of the last two long interest rate cycles as our example, we can use past US history as a guide or
dollar was strong. Capital was attracted to the growth opportunities in the US. Emerging markets started the we can assume that emerging markets will be like the US and apply US history to emerging rate rises.
1990s requiring capital to grow in a debt finance model, which proved unworkable with positive US real
rates. The next cycle was in many ways the complete opposite. US growth looked strong, but it was built on First rate rise Market peak Rise to peak Next recession starts
excessive leverage. There was little income growth. Real rates stayed negative until late in the cycle and the US history February 20121 Q1 20171 126%1 Q3 20171
dollar was weak. In the meantime, emerging markets restructured their balance sheets. So emerging US history using EM rate rise timing August 2009 2
Q3 2014 3
82% – we have had 44% already 3
markets needed less capital but attracted more of it, leading to strong growth. In other words, there was a
hugely different response in two US cycles that look superficially similar.
The point of this table is not to make forecasts – in order to get to these dates and numbers you have to
Conclusion – Where are we now? make some heroic assumptions, and in reality the dates and numbers are not likely to be accurate. But the
main point is that we are still very early in the cycle. No US recession has started without rising rates.
We have learnt a number of things:
Emerging rates have barely gone up. In our view, this means that emerging markets should offer significant
– The US is fairly well behaved in cyclical terms. Markets move down meaningfully only after an extended further upside potential before they reach their peak levels for this cycle.
period of interest rate rises and in anticipation of recession
– Even after the first rate rise, US markets have delivered positive returns, between 5% and 150% The views and opinions contained herein are those Nicholas Field, Abbas Barkhordar and
Allan Conway and may not necessarily represent views expressed or reflected in other
– In the short run, emerging markets respond in different ways to their own interest rates.
Schroders communications, strategies or funds.
Some markets are more affected by the first US rate rise than their own
– In the longer term, there is less data to draw a firm conclusion about the cyclicality of emerging markets,
but what evidence there is suggests it has become more ‘normal’ in recent years, and responds well to
negative real US rates and a weak dollar.
1 Calculated using the average from the last two long US economic cycles.
2 Source: Schroders. First rate rise calculated as the point when aggregate MSCI Emerging Market nominal interest
rates went up.
3 Calculated using the average from the last two US economic cycles, but based on the timing of emerging market
interest rate rises, rather than the timing of US rate rises. 55
INVESTMENT PERSPECTIVES 2012
2.5 Emerging markets investment:
exploding the myths
Written in August 2011 Allan Conway Head of Emerging Markets Equities
Today, emerging economies contribute to over 50% of world GDP growth and this trend is only set to The prime problem with this argument is that it covers a large number of countries over a long period,
continue for the foreseeable future. The increased significance of the emerging markets to global growth, irrespective of their stage of development. It is not perhaps surprising that whether the US grows at 2.2%
underpinned by domestic demand-driven growth and robust fundamentals, has led institutional investors or 2.3% has little impact on the stock market. However, there are many examples that show that when an
to increasingly regard emerging markets as a strategic rather than a tactical asset class. economy is going through a period of rapid economic growth and development, the stock market does
provide premium returns. This can be seen clearly in the two charts that follow for Korea and Taiwan.
This shift in investor perception, which has been reflected by record inflows of over $95 billion into emerging
During Korea’s rapid period of GDP growth (9.6% p.a.) between 1981 and 1992, the stock market provided
markets equity in 2010, has led to a debate about the best method for investors to gain exposure to the
investors with an 18.2% p.a. return. In Taiwan, between 1973 and 1981, growth was 7.9% p.a. and the stock
emerging markets. This paper addresses some of the issues.
market return was 9% p.a.
Myth 1: There is no relationship between emerging economic Chart 2: Markets in times of high growth – Korea
growth and emerging markets stock market performance 60% 12%
A number of academic studies have suggested that there is no significant correlation between an economy’s
rate of GDP growth and its stock market’s returns. Chart 1 below illustrates the point. The natural follow on
from this is that superior economic growth in emerging markets is not necessarily an indicator of superior
stock market returns.
Chart 1: Emerging markets’ real GDP and real local market returns regression 0% 6%
YoY Real Market Return -20% 4%
250% -40% 2%
February 1981 – February 1992
200% GDP Growth = 9.6% p.a.
150% -60% Stockmarket performance = 18.2% p.a. 0%
100% 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Korea Market 5yr CAGR (lhs) Korea GDP 5yr CAGR (rhs)
R 2= 0.0231
0% Source: FactSet, Bloomberg.
-15% -10% -5% 0% 5% 10% 15% 20%
YoY Real GDP Growth
Source: Schroders, Datastream. Data since 1980.
2 INVESTMENT THEMES
Chart 3: Markets in times of high growth – Taiwan Chart 4: Contribution to total index performance from 1990 (pp)
80% 12% 700%
-40% February 1973 – August 1981 2% -100%
GDP Growth = 7.9% p.a.
Stockmarket performance = 9.0% p.a. -200%
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
Taiwan Market 5yr CAGR (lhs) Taiwan GDP 5yr CAGR (rhs) Real GDP Additional nominal GDP Earnings/GDP Implied valuation MSCI EM
Source: FactSet, Bloomberg. Source: MSCI, IMF, UBS estimates. June 2011.
Goldman Sachs, in a recent research paper (Linking GDP Growth and Equity Returns, May 2011) also found Thus, simply looking at a country’s GDP growth and stock market returns is too simplistic. First, it is
two interesting relationships. First, Goldman Sachs ran correlations for GDP growth today and equity returns necessary to look at the stage of development. Rapid growth has correlated in the past with strong returns.
in the previous year and found the results pointed to a strongly positive relationship for both developed (0.78 Second, there is a strong correlation between equity returns today and GDP growth in 12 months’ time.
correlation over 2000-2010) and emerging markets (0.73 correlation over 2000-2010). Furthermore, Goldman Third, there is a strong relationship between changes in consensus forecast GDP growth and stock market
Sachs ran individual country regressions of changes in consensus forecasts for GDP growth in the current returns. Finally, there is a strong relationship between USD GDP growth and USD stock market returns
year and the year ahead on real equity returns. Revisions in the current year forecasts displayed limited i.e. look at countries currency adjusted.
meaningful effect on equity prices, whereas revisions in the next year forecasts highlighted a significant
impact. In the advanced (developed) world a 100bp revision in the next year forecast would, on average, result
in a 14% increase in equity prices. In the case of growth (emerging) markets, the relationship is even more
pronounced, where a 100bp revision in the next year forecast would, on average, result in a 26% rise in equity
prices (Source: GSAM, Consensus Economics and Datastream). Thus equity markets could be viewed as a
leading indicator of GDP growth and revisions to growth have a meaningful impact on returns.
Furthermore, instead of looking at the relationship between inflation-adjusted local stock market returns relative
to real growth rate of GDP or earnings, as the academic studies tend to do, far more pertinent to investors are
the currency-adjusted (USD) stock market returns, currency-adjusted earnings and currency-adjusted growth.
On this basis, the overwhelming driver of emerging returns over the past two decades has been real USD GDP
growth, as demonstrated in Chart 4 next. As UBS has highlighted, equity valuations account for much of the
volatility in returns but GDP growth is clearly the most meaningful contributor to returns.
INVESTMENT PERSPECTIVES 2012
Myth 2: Investing in developed companies carrying out business Chart 6: Operating income and capex exposure of European companies to EMs
in the emerging markets is better than investing in emerging 25%
markets companies directly 20%
Developed market companies are increasingly looking to the emerging markets to secure future growth, and
corporates in many developed economies are generating an increasing proportion of their revenue from the 15%
emerging world, from around 9% in 1990 to almost 20% today, as highlighted in Chart 5.
Chart 5: European companies’ operating income exposure to EMs
DJ Stoxx 600 companies operating income
17% Jan 90 Jan 93 Jan 96 Jan 99 Jan 02 Jan 05 Jan 08
15% Operating Income Exposure Capex Exposure
13% Source: Goldman Sachs Global ECS Research, Worldscope.
74% As a result of these trends, an investment in many developed markets stocks today is often an implicit
From Emerging 9% investment in emerging economies and indeed some investors rely on this indirect route to gain emerging
markets exposure. However, such an approach means investors are still investing in companies with 50%
or more of their income from developed markets. Not only does this dilute the investment, but investors
1990 1992 1994 1996 1998 2000 2002 2004 2006 may also pay a premium for developed companies’ operations in the rest of the world.
Developed (lhs) Emerging (rhs)
The weakness of this implicit approach is also reflected in performance returns. Goldman Sachs has
Source: Goldman Sachs Global ECS Research, Worldscope. produced a BRICs Nifty 50 Developed Markets index which comprises 50 companies from the developed
markets that are believed to directly benefit from strong growth in the emerging markets and, in particular,
Investment in emerging economies by companies in the developed world is a growing trend, as illustrated in the BRIC economies. The median exposure to emerging markets, as defined as a percentage of operating
Chart 6. This is expected to continue as many multinationals are becoming reliant on emerging markets profit or sales, is 29% for the 50 selected companies. However, as highlighted in Chart 7, while the BRICs
growth to generate revenue. For example, Unilever currently generates over half of its sales in the emerging Nifty 50 Developed markets index has modestly outperformed the S&P 500 over the past five years, the
markets, and Nestlé almost a third. index has significantly underperformed the MSCI Emerging Markets index.
2 INVESTMENT THEMES
Chart 7: MSCI EM versus GS BRICs Nifty 50 Developed Markets versus S&P 500 Investors have also justified gaining exposure to emerging markets through an investment in developed
companies by suggesting it mitigates the perceived higher risk of emerging markets. While by their nature
US$ rebased to 100
180 Cumulative Annualised developing economies are undergoing structural change which can lead to increased market volatility, we
believe emerging economies today represent something of a safe haven, with low sovereign, corporate and
160 MSCI EM 44.9% 8.3%
household debt levels, high savings rates, large current account balances and huge foreign currency
140 DS DM 50 6.6% 1.4% reserves. This is in contrast to the debt-ladened developed world. This shift in fundamentals between the
120 S&P -7.7% -1.7% emerging and developed world has taken place since the 1990s, as illustrated in Chart 9 below, but has only
100 been highlighted to investors by the recent global financial crisis. The chart clearly shows that ‘stress’ in the
80 developed world is much higher than in emerging markets, where the trend has been declining for over 20
years. Moreover, an implicit investment in emerging markets via developed companies will not eliminate
these perceived higher risks. This was highlighted recently by BP’s failed attempt to partner Russian energy
giant Rosneft, owing to AAR (a consortium of Russian billionaires who control half of the TNK-BP venture)
blocking the deal.
Chart 9: Stress in emerging markets versus developed markets
Stress Index* Stress Index*
MSCI EM DS DM 50 S&P 10 9
Source: Schroders. Returns from 30 November 2006 to 31 July 2011. 9 8
FTSE has similarly created a developed multinationals index which includes multinationals that derive 30 per 7
cent or more of revenues from outside their home economic region. The FTSE Developed Multinational 6 6
index has returned 134% over a 10-year period to 30 June 2011, while the FTSE Emerging Markets index 5 5
has returned 367%, as shown in Chart 8 below.
Chart 8: FTSE Developed Multinationals versus FTSE Emerging Markets 3
300% 1960 1967 1974 1981 1988 1995 2002 2010
Emerging Markets Advanced Economies (rhs)
Source: Source: Haver, CEIC, IMF, World Bank, UBS estimates. Data as at March 2011.
*UBS proprietary macro-risk index. The index is comprised of: change in Credit to GDP ratio over 5 years, Claims on
Private Sector (% of GDP), Current Account (% of GDP), Budget deficit (% GDP) and Government debt to GDP ratio (%).
As such, we believe that the best way of gaining exposure to the emerging economies is by investing directly
in emerging stocks rather than indirectly through developed companies.
May 01 Nov 02 Apr 04 Sep 05 Mar 07 Aug 08 Jan 10 Jun 11
FTSE EM index FTSE Dev. Multinationals index
INVESTMENT PERSPECTIVES 2012
Myth 3: Giving global equity managers the discretion to invest Furthermore, on a risk-adjusted basis, specialist emerging markets equity managers have also been shown
to deliver a superior information ratio (Chart 11). Indeed, EAFE Plus and ACWI ex-US managers actually have
in emerging stocks is sufficient to gain exposure, rather than a flat and negative information ratio, respectively, in emerging markets.
allocating to specialist emerging markets managers
Chart 11: Information ratios in emerging markets – Rolling three-year median
As highlighted previously, developed companies are becoming increasingly reliant on emerging markets
Average 3 year
growth to generate profit growth. Similarly, ‘international’ and ‘global’ equity managers are also increasingly 1.4 value added for
relying on emerging markets equity exposure to a greater extent in order to generate portfolio returns. Developed 1.2
Universe Median median manager
managers are accessing emerging economic growth implicitly through investment in developed companies but ACWI ex-US 0.00%
also through direct investments in emerging markets themselves, and often the key determinant of their competitive EAFE Plus -0.03%
performance is their exposure to emerging markets. For example, in 2009 the top quartile performing ACWI ex-US 0.8
Emerging Markets 0.40%
manager had over 24% in emerging equities and this accounted for nearly 40% of their return that year. 0.6
Such an approach may ignore the importance of specialist knowledge of political, macro-economic and 0.4
currency factors which have a major influence on the performance of companies. Moreover, regulations 0.2
and governance, although improving, are not as comprehensive as in developed countries. This means that
fund managers are required to understand a diverse range of governance and emerging markets factors in
order to consistently generate alpha. -0.2
Median ACWI ex-U.S. 3 YRIR
The importance of local specialist knowledge is reflected in the performance and risk characteristics of the Median Emerging Markets 3 YRIR
portfolios of specialist emerging markets equity managers compared to the emerging markets component -0.6 Median EAFE Plus 3 YRIR
within EAFE Plus and ACWI ex-US managers’ portfolios. As illustrated in Chart 10, specialist emerging 00 01 02 03 04 05 06 07 08 09 10
markets equity managers have consistently achieved significantly higher returns on average in comparison
Source: Intersec, data to December 2010.
to the broad universe of EAFE Plus and ACWI ex-US managers. This highlights the benefit of enhanced
diversification and increased resources dedicated to researching the markets, together with a superior
ability to harness the best opportunities in the markets. In this context, another useful measure is the batting average. Effectively, this is the percentage of time that
managers under/outperform relative to the index over rolling three-year periods. As can be seen from the
Chart 10: Relative performance in emerging markets – median manager rolling three-year three graphs following, as a broad universe, only specialist emerging markets managers have achieved a
relative returns batting average above 50.
6.0 Average 3 year
value added for
Universe median median manager
ACWI ex-US 0.04%
EAFE Plus 0.27%
3.0 Emerging Markets 1.91%
0.0 Median EAFE Plus Manager EM Allocation
Median EM Manager 3-Yr. Value Added
-1.0 Median ACWI ex-U.S. Manager EM Allocation
99 00 01 02 03 04 05 06 07 08 09 10
Source: Intersec. Data to December 2010.
2 INVESTMENT THEMES
Chart 12: Percent of time managers out/underperform Myth 4: It is better to invest in individual country and regional
EAFE Plus Rolling 3-Year Batting Average
funds rather than a global emerging markets fund
80 Investors choosing to invest with dedicated emerging markets equity specialists are still facing three further
choices: whether to gain exposure by investing in global emerging markets funds, regional funds or
individual country funds. The most suitable vehicle will depend to a certain extent on the investor’s internal
resources and capabilities. However, a number of general points can be made based on the positives and
30 negatives of the three main strategies.
There are a number of benefits for investors who adopt a global emerging markets (GEMs) approach. In
0 particular, when adopting a GEMs approach, getting the country decision right is extremely important. As
00 01 02 03 04 05 06 07 08 09 10 can be seen from Chart 13, the country factor, historically, has been far more important than industry or
style factors. In other words, when looking at say a Brazilian bank versus a Turkish bank, the country they
ACWI ex-US Rolling 3-Year Batting Average
are operating in is more important than the fact that they are both banks. The exception to this is of course
commodity stocks where global factors apply.
60 Chart 13: Contribution of risk factors to explain Cross Sectional Volatility (CSV)
20 49.0 Median
00 01 02 03 04 05 06 07 08 09 10
Emerging Markets Rolling 3-Year Batting Average
20 54.4 Median
Jan 97 Nov 98 Oct 00 Sep 02 Aug 04 Jul 06 Jun 08 Apr 10
Styles Countries Industries
00 01 02 03 04 05 06 07 08 09 10 Source: MSCI BARRA. Available data as at February 2011.
High First Quartile Median Third Quartile Low
Source: Intersec, data to December 2010. Generally, a global emerging markets approach brings significant diversification benefits. As the efficient
frontier charts overleaf clearly demonstrate, the trade off between risk and reward is typically much more
“Thus, investors should achieve better risk-adjusted returns in emerging markets by investing attractive if a GEM approach is adopted.
with specialist emerging markets managers rather than with generalists.’’
INVESTMENT PERSPECTIVES 2012
Chart 14: Efficient Frontiers Chart 15: Dispersion within emerging markets regions
10 year Efficient Frontier 10 year Efficient Frontier 10 year Efficient Frontier MSCI EM Latin Returns Dispersion
MSCI EM versus MSCI EMEA MSCI EM versus MSCI EM Asia MSCI EM versus MSCI EM Latin Net Return (%) USD
% Return (USD) p.a. % Return (USD) p.a. % Return (USD) p.a. 200
14.15 14.1 18.0
13.9 MSCI EM 100% 17.0 MSCI EM
MSCI EM 100% 50
13.95 Latin 100%
13.8 16.5 0
13.85 13.7 16.0 -50
13.75 13.6 15.5 -100
13.5 15.0 2003 2004 2005 2006 2007 2008 2009 2010 YTD 2011
MSCI EM Asia Returns Dispersion
13.55 MSCI EM Asia 100% 14.0
13.3 Net Return (%) USD
MSCI EMEA 100% MSCI EM 100%
13.45 13.2 13.5 200
24.0 24.5 25.0 25.5 26.0 26.5 27.0 23.9 24.0 24.1 24.2 24.3 24.4 24.5 23.5 25.5 27.5 29.5 31.5 33.5 150
Standard Deviation Standard Deviation Standard Deviation
Source: FactSet, Schroders, as at March 2011. All figures 10 year annualised price returns. 50
Taking money out of the EMEA or Asian region and investing in GEMs reduces risk and increases return. -50
Taking money out of GEMs and investing in Latin emerging markets does increase risk, but significantly -100
increases return. 2003 2004 2005 2006 2007 2008 2009 2010 YTD 2011
Similarly, countries in one region may be more correlated with countries in another region versus MSCI EMEA Returns Dispersion
those in the same region. For example, Russia is more correlated with Brazil than it is with Poland. Net Return (%) USD
Thus a regional approach may also be inappropriate. Each country must be looked at separately. 200
Chart 15 clearly shows this dispersion within regions. 150
2003 2004 2005 2006 2007 2008 2009 2010 YTD 2011
Source: FactSet, Schroders, as at March 2011.
2 INVESTMENT THEMES
Chart 16: JPM EMBI global sovereign spread
Although a country approach provides the most control over asset allocation and exposure can be fine
tuned accordingly, investing in single country funds is an even higher risk and can be costly, not just in terms 1,200
of hiring internal expertise, but also in terms of managing the strategy.
Investing with a GEM manager who is constantly monitoring and investing in the widest range of 1,000
opportunities should result in lower risk and significantly higher returns.
A GEM approach is also likely to be the cheapest and most efficient option for the end investor. Typically the
investor would need to allocate fewer investment professionals to the emerging markets asset class, as
there is likely to be a smaller number of external managers to assess and monitor.
There are relatively few negatives for investors adopting a GEM approach. The main negative is that the 400
investor has less control in terms of maintaining any desired structural overweight or underweight positions
to particular regions or countries if they only use this approach. 200
Although combining a global approach with a regional or country strategy can solve this to a certain extent,
it also introduces an additional level of complexity in terms of monitoring net exposure to each region and 0
country. The cost of managing the assets and monitoring the external managers will also increase. Dec 98 Dec 00 Dec 02 Dec 04 Dec 06 Dec 08 Dec 10
Thus, we would contend that adopting a GEM approach rather than investing in individual countries and Source: Bloomberg.
regions should produce a much better profile of risk-adjusted returns.
Chart 17: GEM equity prospective P/E
Myth 5: Emerging markets debt is a better way to gain exposure 22
than through emerging markets equity
Interest in emerging markets debt (EMD) has been strong owing to the robust economic fundamentals of the
emerging world, with limited need for balance sheet repair (in stark contrast to the developed world);
together with the attraction of higher-yielding returns in a global environment – characterised by loose
monetary policy and near-zero interest rates.
The strong improvement in economic fundamentals has led to a major re-rating of emerging sovereign debt.
Spreads relative to developed debt have narrowed significantly, as can be seen on Chart 16. The spread on
the Emerging Market Bond index global sovereign has fallen from over 1100 basis points at the end of 1998 10
to less than 300 basis points today. In contrast, the iTraxx Sovereign index for Western European CDS has
been trending up on the back of continued developed sovereign debt concerns.
Furthermore, certain emerging countries are judged to be less risky borrowers than several western
countries, with recent sovereign debt issues yielding less than similar maturity euro-denominated debt of Jun 94 Nov 96 May 99 Oct 01 Mar 04 Aug 06 Jan 09 Jun 11
peripheral European countries, including Spain. MSCI EM 12m Forward P/E
Source: FactSet, MSCI, data shown to 16 June 2011.
INVESTMENT PERSPECTIVES 2012
Myth 6: Investing in emerging markets through ETFs is
Over 10 years to 30 June 2011, the MSCI Emerging Markets index has returned 13.5% annualised compared better than investing with traditional active managers
to the EMBI Global Total Return index, returning 10.2% annualised (in US dollar terms). However, the strong
For a more comprehensive review of this topic, please refer to a Talking Point paper entitled ‘Active versus
performance of emerging markets equity has been supported by robust earnings growth rather than a
Passive’, published by the Emerging Markets Equity team in May 2010. We provide a summary of the
re-rating of the market, as can be see in Chart 17. Furthermore, while the case for EMD is weakened by the
reduced risk/reward profile for investors in the asset class, the outlook for emerging markets equity is
benign. Emerging markets equities are attractively valued, trading at 10.4x (PE), which is below its long-term – Equity markets are not efficient and GEMs are much less efficient than developed markets
average, and earnings growth expected to be approximately 15-20% over the next 12 months, as – By using a passive approach investors are foregoing the opportunity of capturing pricing anomalies
highlighted below. and locking themselves into momentum investing
– GEM ETFs are not that cheap. The average Total Expense Ratio (TER) is 79 basis points. In addition, ETFs
Emerging Markets USA World
have underperformed their country indices, on average, by 27 basis points over the past five years. Thus,
P/E 10.4 12.1 11.5 investors are likely to find themselves, on average, 106 basis points below the index in any given year
EPS Growth 15.1 15.6 14.9 – On a gross basis, the average active GEM manager has outperformed the index in eight of the last
10 calendar years. The average GEM ETF has only outperformed in four of the last eight calendar years.
PE/EPS Growth 0.7 0.8 0.8
Source: Factset, MSCI. 16 June 2011, IBES – 12m forward forecast.
Thus, while emerging debt has undergone a major re-rating over the last 10-15 years, emerging markets
equities have not yet been re-valued to reflect the improved fundamentals, and still appear attractively valued.
2 INVESTMENT THEMES
How best to gain exposure to the emerging markets is ultimately a function of an investors’ risk preference
and risk tolerance, together with an investor’s internal resources and capabilities. However, we believe the
analysis above supports the following conclusions:
1. The argument that there is no significant correlation between an economy’s rate of GDP growth and its
stock market returns has been shown to be flawed historically.
2. The strength of the investment case for emerging markets, in itself, warrants an explicit allocation, rather
than relying solely on an implicit and often diluted investment through developed companies.
3. It makes sense to allocate to specialist emerging markets equity managers who, on average, have been
shown to consistently outperform the emerging markets component of many ‘international’ and ‘global’
equity managers who often lack experience and expertise in emerging markets.
4. Investing in global emerging market funds, at least for core exposure, should yield lower risk and better
risk-adjusted returns than investing in single country or regional funds.
5. While emerging debt has undergone a major re-rating over recent years, emerging equity has yet to
re-rate, and still appears attractively valued.
6. Passive investors will forego the opportunity of capturing price anomalies in inefficient emerging markets.
Active emerging market managers have, on average, outperformed the MSCI Emerging Markets index;
whereas passive managers (allowing for tracking error and costs) have underperformed.
The views and opinions contained herein are those of Allan Conway, and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
2.6 Global demographics:
Canada’s unique position
Written in June 2011 Virginie Maisonneuve Head of Global and International Equities and Katherine Davidson Research Associate
Canada has a unique population structure: after the ‘loudest’ post-war baby boom in the developed world, it is Figure 1b: Gridded population cartogram for Canada
now on the verge of acute population ageing. It faces the same ageing-related issues as all other developing
countries – slowing growth and pressure on government budgets – but the outcomes could be even more
harmful if the transition is not properly managed. Is Canada up to the challenge?
Canada is the second largest country on earth by land mass, after Russia. Yet, at 35 million people, its
population is around a tenth that of the US and half that of the UK (which ranks 79th by land mass). It has
6.7% of the world’s land but just 0.5% of its population. As a result, its population density is among the lowest
in the world, at little over three people per square kilometre. This compares to 30 in the US, 250 in the UK, over
300 in India and Japan, and a staggering 7,000 in Singapore.1 Few other countries have such an abundance of
land relative to their populations: Australia, Mongolia and Iceland being notable exceptions. Given this disparity,
it is perhaps unsurprising that Canada’s natural resource endowment receives more attention than its
demographics, despite it having one of the most interesting demographic profiles in the world.
The sparseness of Canada’s population distribution is evident from the cartogram on the right, which shows that the
vast majority of the population is concentrated in a few large cities and large swathes of the country are completely
uninhabited. By contrast, the population is generally more evenly disbursed in Europe and the United States.
Figure 1a: Gridded population cartogram for US
Canada’s population is unusually concentrated, not only geographically but also in its age structure.
Canada’s baby boom was far more pronounced than that of other countries, with total fertility (average
children per woman) rising to highs of almost 3.9 in the post-war years, compared to 3.7 in the US and
below three in Western Europe. The drivers of the boom were essentially the same as in other geographies,
but were amplified by the large number of immigrants during the 1950s, most of who were of childbearing
age. Canada’s baby boom also went on for longer than America’s due to the slower uptake of the
contraceptive pill and lower female employment.2
During the subsequent ‘baby bust’, fertility dropped sharply to just 1.6, below the US or Europe, and has
remained at or below this level since.3 The more volatile fertility rate translated into a much larger baby
boomer generation relative to the size of the population: even today, one in every three Canadians is a
boomer.4 This is shown by a greater degree of ‘bulginess’ in Canada’s population pyramid.
2 INVESTMENT THEMES
Figure 2: 2010 population pyramids for Canada and the United States However, this is something of a double-edged sword. Baby boomer retirements will be far more material for
Canada than other developed countries, with the dependency ratio (inverse of the working age proportion)
Canada – 2010 United States – 2010
expected to rise 8%+ over the next 20 years compared to a more moderate 4.5% in the US. In absolute
terms, the working age population will continue to grow but at a glacial pace of two-tenths of a percent each
year to 2030, and significantly slower than total population growth. Still, this is a far better outlook than for
Japan and much of Western Europe, where both the population and labour force will be shrinking.
60-64 60-64 Studies have found that population age structure has a significant impact on economic growth. While
50-54 boom more 50-54
Canada’s growth in recent decades has been boosted by its outsized boomer population, their gradual
pronounced than retirement will tend to dampen future growth.5 This is primarily because labour supply growth is a core
40-44 the US 40-44
component of GDP growth, and labour supply tends to move in line with the working age population.
The only ways to break that relationship are to increase immigration or raise participation rates, especially
of older workers.
0-4 0-4 “Canadian demographer David Foot, argues that ‘demographics explain two-thirds of
-5 -4 -3 -2 -1 0 1 2 3 4 5 -5 -4 -3 -2 -1 0 1 2 3 4 5
everything’ – from waiting lists at tennis clubs… to the changing structure of the Canadian
Male Female Male Female
Source: US Census Bureau, 2010.
The former is a policy that Canada has embraced wholeheartedly, with the highest immigration rates in the
An Ageing Economy developed world. This is why Canada’s population will continue to grow, albeit slowly, until 2050, while many
other developed countries will shrink. By the 2020s, all population growth is expected to come from
This uniquely ‘distorted’ population structure means that demographics are more relevant for Canada than immigration, and many sectors of the economy (transport, primary industry, construction) will be dependent
almost anywhere else in the world. Canadian demographer David Foot, argues that “demographics explain on foreign workers.6 In light of this, it seems unlikely that immigration could be raised to high enough levels
two-thirds of everything” – from waiting lists at tennis clubs and occupancy rates of Toronto office buildings to completely offset the effect of domestic population ageing. UN simulations for a range of countries (not
to the changing structure of the Canadian beer market. While the large baby boomer cohort was in working including Canada) have found that immigrant flows would have to be extremely large, almost double the
age, Canada benefitted from a ‘demographic dividend’ and experienced relatively high GDP growth current population for the US!7
compared to other developed economies.
Canada has also taken steps to improve old-age participation, in particular by outlawing ageism in the
Figure 3: Proportion of the population in working age (15-64) workplace8. In some provinces, forcing an employee to retire is now considered a human rights violation.
Despite this, effective retirement ages in Canada fell during the 1980s and 1990s, and economic activity
rates for older people are still below levels in the US and Japan. This could be improved by introducing
‘Japan-style’ re-hiring programs, or financial incentives for hiring older workers. However, participation is
not a panacea – studies suggest that even a hypothetical 100% activity rate would only moderately
improve growth.9 Raising the official retirement age would have a bigger impact, as would reducing
options for early retirement, but clearly these are unpopular measures.
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Source: UN World Population Prospects, 2008 revision.
INVESTMENT PERSPECTIVES 2012
Figure 4: Economic activity rate, 2009 The fiscal impact of ageing
As GDP growth slows and the population ages, Canada’s government faces the same dilemma as others
70 across the developed world – how to manage the costs associated with swelling numbers of retirees.
Because of its unique population structure, Canada is expected to face the highest age-related spending
of any OECD member state. In net present value terms, the cost of ageing will amount to over 700% of
50 current GDP, almost 35 times as much as the crisis.15
40 Figure 5: Net present value of fiscal impact of the financial crisis and population ageing
30 % of GDP Cost of crisis/cost of ageing
Canada France Germany Greece Italy Japan United Kingdom USA
Men – 60-64 years Men – 65 plus
Source: ILO (2010).
Given minimal expansion in Canada’s labour supply, most future growth will have to be driven by 100
improvements in labour productivity. However, the impact of ageing on labour productivity is unclear:
older workers have more experience, but have declining cognitive abilities and may be slower to learn.10
Canada Korea Spain US Australia UK Germany France Mexico Turkey Italy Japan
Anecdotal evidence suggests that there can be advantages to an older workforce, and that productivity
can be improved through relatively simple steps, but remarkably few companies worldwide have taken Crisis Ageing
steps to prepare for workforce ageing.11
Source: IMF 2009.
On balance, it looks very likely that Canada will experience lower GDP growth in coming decades. Slower
population growth will mitigate the impact on per capita GDP, and hence living standards, but even this may However, these figures do not reflect the actual severity of age-related spending costs for each country in
eventually decline.12 On the other hand, rising global demand for natural resources will continue to support light of their individual pension and healthcare systems and massively different states of current fiscal health.
growth and government coffers, as long as Canada can import enough workers to man the mines. Canada may have the largest burden but, unlike Spain or Italy, it should also have the strength to bear it.
There will also be changes in the composition of GDP as a result of the demographic transition. Specific Firstly, Canada’s current fiscal position is among the strongest in the OECD. Unlike the UK or US, which
industries and companies will be affected differently by the changing demand patterns of older citizens and have been in deficit since the early 2000s, Canada ran a fiscal surplus for most of the last decade. Its
by the changing supply of workers. As we have already noted, the healthcare sector will be the major government debt is among the lowest in the developed world: 85.7% of GDP gross and just 32.6% net.
beneficiary of ageing, and the financial sector is also expected to increase its share of GDP.13 On the other As a result, its interest payments for 2011 are expected to constitute a very manageable 0.6% of GDP,
hand, the contributions of education, manufacturing, construction and retail to GDP will fall. National saving well below that of the UK (3.5%), US (2.3%) or euro area (2.9%).16
will fall as retirees run down their savings, implying capital inflows and widening trade surpluses.14
2 INVESTMENT THEMES
Figure 6: Government debt, 2010, % of GDP Figure 7: Old-age poverty rates and old-age safety nets
50 France 8.8
0 NZ 1.5
0 5 10 15 20 25 30 35
-50 Old-age poverty rate (% of over 65s with equivalent incomes below half population median)
Gross debt Net debt Canada
Source: OECD. UK
Even more importantly, Canada has been relatively quick to recognise its impending demographic transition Australia
and adjust its institutions accordingly. Both health and pensions costs, which together account for the vast France
majority of age-related spending, look likely to be kept in check as the population ages. Japan
“The challenge for Canada today is to manage the costs of a rapidly ageing population without
compromising its superior health status and further worsening standards of service.”
0 5 10 15 20 25 30 35 40 45
Value of basic, resource-tested and minimum retirement benefits
Canada’s public pension scheme has two branches: the Old Age Security pension (OAS) and the Canada Percentage of economy-wide average earnings
Pension Plan (CPP). The first pays out a basic pension (~C$500 per month) to all citizens and is funded out Source: OECD (2009), Pensions at a Glance.
of tax revenue. While nominally flat-rate, the scheme is actually quite progressive, with retirees with little/no
other income also receiving income support, and high-earners required to pay back a percentage of their
The second branch is the Canada Pension Plan, a contributory, earnings-related program much like Social
benefits or receiving none at all. The OAS is one of the most generous ‘safety nets’ in the world, ensuring
Security in the US. Since 1998, the CPP has been funded on a ‘steady state’ basis, making it something of
low levels of old-age poverty, but the low flat-rate and inflation (rather than earnings) indexation mean that
a hybrid between pay-as-you-go and fully funded. The mandatory contribution rate of 9.9% is expected to
it should remain a small percentage of GDP (2-3%) despite baby boomer retirements.17
hold for the next 75 years, and has been set to ensure that contributions cover payments until at least 2020
(see Figure 8). Thereafter, benefits will be partly funded out of investment income, but the plan should still be
perfectly solvent by 2050. This is in contrast to the US Social Security scheme which is expected to face a
permanent shortfall as early as 2016 and be completely exhausted by 2039.18
INVESTMENT PERSPECTIVES 2012
Figure 8: Actuarial position of the Canada Pension Plan to 2020 Figure 9: Annual growth rate of public expenditure on health per capita, real terms
1995 2000 2005 2010 2015 2020 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08
Contributions Investment Income Expenditures Canada UK US
Source: Canadian Office of the Chief Actuary (2010), 25th Actuarial Report on the Canada Pension Plan. Source: OECD health data, 2010.
Canada’s ‘third pillar’ is also relatively well-developed, with private pensions and other investments providing Since budget cuts in the early 1990s, cost control has been largely achieved by limiting capacity. The number of
over 40% of retirement income, compared to the OECD average of 20%. This is similar to the US, but doctors per 1,000 residents has barely risen; the number of nurses and hospital beds has fallen, and Canada
Canada’s private funds fared better through the crisis.19 As a result of this lower reliance on the state, has lagged other OECD countries in its stock of medical technology.20 Capacity control does not appear to
Canada’s public pension spending is significantly lower than the OECD average. have adversely affected health outcomes, with life expectancy and infant mortality continuing to improve and
outperform the US. However, continued demand growth has necessitated healthcare rationing and the user
On healthcare, Canada does spend more than the OECD average, at 10.4% of GDP, though still significantly
experience has deteriorated: waiting lists for procedures are long and it is often difficult to find a family doctor.21
below the US (16% of GDP). About 70% of this is state-funded, accounting for around 40% of provincial
budgets. Given the scale of the demographic transition, and Canada’s relatively steep age-benefit profile, The challenge for Canada today is to manage the costs of a rapidly ageing population without compromising
we would expect to see some increase in public healthcare costs. its superior health status and further worsening standards of service. Some provinces are already slashing
generic drug prices and considering introducing highly controversial user fees. Additional OECD
However, Canada’s strong record for controlling healthcare spending means that there is a relatively low
recommendations include negotiating an element of performance-related pay for doctors, and allowing greater
risk of costs spiralling completely out of control. As elsewhere, per capital healthcare costs in Canada
involvement by the private sector to improve efficiency and take the pressure off stretched public services.22
have outpaced overall inflation, but the gap is far smaller. Figure 9 shows that public healthcare spending
has grown slower in Canada than the US or UK for nine out of the last ten years. Without reform, the OECD expects public healthcare spending in Canada to increase by up to three
percentage points of GDP, implying a total (public and private) spending level of 14.6% of GDP by 2050.23 With
reform, this could be reduced to a very manageable 12%. Again, this compares favourably with the US where,
even assuming slower cost inflation, total healthcare spending is expected to reach 37% of GDP by 2050.
If, however, costs continue to grow at historic rates, healthcare could consume 100% of US GDP by 2080! 24
2 INVESTMENT THEMES
As global investors and stock pickers our goal is to identify high conviction holdings within high quality 1 UN World Population Prospects, 2008 Revision.
growth companies, showing sustainable competitive advantage and attractive valuation to build our 2 David Foot (1996), Boom, Bust and Echo.
portfolios. To do so, we like to have a coherent macro economic and thematic road map as a framework 3 Ibid. Note that the ‘echo-boom’ generation, the children of the baby boomers, is larger than the generations before, not
to our stock analysis and selection. Demographics is one of the key trends that we have identified along because of an improvement of fertility, but simply because there was a large number of women at child bearing age in
with climate change and ‘Supercycle’ (or the role of the large emerging markets economics in the global the 1980s-90s.
economy) on this road map. Many of our current holdings listed in Canada are resource companies. 4 US Census Bureau, Schroders.
They will need to adapt to the demographic challenges that we have highlighted in this report. 5 Bloom et al (2003), The Demographic Dividend.
6 McMullin et all (2004), Labour Force Ageing and Skills Shortages in Canada and Ontario.
The views and opinions contained herein are those of Virginie Maisonneuve and Katherine 7 UN Population Division (2000), Replacement Migration.
Davidson, and may not necessarily represent views expressed or reflected in other Schroders 8 Foot (2006), A Fortunate Country.
communications, strategies or funds.
9 UN (2000), as above.
10 Gross and Minot (2008), Effects of Japan’s Aging Population on HR Management.
11 A 2007 survey found that, of 28,000 employers in 25 countries, only 14% had a strategy for recruiting older workers.
Manpower (2007), cited in Nomura (Nov 2008), The Business of Aging. Anecdotal evidence on productivity comes from
a BMW study, cited in The Economist (June 2009).
12 Fougere et al (2009), Population Ageing, Time Allocation and Human Capital: a General Equilibrium Analysis for Canada.
13 Fougere et al (2007), A sectoral and occupational analysis of population aging in Canada using a dynamic CGE
overlapping generations model.
14 Fougere et al (2009), as above.
15 IMF (2009), Fiscal Implications of the Global Economic and Financial Crisis.
16 OECD Economic Outlook 86, 2010.
17 OECD (2009), Pensions at a Glance; Canadian Office of the Chief Actuary (2008), 8th Actuarial Report on the Old Age
Security Program. Estimates include OAS pension, income support, and allowance.
18 CBO (2010), Long-term Outlook for Social Security.
19 OECD (2009), Pensions at a Glance.
20 OECD Health Data 2010.
21 OECD Economic Surveys: Canada, September 2010.
23 Assuming public and private continue to grow at the same pace as they have historically. OECD (2006), Projecting
Health and Long-Term Care Expenditures: What are the Main Drivers?
24 CBO (2010), The Long-term Outlook for Health Care Spending.
INVESTMENT PERSPECTIVES 2012
2.7 How likely is Germany
to leave the euro?
Written in April 2011 Alan Brown Group Chief Investment Officer and Philippe Lespinard Chief Investment Officer, Fixed Income
“ We have a Treaty under which there is no possibility of paying to bailout states in difficulty” than an illusion resulting from the relative weakness of other EMU members – the growth of Germany’s
– German Chancellor, Angela Merkel, 1 March 2010. economy by 3.6% in 2010 was the fastest in over two decades, and at just 7.3%, unemployment is the
lowest it has been since 1991.
Speculation regarding the future of the eurozone continues to gather momentum. Persistent imbalances in
the economic health of the core and peripheral economies have raised serious questions regarding the The single currency union has played a central role in supporting Germany’s dramatic recovery. The weak
sustainability of the single currency, and have made it increasingly likely that one or more nations will leave euro, pushed down by worries about peripheral debt, has provided an invaluable advantage for a country
the European Monetary Union (EMU) over the next few years. as strongly reliant on exports as Germany, and in light of this one could argue that the problems in the
periphery have actually been beneficial for Germany, despite the costs associated with bail-outs.
While attention focuses on the possibility of weaker members falling out of the eurozone, Germany stands at
the head of the euro debate. As the biggest contributor to the Greek and Irish bail-outs, and currently Germany’s heightened competitiveness in the global markets has contributed enormously to the strength of its
suffering from a serious shift in public opinion against the single currency, Germany is considered by some a employment, growth, trade and confidence figures, including an impressive 13.7% growth in production in 2010.
possible contender for being the first country to leave the eurozone. Rising out of the euro and issuing new If Germany were to abandon the euro in favour of new Deutschemarks, these would be expected to appreciate
deutschemarks could certainly be highly populist! materially, effectively wiping out the competitive advantage presently afforded by the currency weakness.
However, the factors affecting Germany’s decision to uphold or abandon the single currency are complex In addition to the benefits which have arisen for Germany as a result of Europe’s current economic situation,
and often conflicting, and at this point there is little certainty as to how events will unfold. With this in mind, one must consider the advantages that drove the members of the EMU to sign on to the idea of a single
the following article examines the costs and benefits to Germany of eurozone membership, before currency in the first place.
presenting the contrasting opinions of two in-house experts – Group CIO Alan Brown, and Fixed Income
One of the most important advantages associated with the introduction of the euro was the reduction of
CIO Philippe Lespinard.
nominal exchange rate risk for companies trading across European borders. The elimination of this risk
“There is a grave threat of contagion effects for other member states in the monetary union contributed greatly to the 20% increase in the volume of trade between EMU member states between January
and increasing negative feedback loop effects”. – Bundesbank Chief, Axel Weber, 5 May 2010. 1999, when the euro was introduced, and 2002. Additionally, with the need to diversify across European
countries to minimise currency risk removed, German companies have since been able to structure European
Why should Germany stay? production units according to optimal cost considerations, allowing for greater economies of scale.
The obvious commitment of German politicians to preventing the collapse of the single currency union is a strong The elimination of foreign exchange costs between the eurozone countries – and the associated reduction
indication that they feel the benefits of EMU membership to outweigh the costs. So, what are these benefits? of trading costs – has also been beneficial for these countries.
“The ‘no bailout’ principle is anchored in the EU treaty and has to be taken absolutely seriously. However, at only ~0.5% of GDP, the reduction in transaction costs was minimal, so this factor may have
It is not possible to defuse the problem here through direct financing”. – ECB Executive Board been less influential than the elimination of nominal currency risk in boosting trade figures.
Member, Ewald Nowotny, 2009. In addition to the general benefits of belonging to the EMU, there are certain advantages enjoyed specifically
Economic benefits of staying Firstly, the single currency has strengthened the market for German goods – making them the leading
In a time when most of Europe is suffering in the aftermath of the recession, Germany is experiencing a producer within Europe. Lower trading costs within the eurozone incentivise countries to trade with Germany
strong recovery. In February 2011, Germany’s figures for industrial and consumer confidence were 16 and 9 in preference to non-EMU members, while the single currency keeps German goods at an affordable level
respectively, compared to 7 and -10 for the eurozone as a whole. Germany’s apparent prosperity is more for peripheral countries (whereas one would otherwise expect the relative strength of the German currency
to act as a deterrent).
2 INVESTMENT THEMES
It has also provided the German financial sector with a market of borrowers. Germany has traditionally had a These financial losses, as painful as they may be, would pale in comparison with the loss of exports to
strong domestic deposit base and a low return on domestic lending. The single currency has allowed them the rest of the former eurozone. The efforts made by Germany to regain its competitiveness following
to seek higher returns without currency risk by lending to the comparatively less frugal peripheral countries. reunification and the enormous costs associated with harmonizing living standards with the East would be
in vain in the face of a devaluation of its key trading partners’ currency. Productivity gains that took ten to
Political benefits of staying twenty years to build would turn into a competitive disadvantage and Germany’s industrial firms may be
forced to outsource jobs to the countries remaining in the eurozone.
Monetary union was seen as a step towards achieving the ‘dream’ of European political cohesion. In the
grand bargain struck by the founders of the European Union, Germany traded some of its economic There are also costs associated with instating a new currency, such as the replacement of ATMs, tills, coins,
sovereignty, and in particular its monetary policy embodied by the universally-admired Bundesbank, notes and so on. However, these costs are negligible in comparison to those that would arise from sources
for the political recognition it deserved as a great power but had not been accorded since the war. such as the reintroduction of currency risk, and can hardly be considered prohibitive. As a rough indication,
the costs associated with instating the euro were below 0.8% of GDP for all 12 EMU members.
Despite the fact that the eurozone represents monetary union without fiscal or political integration, the
introduction of a single currency has strengthened political bonds between the EMU members. A high level
of political cohesiveness allows for better coordination of actions requiring cross-country involvement. This
Political costs of leaving
has assisted greatly in the implementation of EU initiatives such as the harmonisation of product standards, In the grand bargain of the formation of the EU, Germany inherited one of the most influential and respected
a scheme which proved greatly advantageous for Germany by preventing other countries from undercutting institutions: the European Central Bank located in Frankfurt. The location chosen as the seat of the ECB
them with cheap and shoddy goods. was a symbol of Germany’s influence in forming the economic principles of the union. By recapturing its
sovereignty in economic and monetary policy, Germany would lose its political standing in Europe and its
Even Germany’s role as ‘holder of the purse strings’ has its benefits – it gives Germany a greater level of
influence on the European institutions, not least the seat on the ECB.
political influence over the rest of Europe, and allows them to at least try and influence the national policy
of other EMU members. The German-led proposal for a competitiveness pact between eurozone nations, Of course there are alternatives which could mitigate any loss of political standing: It may be simplistic to
which would include the linking of wages to national productivity levels, is an example of this. consider any withdrawal of Germany from the eurozone to be a unilateral act. It would be perfectly possible
to have two ‘euros’: New Deutschemarks for the Northern core and euros for the South.
The final political benefit of the single currency union has been the strengthening of diplomatic relationships
between EMU members. While there have obviously been many other factors involved in supporting the
longest period of peace in the documented history of Europe, this could be seen to have played a part. Why might Germany leave?
And while there may be many costs associated with the euro, these pale in comparison with the costs “This must be done to avoid a chain-reaction to the European and international financial system,
(both financial and human) of war. and contagion to other eurozone states. There is no alternative”.
(on the Greek bailout) – German Chancellor, Angela Merkel, 5 May 2010.
Economic costs of leaving Having discussed the reasons that Germany may wish to remain a member of the single currency union, it is
In addition to the benefits Germany would lose by leaving the eurozone, they would also suffer a number of now time to consider the factors that may drive Germany to abandon the euro.
If Germany left the EMU and introduced a new currency, we would expect this to rapidly appreciate against Inherent unfeasibility of monetary union without fiscal cohesion
the euro. Germany’s banks, insurers and savers hold a substantial amount of euro-denominated debt, so France and Germany’s proposal for increasing the level of fiscal consolidation across the EMU (in return for
the depreciation of the euro relative to its new currency – and the resulting reduction in the real value of providing an increased level of support to the weaker economies) was met with resounding ‘no’s from other
interest and principal repayments – could cost Germany a lot of money. While Germany is a major power member states, who fear the loss of their national independence – but without it, monetary unions are
in Europe, it actually has a relatively weak financial sector and this could cause the collapse of the German inherently unstable. Fixed nominal interest rates across countries with differing rates of growth and inflation
banks, plummeting Germany into a deep recession and likely adding a large amount of debt to the cause a wide divergence in real interest rates, and this serves to heighten the disparity in the rate of
government’s balance sheet in the rescue process. expansion across nations – for example, most of the peripheral eurozone countries have lost between
20 and 35% of their competitiveness since the euro came into existence.
INVESTMENT PERSPECTIVES 2012
2000=100, real effective exchange rates based on unit wage costs While the German public may be willing to bail out the peripheral countries on a one-off basis, they are
140 unwilling to extend an open-ended guarantee – so public opinion will be strongly dependent on the outlook
for the future economic health of the peripheral nations.
The single currency has been lauded for promoting peaceful relations between member states, but, as
evidenced by Yugoslavia, the Basque separatists and the IRA, there is no history to suggest that single
110 currency areas are immune to civil wars or terrorism. It could even be argued that membership of the euro
100 (as opposed to the EU) has heightened, rather than reduced, tensions, with Germany quickly tiring of its role
as guarantor and the peripheral nations unwilling to suffer from the severe fiscal tightening measures forced
upon them by the core.
70 Economic costs of staying
60 An additional issue is the trading advantage that Germany enjoys as a result of having a ‘Mediterranean’-
50 priced currency is something of an illusion. In effect, through the structural current account surplus that
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Germany ‘enjoys’ with Southern Europe, Germany is currently exchanging quality manufactured goods for
increasingly dubious financial promises. While writing off a significant portion of peripheral eurozone country
Italy Spain France Portugal Germany UK US Greece
debt today would undoubtedly be painful, allowing this structural imbalance to continue in the years ahead
Source: OECD, Datastream, Bloomberg, Schroders. could lead to a build up of truly disastrous exposures in the future.
With the rejection of this proposal, many people are questioning the likelihood of the eurozone surviving in While the peripheral nations may have provided Germany with a willing market of borrowers, this has placed
its existing form over the coming years, and believe that Germany would be better to break away before they the banking sector in a dangerous position. If one (or more) peripheral nations were to default on their debt,
become too deeply involved in the peripheral debt crisis. or, as Ireland is threatening, if there were to be haircuts on senior debt, then Germany’s financial sector
would be in serious trouble.
Political costs of staying
Economic benefits of leaving
Germany has contributed disproportionately to bailing out Greece and Ireland – at €22.4bn, over a fifth of
Greece’s €110bn bail-out package took the form of German guarantees. The potential redistribution of A new German currency would be expected to appreciate rapidly against the euro. While this could damage
German taxpayers’ money to the peripheral countries if these guarantees were to be called has fed the Germany’s position as an exporter, as German goods would become relatively more expensive, it would
growing public perception of hard-working Germans funding the propensity of southerners to live beyond also increase Germany’s comparative wealth against other countries – making other currencies relatively
their means. cheaper and imports more affordable.
Recent opinion polls have revealed that almost 60% of Germans would like to abandon the single currency
union. The growing unpopularity of EMU will membership with the German public is largely due to the fact
So, how likely is it that Germany will leave?
that the benefits are not as easily quantifiable as the costs. For example it is far easier for the general public This is an extremely hard question to answer. The situation in the eurozone is incredibly complicated, and
to understand the effect of Germany contributing €22.4bn to the Greek bail-out costs than it is for them to there are many factors which could influence Germany’s decision.
grasp the varied and complex advantages arising from the elimination of nominal exchange rate risk. While
Even within Schroders opinions on this matter are greatly divided. To provide the broadest possible view on
the political elite clearly understand the benefits of belonging to the single currency union, there is the
this subject we will therefore explore this question from the very different perspectives of two Schroders
possibility that an anti-euro political party could gain significant levels of public support – a real danger for
experts – Group CIO Alan Brown and Fixed Income CIO Philippe Lespinard.
a coalition government such as that in Germany.
2 INVESTMENT THEMES
Alan Brown, Group Chief Investment Officer Philippe Lespinard, Chief Investment Officer, Fixed Income
“ We are clearly confronted with a tension within the system, the ill-famous dilemma of being “It is sometimes said that while the single monetary policy may be ‘right’ for the euro area as
a monetary union and not a full-fledged economic and political union. This tension has a whole, it is ‘wrong’ for many individual countries within the area. I disagree with this view.
been there since the single currency was created. However, the general public was not First, it overlooks the fact that within a single currency area adjustment can occur via prices
really made aware of it.” – European Council President, Herman Van Rompuy, 25 May 2010. and wages.” – Then President of the European Central Bank, Wim Duisenburg, 1999.
Despite the difficulties associated with Germany leaving the eurozone, such a move would be neither I consider a break-up of the eurozone to be extremely unlikely. The single currency is a step on the road
impossible nor unprecedented – in fact it would be at least the 70th single currency union to have broken up towards ever-closer union and its benefits far outweigh its drawbacks. The flaws in its design may be
since the end of World War Two. The EMU simply cannot continue in its present state – the system of apparent today, but the political will to remedy them is very much present. At the heart of the debate about
monetary union without fiscal and political cohesion is inherently flawed and ultimately unsustainable. What the future of the eurozone lies the question of whether bureaucratic fixes are enough to keep the European
matters is not having a fixed nominal exchange rate and a single interest rate; it is having the right real integration project alive (as some countries seem to wish) or whether a more democratic approach is
exchange rate and the right interest rate. It is arguable that the speculative housing bubbles in Spain and necessary to proceed further, as the German political class demands.
Ireland were by-products of inappropriate German-style interest rate levels.
In the near term, the choice lies between the reintroduction of currency risk in the European economy and
And while nominal exchange rates between members have obviously been fixed, real exchange rates have the recognition of credit risk in the sovereign debt markets. The single currency is deeply entrenched and
not, either within the eurozone, or with trading partners. In fact the UK, with the pound floating between the there is simply not enough capital in Europe to deal with the reintroduction of currency risk. One does not
dollar and the euro, has had a far more stable trade-weighted exchange rate than either currency (until the need to go too far back to remember the dreaded currency crises and recessions that preceded
last couple of years when the UK has managed a competitive devaluation at just the moment when it devaluations on a regular basis.
In contrast to the losses associated with the break-up for the single currency union, the costs associated with
Unless the core economies somehow convince the other member states to accept a greater level of fiscal restructuring peripheral debt are calculable and containable. For Germany, it would be far preferable to have
integration, it is unfeasible that the EMU continue in its present state. However, the introduction of a greater Greece, Ireland and Portugal restructure their debt than risk the loss of its hard-won industrial competitiveness,
element of fiscal integration seems unlikely, especially given that a core component of the original agreement the collapse of its banking sector and the reintroduction of currency risk – it is impossible to accurately
was that individual members retain their political independence. estimate the costs of the latter scenario, or predict how far-reaching and long-lasting its effects will be.
The EMU is at heart a political project, and relies on public support from both the core ‘lenders’ and the Of course, Germany’s financial might and new found political power may not be enough if Spain, or worse,
peripheral ‘borrowers’. The flow of taxpayers’ money to the periphery has damaged the euro’s popularity in Italy, reached a point where they came to require a similar level of assistance. However, I believe that the
Germany, and the harsh fiscal controls which have been imposed on Europe’s debtors have eroded popular political desire for union is strong enough that a European Treasury would be formed before the eurozone
opinion in these states. While politicians may appear determined to uphold the single currency union, they were allowed to collapse.
cannot do this without the public vote – an anti-euro party could simply be elected to rule in their place, or, in
the case of Germany, the Constitutional court may rule their actions to be unconstitutional. The views and opinions contained herein are those of Philippe Lespinard and Alan Brown and
may not necessarily represent views expressed or reflected in other Schroders communications,
For these reasons I do not expect the EMU to continue to exist in its present state in the long-term – whether
strategies or funds.
Germany (and possibly others) floats out of the eurozone or one or more of the peripheral states falls, some
form of change in the membership of the eurozone seems highly likely, quite possibly within the next five years.
INVESTMENT PERSPECTIVES 2012
2.8 Sovereign debt crises: lessons from history
Written in July 2011 D’Maris Coffman Winton Centre for Financial History, University of Cambridge
Structure of nineteenth century bonds
The period in the late nineteenth and early twentieth century known as the ‘Belle Époque’ is perhaps best Back in the late nineteenth century, however, sovereign bonds were highly diverse in terms of instruments
remembered in Europe as a peaceful time of optimism and technological advancement, but it was also a and the way they were collateralised, and the market was supported by a sophisticated financial press.
crucial time for bond markets and may provide some solutions to the debt problems faced in Europe today.
Bonds were very long duration, with maturities of between 20 and 80 years. They were treated like
This is the view of D’Maris Coffman, a financial historian from the Winton Centre for Financial History at the
perpetuities and yields were simply calculated by dividing the coupon by the price. They also often
University of Cambridge who shared her insights at the Schroders Secular Market Forum recently.
contained highly idiosyncratic clauses. For example, many bonds from developing markets included lottery
Coffman, who is director of the Winton Centre for Financial History at Newnham College, described the era clauses whereby each year 5% of an issuance would be selected for redemption via a lottery.
between 1873 and 1913 as the first era of financial globalisation. She singled out a quote from JM Keynes
Almost all international bonds were denominated in sterling, and those that were not usually contained
which summed up the international spirit of that time:
exchange rate clauses.
“The inhabitant of London could order by telephone, sipping his morning tea in bed, the various
Significantly, many bonds of late nineteenth century also contained collateral agreements which meant that
products of the whole earth, in such quantity as he might see fit, and reasonably expect their
bonds would be serviced either by specific tax or export revenues. The result was that if a sovereign
early delivery upon his doorstep; he could at the same moment and by the same means
borrower defaulted, creditors could seize control of those assets. There was, however, a principle of
adventure his wealth in the natural resources and new enterprises of any quarter of the world,
sovereign immunity to prevent, for example, the British seizing a country’s ships when in port to service
and share, without exertion or even trouble, in their prospective fruits and advantages; or he
bond payments. But where collateral agreements detailed specific revenue sources, international creditors
could decide to couple the security of his fortunes with the good faith of the townspeople of
could get access to them.
any substantial municipality in any continent that fancy or information might recommend.”
Bond market similarities Creditor action
The reason this is relevant today is because mechanisms for creditor action against defaulters are emerging
As well as being the era in which financial globalisation began in earnest, Coffman described the Belle Époque
again. The Chinese government has started unilateral negotiations with Greece, offering to accept
as ‘a period in which bond markets were structurally more similar to those today than anything that happened
concessions, such as the operation of particular port, in lieu of interest payments, or in exchange for a
between 1914 and 1989.’ Citing the work of colleagues at the International Monetary Fund, Hebrew University
liquidity infusion with which to service other bondholders.
of Jerusalem, and University of Tasmania, Coffman argues that there are significant parallels.
Coffman argued that such deals could become increasingly de rigeur as there are signs that sovereign
What brought about the more mature bond markets of the past two decades was the Latin American debt
immunity is breaking down. She cited the example of the vulture hedge fund Elliot Associates which in the
crisis of the 1980s, Coffman thinks, and the Brady Bonds used in part to resolve it.
nineties bought convertible loans from Peru, then refused to convert them to Brady Bonds, and sued the
“The European union, Asian bond markets and Latin American bond markets all came out of a moment of government. When Peru quickly settled the dispute, Elliot Associates received six times the amount it would
crisis in the 1980s, made possible by the end of the Cold War,” she said. have got through the proposed Brady Bond settlement.
To look at how creditor action can work and to assess how governments can collateralise debt as a potential
solution to default problems, Coffman talked in detail about the Corporation of Foreign Bond Holders. It was
set up in 1868 and provided a forum for British creditors to coordinate their actions in dealing with foreign
government bond defaults.
2 INVESTMENT THEMES
Collateral clauses and the Ottoman Empire The Latin Monetary Union
Because of the nature of the collateral clauses often written into bond agreements, there were takeover A key parallel Coffman made between the Belle Epoque and today was the emergence of the Latin
opportunities for bondholders working together. They could in theory simply seize control of a Russian rail Monetary Union (LMU) in 1865, which has clear similarities with the single European currency of today.
road or a Queensland mine in order to generate the revenue to service a bond. However, in practise this
It was part of Napoleon III’s plan to marginalise the British by building a trading bloc within Europe made
seldom happened, Coffman said, and sometimes there was a debt for equity swap whereby bondholders
up of France, Belgium, Italy and Switzerland, and to internationalise the French franc. The nations agreed
could acquire equity in industrial ventures, but more often an international committee would be set up.
to change their national currencies to a standard of 4.5 grams of silver or 0.29 grams of gold – a ratio of
She singled out the Ottoman Empire as an example of how international creditor action worked. As a result 15.5 to 1 – and make them freely interchangeable
of lobbying by international bondholders the Council for Ottoman Debt Administration was set up in 1881.
“If it was meant to increase trade in France and other LMU countries, then it succeeded, but if it was meant
The council was made up mostly of creditors to the declining empire and they worked directly with Ottoman
to internationalise the franc it failed miserably,” Coffman said.
tax authorities and got funds directly from the government’s tax revenue coffers. They realised that the
revenues assigned in the original collateral agreement were not generating the necessary capital, so they It did create a miniature currency union however. But, with clear parallels to today’s euro, newer entrants
were able to negotiate for even more of the country’s revenues. Coffman compared the situation to what and more peripheral countries caused difficulties.
the Chinese have been doing with Greece recently.
Spain and Greece joined the LMU in 1869 and immediately saw the benefits as they found their bond
On one hand, this system was a great success, she said. Creditors were repaid, while the Ottomans were spreads decreasing. However, they then became the serial defaulters of the 19th century.
able to borrow more cheaply on international capital markets in the last two decades of the 19th century
than in their domestic market. But on the other hand, some have argued that the concessions destroyed Then, in 1889 once Serbia, Romania and Bulgaria broke free from the Ottoman Empire and established their
the sovereignty of the Sultan and slowed down the Ottoman Empire’s integration with European markets. independence, they turned to the LMU as well. They thought that if they could establish convertibility in the
bloc and issue their loans in francs, they would get access to much cheaper capital than they would if they
worked with the British or if they turned and worked with the same people overseeing the Ottomans and
Parallels today forcing them to make concessions to service their debts.
Coffman drew parallels with the situation today concerning the likes of Greece and Italy. “They had an
“The LMU became a way out for bad sovereign borrowers of the 19th century,” Coffman said.
international committee working with revenue authorities so they could make sure that tax revenues
collected went directly to bondholders without being siphoned off and used for some sort of domestic In conclusion, Coffman said she thinks the way forward for debt markets is in the ‘renewed scope for
project,” she said. “That is the interesting thing in dealing with Greece and Italy today. We all know the international creditor action’.
representations the Greeks made in joining the EU were not accurate and with the Italians we can see that
“I don’t think the IMF and the World Bank are going to be able to handle this situation, and the track record
public revenue disappears all the time. The question is whether or not it is feasible for creditor organisations
of the ECB doesn’t encourage a great deal of faith that central bank coordination will solve the problem
to somehow work with fiscal authorities to top-slice public revenue, like in the 19th century.”
either. As to what forms these creditor actions might take, you have a range of very creative and diverse
Between the years 1877 and 1913 the number of loans in default in international bond markets fell solutions from the 19th century which may show the way forward.”
dramatically – something Coffman puts down to the actions of such organisations as the Corporation of
The views and opinions contained herein are those of D’Maris Coffman and may not necessarily
Foreign Bond Holders.
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
2.9 To be or not to be… in China:
a global investor’s perspective
Written in April 2011 Virginie Maisonneuve Head of Global and International Equities
China is the land of ‘big numbers’. The Chinese ‘economic miracle’ that took place during the past 25 years Figure 1: Projecting when China’s economy will overtake the US’s economy
has been confirmed by the recent global economic crisis and the country is expected to overtake the US as Passing the buck
the largest global economy as early as 2027. But China is a land of contrasting statistics and faces several GDP,* $trillion Based on the following long-term assumptions, annual average, %: Real GDP Inflation** Yuan
challenges, both externally and internally. Its latest five year plan sheds some light on how the government 25 2019 growth appreciation†
will take on those challenges and further its economic ascension. The extent of the success of the plan will China 7.75 4.00 3.00
also have important implications for the ongoing global economic recovery as well as for global investors. 20 United States 2.50 1.50
By investing either directly in Chinese companies or through global companies with significant exposure to
Chinese demand, the strong structural growth potential that China offers is incredibly attractive from a 15
long-term investment basis. United
China: bigger than you think?
5 *At current prices and market exchange rates.
China was the largest economy in the world for 18 of the past 20 centuries until 1850 (Financial Times). **GDP deflator.
As we know, China is the land of ‘big numbers’. While many did not believe in the validity of a Chinese China Forecast † Against the dollar.
‘economic miracle’ 25 years ago, consensus now has clearly shifted. This economic ascension was further Source: The Economist.
promoted by the global financial crisis as China gained relative economic power in light of the general 2000 2005 2010 2015 2020
weakness of many other leading nations, in particular Japan. However, having worked in China in the mid Figure 2: The largest economies in 2050
1980s and looked at the country’s development from a domestic, Asian, emerging market and global
perspective via different positions, I am still convinced that the impact that China will have over the next
20 years on the world is not fully discounted.
China overtook Japan as the second largest world economy in 2010. At about US$6tr, China is now 80,000
approximately the same size as India, Russia and Brazil together. What is next? 70,000
Some forecasters have brought forward the date where they see China surpassing the US economy on a 50,000
nominal basis from 2041 to 2027. On a purchasing power parity basis, the crossover would happen around 40,000
2015. By 2050, Goldman Sachs estimates that China’s GDP will reach US$85tr versus the US at US$38tr. 30,000
Furthermore, if one focuses on expected growth contribution to the global economy for the 2010-2019 20,000
period, China would represent the largest growth contributor with a share of over 30%. With regards to 10,000
the size of trade, China is expected to overtake the US in 2016. 0
*GDP projections have been re-based from 2007 to 2010 to incorporate recent data. Growth and currency appreciation
paths from 2011 to 2050 are kept the same.
78 Source: GS Global ECS Research. GSAM Calculations.
2 INVESTMENT THEMES
If we now focus on several other facts in the land of the large numbers, noticeable is the fact that during the The 12th five-year plan: managing transition
financial crisis, China’s vehicle market became the largest in the world and is likely to be five times larger
than Japan’s by 2015. Looking at foreign exchange reserves, China again stands out. It has a total of The 12th five-year plan continues to emphasize some of the key aspects of the 11th five-year plan, including
US$2.85tr compared to Japan and the EU, the next largest holders, which have US$790bn and US$133bn helping reduce social distortions, increasing the focus on consumption and improving the intensity of energy
respectively. As for monetary supply (M2), China surpassed the US in 2010 with a total of US$11.4tr versus used as well as energy conservation. During the last plan, China built 16,000km of railway and expanded its
the USA at US$8.9tr. road system by 639,000km including 33,000km of expressways. It also built 33 airports. With regards to
energy preservation, the country added 445m kW of capacity in new power plants, including hydropower
(96m kW) and nuclear (3.84m kW). Outward foreign investment reached US$220bn.
The land of contrasting characteristics
The backbone of the 12th five-year plan is targeting a successful transition from an industrial-based growth
However, China’s absolute size as the second largest economic power in the world, masks many contrasts.
model to a consumption-based growth model. At this stage of development in the Chinese economy, and
On a per capita GDP basis, China at US$4,520 is broadly where the USA was in 1966 and ranks 90 globally,
given the potential limitation of further growth in the contribution of net exports to GDP, it makes a lot of
behind Thailand and ahead of Iran. However, the level of its exports per capita is that of the USA in 1980 and
sense for China to make the transition towards a consumption-led model.
despite being the largest vehicle market in the world, its car penetration is equivalent to the USA in 1917. On
the other hand, its steel consumption per capita is higher than the USA today. Let’s review the key points of the 12th five-year plan.
Figure 3: Putting China in perspective Sustainable growth: The new plan can be articulated around five ‘sations’: industrialisation,
‘informatisation’, urbanisation, marketisation and internationalisation. These are key tools to achieve a targeted
China/US (x, Current)
growth of 7% over the next five years (down from 11.2% achieved in the 11th five-year plan). Technology and
3.0 innovation is at the core. Energy preservation and a strong focus on using non-fossil energy are also key; the
Electricity Consumption Intensity
plan stipulates that in 2015 11.4% of China’s energy needs will come from non-fossil fuels, from about 8%
2.5 Steel Consumption
today. This is the equivalent of taking an economy the size of Italy out of fossil fuel! Energy consumption and
Bank Loans carbon dioxide emission per unit of GDP is also targeted to be reduced by 16% and 17% respectively.
2009 China GDP per capita = 1966 GDP per capita
Social stability: China aims to create 45m urban jobs in the next five years. Low-income housing will be
1.5 made available to 20% of the country’s urban population with 36 million new homes built and made further
accessible through the promotion of wage growth.
1.0 Fiscal and tax reform: This will be accelerated, and will include modification of resource taxes to reflect
Life Insurance Penetration Mobile Phone Penetration supply and demand and the cost of environmental damages, as well as income redistribution.
0.5 Stock Market Capitalisation
Electricity Consumption per capita Domestic Bond Outstanding
Exports of Goods The financial system: This will be further developed with a particular focus on developing the bond market
Passenger Car Penetration Fixed Investment
Air Travel GDP Exports of Services and creating a ‘secure system’. In addition, China has stated that it will promote the internationalisation of
the currency. I believe this is the first step towards a full convertibility of the currency, which could well be
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 achieved towards the end of this five-year plan. China’s worries about the global dependence on the US
X-axis measures the equivalent year of US when the level of demand was equal to that of China. Y-axis measures the (economic and currency wise) has been further heightened by the crisis and its desire to help balance the
current level of demand in China compared to the US. world with another large currency (her own) has been put forward.
Source: World Bank, Swiss Re, IMF, Gartner, Eurostat, US Department of Agriculture, World Federation of Exchanges,
Growth and inflation: For 2011 in particular, economic growth is targeted at 8% and inflation at 4%.
Credit Suisse estimates.
The latter may turn to be a challenge given the increase in commodity prices (including soft commodities).
Inflation control encompasses liquidity control but also an emphasis on the supply of food with an increase
Those contrasting features give China a dual status of both a leading global nation with strong geopolitical
in local government responsibilities. For example, provincial governors will take responsibility for the ‘rice
power, and of an emerging economy with a lot to do to address its large domestic imbalances and (as a
bag programme’ and city mayors for the ‘vegetable baskets program’. Finally, the restructuring and
consequence) improve the standard of living as is expected by many of its citizens after decades of hardship.
development of the agricultural distribution system will be put in place.
To manage this going forward, the country has just finalised its next five-year plan and outlined its priorities.
INVESTMENT PERSPECTIVES 2012
Domestic demand is key to global recovery Figure 4: Total population of China and population of working age (15-64 yrs)
The success of the measures put in place to promote such growth (base salary increases, better health and 80% 1.6
insurance plans etc.) is key not only to China but also to the global economy. Although its economy is larger Forecast
than Japan’s, China’s current consumption is only 60% of the level in Japan. In the aftermath of the financial 70% 1.4
crisis and with US consumers still recouping from high leverage and a difficult economic environment, the 60% 1.2
success of the 12th five-year plan and the boost to Chinese consumption could be a new structural global
growth engine that many have not truly considered. Can China relieve the US from its consumption
leadership role? With US$10.5tr in consumption, the US represents 17% of global GDP. Since 2000, the 40% 0.8
world economy has grown from US$32tr to over US$60tr. During that period, the US has added US$4.8tr 30% 0.6
to its GDP, with 74% of that growth being consumption-led.
China, with a current consumption-to-GDP ratio of 48% shows private consumption accounting for only 10% 0.2
35% of GDP. Interestingly, while consumption grew a healthy 15% over the past few years, the strong
growth in fixed asset investment (25-30% p.a.) and exports (30% p.a.) means that the wage-to-GDP ratio in 0% 0.0
China actually came down during the past couple of years to about 50%. Private consumption-to-GDP fell
from 42% in the 10th five-year plan to 36% in 2010. Over the next five years, assuming a 19% wage growth
Working age population Total population % working age
p.a., the wage-to-GDP ratio in China could grow from 50% to over 62%. Given these figures, we would
expect that Chinese consumption could surpass that of Japan (currently about US$3tr) in 2013 and reach Source: UN World Population prospects.
US$6tr by 2015 but still be below the US and EU consumption levels.
Figure 5: Dependency ratio
Consumption and demographics: peaking labour force
% of population aged 15-64
While China’s success has been partially based on its ‘endless’ cheap manufacturing workforce providing 90
factories to the rest of the world, some will be surprised to hear the country is facing a degree of labour 80
shortage. Where is this coming from?
The one child policy was a key instrument in reducing the Chinese fertility ratio from 2.9 in 1979 to 1.7 today. 60
The policy was put in place after an initial government initiative by Premier Zhou Enlai in 1971 (the voluntary
‘later, longer, fewer’ policy) halved fertility rates from 5.9 in 1970 to 2.9 in 1979.
The result of the policy was that China’s demographic pyramid grew ‘fat’ in the middle – in other words with
a large proportion at working age and a small proportion of 0-14 year olds and over 64 year olds. With an
abundant young labour force, China reaped a noticeable ‘demographic dividend’. Today, China is still a
relatively young country with a median age of around 30 and more than 70% of its population is of working 10
age (between 15 and 64 years old). Furthermore, its current dependency ratio is among the lowest in the 0
world. However, the long run implications of falling fertility rates are more troubling. China is ageing very fast,
even faster than Western Europe. While its total population will continue to grow, albeit at a diminishing rate
until 2030, the working age population has recently reached a turning point. Indeed, it is expected to peak in Children Elderly
2015 and fall by 2050. While China’s labour force is still growing (from 977m in 2010 to 993m in 2015), the Source: UN World Population Prospects.
number of ‘youngsters’ (15-24 year olds) entering the workforce will fall by almost 30% over the next 10
years. Does this derail the bullish consumption story for China over the next 20 years?
2 INVESTMENT THEMES
An ageing labour force matters because older workers are less likely to be mobile and move to coastal First, aligning local government’s interests with the national government’s interests to enable a successful
factories. For example, statistics in China show that 25% of workers aged 16 to 30 years old migrate, implementation of the five-year plan will be key. In the transition from industrial- to consumption-led
compared to only 11% of those in their 40s. economic growth, incentives for major government entities must be adjusted to help change mentalities
and habits. Aligning local and central government targets and processes is key. A tax reform will be
In our view, the key to understanding the economic impact of the peaking labour force in China is to assess
challenging but might not be enough and therefore more qualitative guidance might be needed.
the labour force potential for productivity growth as well as the absolute size and average wealth of that
population. China still has a massive rural population and the potential benefit from continued reallocation Second, while targeting consumption-led growth clearly justifies higher wages and income to enable
of workers from the rural to the urban area is large. The 12th five-year plan targets urbanization, aiming to spending, it might create new challenges for corporate profitability and productivity overall. The key resides
increase levels to 51.5% from 47.5%. in technological improvements and the focus on higher added value products, especially in the Pearl River
Delta and Guangdong area.
Furthermore, rural surplus labour is large. There are 510m people living in rural areas and the
government has estimated that 197m people are effectively needed to produce the 2008 agricultural Third, income disparities pose a challenge. Tackling social disparities in China both on an income gap basis
output. This indicates that there are potentially over 340m rural workers who could be available for and between rural and urban areas will be crucial and challenging. China has stopped publishing its Gini
reallocation. With regards to productivity, it has been estimated that non-primary sectors in China are coefficient, but it is estimated to be above 50. The renewed focus of the 12th five-year plan on this issue
four to five times more productive than industries such as farming. In addition, according to one of the (social housing, health care, education) is important and is crucial to achieving the government’s goal of
leading scholars on demographics in China, Dr Cai Fang, an extra year of education for Chinese sustainable economic growth. It will also be a major cornerstone of its income redistribution tax reform and
students could lead to a 17% increase in productivity in the manufacturing sector. help develop a substantial middle class in China over the next decade. As we have seen with the recent
events in the Middle East, income unfairness in a rising inflationary environment can trigger stable
The combination of declining savings (currently at 44%), labour reallocation (and productivity increase
populations to protest.
stemming from improvements in agriculture techniques and the migration of rural population to
non-primary industries in the urban areas) and increasing income will underpin strong consumption Figure 6: Consumption gap in China: Rural consumption as a % of urban consumption
over the next 20 years in China, despite a peaking labour force.
Challenges to China’s future can be divided into two camps: external and internal.
Externally, there are two major potential challenges. First, given China’s size its impact on key commodities Medical Service
such as oil, iron ore, copper and soft commodities are well known. China remains exposed to the external Household Facility,
conditions affecting the price of such commodities, as it is extremely dependant on importing them. Article & Service
China’s goal to lower dependence on oil is ambitious and laudable in the context of climate change but Transport, Post &
will be challenging. Furthermore, its ‘green policy’ relies a lot on an aggressive build up in nuclear capacity, Telecommunication
which might need to be altered after the recent events in Japan. Recreation, Education
& Cultural Service
Second, although China’s geopolitical role has increased with its economic power, the country has refrained
from getting involved in many global issues except those regarding Taiwan and Japan. How long can it Clothing
maintain this posture given that it is the second largest world economy? This will be especially pertinent
0% 15% 30% 45% 60% 75%
if the Renminbi was to become a reserve currency.
Rural Consumption as % of Urban
Internally, we see China facing several challenges. Sources: CEIC, Euromonitor, Morgan Stanley Research.
INVESTMENT PERSPECTIVES 2012
Figure 7: China’s regional disparities in a global context Figure 8: China has one of the highest bank lending ratios
GDP per capita (US$ 2009) Bank loans (% of GDP)
Western Central China
0% 20% 40% 60% 80% 100% 120% 140% 160%
Sources: CEIC, Morgan Stanley Research. *India, Korea and Italy are 2008.
Source: CEIC, Morgan Stanley Research.
Fourth, inflation may not be easy to contain. The government’s reform in the agricultural and distribution
areas, combined with a focus on supply stability for food in particular, seems well thought through. However,
Figure 9: Financial intermediation in China is dominated by commercial banks
it will not be easy to keep inflation at the 4% targeted rate. The increased impact of imported inflation
combined with structural inflation linked to a shift towards a consumption model must be expected. % of total
Fifth, how robust is the financial system? China’s bank loans-to-GDP is over 120% and is one of the highest
after the UK. Furthermore, many have been increasingly critical of the ‘reckless’ loans granted by some 32 32
banks to local governments, especially for ‘glamour projects’. However, China’s total debt-to-GDP (including 46
private and government debt) is relatively low (below 200%) compared to most countries. Furthermore, 70
China’s external debt remains one of the world’s lowest (about 16% of GDP). Currently, financial 60
intermediation in China is dominated by commercial banks (85%), while other countries like the USA have 50 62
more diversified structures with 16% banks, 60% bonds and 22% equities. China’s goal is to increase 40 25
diversification in this area in order to be less vulnerable.
30 63 61
US EU Japan Korea China
Equity Bond Loan
Source: CEIC, Morgan Stanley Research.
2 INVESTMENT THEMES
Shopping around the world for best ideas gives investors the flexibility to focus on high conviction holdings. Figure 10: Oil demand per capita – China versus global peers
From a global perspective, the strong structural growth potential that China offers is incredibly attractive tons per capita
from a long-term basis. Clearly valuation, market and earnings volatility must all be integrated to fine tune the
appropriate level of Chinese exposure to the portfolios. This level should be achieved either via Chinese 2.74
companies listed in China and off shore exchanges (US, Singapore, Hong Kong etc.) or via global
companies deriving a substantial part of their earnings and growth from China.
Among the areas with the strongest growth potential are: 2.0
Consumers: growth in wages will underpin strong earnings potential for investment in consumer related 1.55
areas, including travel, luxury goods, consumer discretionary and services. With a ratio of service-to-GDP at 1.34
only 42%, China is behind the US and Japan but also India. It even lags the level registered in Japan 40
years ago! China will become the largest aviation and luxury goods markets in 2020 and 2025 respectively.
E-commerce and online payment systems are also expected to provide strong growth in China. With a
current 2% market share of retail sales, it can easily grow to 7% by 2015, which would dictate an overall 0.30
e-commerce market size of over US$300bn by 2015.
Financials: the financial crisis has brought Chinese banks to the forefront of the global banks league with US Europe Japan Korea China (2009) China (2015)
the top four Chinese banks ranked among the top 25 global financial institutions. If one assumes that the
current total bank loans-to-assets of 50% is maintained until 2015, the growth in the banking industry in Source: BP Statistics, industry data Credit Suisse estimates.
China is indeed very large with a total assets base in 2015 of about US$32tr compared to US$8.9tr in 2009.
This would mean that Chinese bank assets would be larger than both Japan’s and the UK’s in 2015 and The views and opinions contained herein are those of the Schroders Global and International
comparable to those of the EU. Non-bank financial assets will show the strongest growth, in particular Equities team, and may not necessarily represent views expressed or reflected in other
insurance and capital market activities. The life insurance market is expected to grow by 200% between Schroders communications, strategies or funds.
2010 and 2015 with a value of approximately US$630bn by 2015, larger than the Japanese market in 2009
and about 80% of the USA. The Chinese bond market development will also be noticeable, growing from
11% of GDP to 24% of GDP over the next few years.
Commodities: because of the structural shifts in the management of the Chinese economy discussed
above, China’s role in driving marginal global demand will decrease but will remain strong as investment
programmes such as the public housing program, energy efficiency linked infrastructure investment and the
improvement of the infrastructure inland will continue to drive healthy demand. With an expectation for steel
demand to reach 755m tons in 2015 from about 600m tons in 2010, the steel consumption that China will
profile in 2015 could still be 75% of global demand. With regards to oil, although the current plan targets an
increase of only 25% for the period to 556m tons due to the energy efficiency efforts, this will still be 14% of
the global oil demand or 2.8 times Japan’s and about 80% of the EU’s oil consumption.
INVESTMENT PERSPECTIVES 2012
2.10 Unquenchable thirst? The implications
of water scarcity in China
Written in January 2011 Rory Pike ESG Equity Analyst and Rick Stathers Head of Responsible Investment
Annually water issues cost China 2-3% of its GDP and the situation is not improving. At current supply levels Opportunities may also exist to invest in infrastructure and government spending on efficiency, however, given
China’s water deficit is 30-40bn m3/year, which could result in a total deficit of 80% by 2050. While there are that infrastructure improvement may only have a limited success we see the best prospects lying with tariffs.
opportunities to combat water scarcity through increasing efficiency and tackling widespread pollution,
demand is expected to continue to grow alongside economic growth, population growth and income. Introduction
The Chinese Government has, however, taken steps to tackle the problems. Its initiatives have focussed on Across the world, water and how to deal with its finite supply, is emerging as a material issue. In China,
three areas: infrastructure projects; regulation and legislation; and pricing. Emphasis has been placed on however, water has already become a central theme in China’s efforts to make its economic development
investment in infrastructure projects, e.g. the South-North Water Transfer project, though the success of more sustainable. Here we explore the underlying situation, the response of the Chinese government, the
these has been questionable. The 12th five-year plan is likely to include significant further investment in outlook for China, where investment opportunities might lie and opportunities for managing risk to investments.
infrastructure and water treatment.
Increasing supply, however, is unlikely to resolve the situation singlehandedly, given that water is already The situation
scarce and demand is likely to continue to increase. Consequently, the ability of the Chinese government to
China’s ability to provide sufficient water supply, to meet the demands of domestic and industrial
utilise regulatory and market based measures will likely prove vital. Though there has been significant
consumption, is severely limited by a number of independent factors. In some instances they feed
impetus from central government in trying to tackle the issue of water scarcity this has not been translated
into each other but it is important to understand each of them separately.
into efficient management of the issue on a local level. Enforcement of regulation is inconsistent and conflicts
of interest are abundant, with those holding local authority frequently also heavily invested in local
Fig 1: Chinese regional water scarcity
businesses and these businesses representing vital parts of the local economy.
Allowing the price of water to fully reflect its market value, then, represents the most efficient method of
combating water scarcity. This is because rather than trying to squeeze further supply from an already scarce
resource it tackles the issues of demand. While there have been increases in water tariffs in recent years
China’s water price remains exceedingly low when expressed as a percentage of net disposable income.
It is hard to anticipate how successful China’s handling of their water situation will be, and expert opinion
remains divided on the issue. What is abundantly clear, however, is that water is already a significant issue
No scarcity (>3,000m3 per capita)
for China and one which will have material impacts on the economy. Consequently it is likely that the
Mild water scarcity (<3,000m3 per capita)
Chinese government will be required to utilise all methods at their disposal and tackle the underlying issue of
Moderate water scarcity (<2,000m3 per capita)
demand, which can only really be achieved through allowing prices to appreciate and reflect the underlying
Severe water scarcity (<1,000m3 per capita)
value of water.
Extreme water scarcity (<500m3 per capita)
Though the market is anticipating some continued price rises it seems that they may have underestimated the
levels with which they must increase. The best opportunities, then, for investment in Chinese water are in
companies that are exposed to collecting water tariffs and will consequently benefit from their rise.
84 Source: China Statistical Yearbook 2009; Nomura estimates.
2 INVESTMENT THEMES
Natural lack of water Increasing demand
China lacks water in two important but separate ways: firstly, China has low per capita water supply; and Fig. 2 demonstrates just how much demand is expected to continue growing in China over the next thirty years.
secondly, uneven spatial distribution of the water. Per capita water availability is 2,156m3/year, which is about In the past 50 years there has been massive population growth, industrialisation and urbanisation; all of which
a quarter of the world average of 8549 m3/year.1 have greatly contributed to a huge increase in the demand for water. This underlying demand will continue to
grow for three reasons: firstly, continued economic growth will lead to continued industrial expansion; secondly,
Table 1: Regional water distribution2 population growth is expected to continue until 2030;8 and finally, as the income of the population increase there will
Region Water availability Arable land Population GDP
be growing demand for water intensive products and diets. However this is unlikely to be completely translated into
North 19% 64% 46% 44%
increased demand because there remains significant scope for reducing demand through increased efficiency.
South 81% 36% 54% 56%
Fig. 2: Projected Chinese water demand
As can be seen in Table 1, the north of China, with the majority of arable farming land, almost half of the Per capita
Shares by sectors (%)
population and GDP has access to less than a fifth of the country’s water, consequently per capita water Total demand (km2) demand (m3) 2000 2030
is 757m3/year, less than the 1,000m3/year defined as water scarcity.3 This uneven natural distribution has 2000 2030 Increase 2000 2030 Municipal Industry Agriculture Municipal Industry Agriculture
been exacerbated by rapid urbanisation, thus almost half of Chinese cities have insufficient water supplies River Songhaujiang 35.2 51.7 16.5 559 689 9 22 69 9 20 71
and 100 experience severe water shortages. For example, Beijing has a per capita availability of around Basins
Liao 19.6 22.7 3.1 356 355 13 18 69 20 25 55
300m3/year, which is described as severe water scarcity.4 Hai 40.2 42.9 2.7 312 262 13 17 70 21 21 58
Huang 43.7 48.1 4.4 397 364 7 14 79 13 19 68
Overuse Huai 65.1 71.6 6.5 332 320 10 16 74 18 20 62
Yangtze 193.9 223.9 30.0 454 451 10 29 61 15 33 52
Compounding the issue of geographically uneven water distribution is the breakneck speed with which
Southeast Rivers 33.9 33.8 -0.1 471 367 12 26 62 20 34 46
China is consuming its water resources. At current supply levels the annual shortage of water is estimated to
Pearl 79.2 81.0 1.8 492 405 13 20 67 20 29 51
be 30-40bn m3/year, which could result in a total deficit of 80% of the annual supply by 2050.5 The idea of
consuming more water than there is in supply may seem oxymoronic, but what it really means is that surface Southwest Rivers 10.6 13.6 3.0 530 544 8 3 89 14 6 80
supplies are being totally consumed and groundwater supplies are being diminished faster than they can be Northwest Rivers 59.8 64.2 4.4 2062 1646 2 3 95 4 3 93
replenished. There are a number of problems associated with depleting groundwater resources: they Regions 6 Northern Regions 263.6 301.2 37.6 453 432 8 14 78 13 17 70
replenish slowly, so while they represent a resource now they will take many years to return to current levels; 4 Southern Regions 317.6 352.3 34.7 467 433 12 25 63 17 31 52
as they deplete their water level drops making it more expensive and more challenging to extract water from Nationwide 581.2 653.5 72.3 461 432 10 20 70 16 24 60
them; as aquifers (underground layers of water-bearing permeable rock or unconsolidated materials) Source: World Bank, Water Scarcity in China.
deplete, their permanent capacity to store water is reduced; and depletion can also lead to surface level
subsidence. These are not usually major problems, but China is consuming its groundwater supplies at an While an increase in demand of 12.4% may not appear that large it must be understood in the context of
exceedingly rapid rate. In recent years Beijing’s water table has dropped by 50% to 300m and since the China already running a significant water deficit and that a water deficit cannot continue forever. Eventually
1980s6 the area of groundwater exploitation has grown from 87,000km2 to 180,000km2.7 groundwater aquifers will become exhausted; in the Hai-Luan basin, for example, groundwater is being
withdrawn at a rate of 95.5%, contributing to major drops in the water table.9
INVESTMENT PERSPECTIVES 2012
Inefficiency Changing Meteorological Patterns
China’s relationship with water is characterised by extreme inefficiency. Agriculture is especially wasteful, Changes in rainfall patterns over the last 100 years have meant that the south, where water is already
only 45% of the water that is withdrawn ever actually makes it to crops. While recycling levels in industry are relatively abundant, has seen its per annum rainfall increase by around 20-60mm/decade while the north,
40%, compared to the 75-85% achieved in developed economies. Paper producers in China use over with its pre-existing dearth, has seen per annum rainfall fall by 20-40mm/decade.15 Climatic change has also
double the amount of water of their developed economy counterparts and steel producers consume meant that weather patterns have become increasingly volatile, with an increasing prevalence of extreme
60% more. Annually China’s water loss to leakages is double that of Brazil and ten times that of the UK.10 floods and droughts. Water flows in the Hai, Huang and Huai river basins have declined by 41%, 15% and
There is clearly significant scope for increasing the efficiency of water supply and consumption in China; 9% respectively in the past 20 years.16 Changing patterns of precipitation have exacerbated the already
however this is linked in to popular attitudes to water and its consumption. profound disparities between water availability in the north and south of China. 2009 saw the worst droughts
in China for the last 50 years, consequently, in certain areas, over 50% of agricultural production was lost.17
One potential side effect from increased efficiency is that it could decrease the amount of China’s food
supply that is internally produced, crops with low water efficiency, e.g. winter wheat, could be dropped and The challenges imposed by glacial melting and changing meteorology are very different to those imposed by
a greater proportion of food requirements imported. Very little study has been carried out into what the the other factors, in that they have not been directly caused by China’s actions and there is little that China
impact of increased Chinese demand would have on world food prices, though clearly there would be can directly do to change their course, though not through lack of trying.
increased pressure on world food supply.
Water shortages, both as physical shortages and as a product of pollution, are already having material
Water productivity in China is low compared to international peers. In 2003 465m3 of water was used to impacts on China. It has been suggested that over 300m people in rural China do not have access to
produce 10,000 RMB, 20 times the quantity used by Japan and European countries.11 The 12th five-year drinking water, while the World Bank has estimated that water issues already cost China 2-3% of its GDP.18
plan has included targets for a 30% cut in the amount of water required to produce 10,000RMB of GDP.12
Clearly this will provide an incentive for both investment in infrastructure and also demand for companies The response
that provide services which increase water efficiency. The simplest way, however, to decrease water
consumption per GDP would be to raise the cost of water. The response, and potential future response, of the Chinese government to the issues that have emerged
around water has focussed on three areas: major engineering projects; regulation and legislation; and pricing.
Major engineering projects
Urbanisation and industrialisation in China have been achieved, by and large, without consideration for the
impact they have on the environment. Consequently, a significant amount of China’s waterways are now Historically China has sought to solve many of its problems with grand, sweeping projects. In relation to
polluted and not suitable for industrial use, let alone drinking. 58% of the 40 major lakes in China are water this has manifested itself in the form of the South-North Water Transfer project. The idea for the
eutrophic and hypertrophic. Only about 1% of surface water meets drinking water standards and 50% project is not novel, in fact it has its origins in the China of Chairman Mao, who said in the 1950s: “There is a
of all shallow groundwater is polluted.13 Cities at the end of rivers also experience the worst of the pollution lot of water in the south of China and too little in the north. If it’s possible, we could borrow a bit and bring it
given that it has had the whole way down the course of the river to build up. north.”19 In 2002 construction work began on redeveloping the Grand Canal in order to allow it to act as the
eastern part of the water transfer project. According to plans the eastern part of the project should be
functional by 2012, while the central section is expected to be completed by 2014 and the construction on
Dwindling supply the western section of the project is yet to begin. Theoretically the idea of moving large amounts of water
China’s rivers are partially supplied with melt water from Himalayan glaciers. Unfortunately these Glaciers from the surplus of the south to the scarcity of the north is a simple plan, in reality there are a number of
have spent the past 100 years shrinking and they look set to continue doing so for the conceivable future. issues with the projects and clear indications that it is not a silver bullet capable of singlehandedly relieving
Since 1900 their area has shrunk by around 30% and a recent study has suggested that they could achieve the pressure of water scarcity.
a further 30% shrinkage in the next 40 years.14 To make matters worse the faster the glaciers melt the more
water they release and consequently their melting could foster the illusion that issues of water scarcity may
not be too serious. There is a certain contention over how quickly glaciers are melting, though it is irrefutable
that they have retreated significantly in the last century and are continuing to retreat.
2 INVESTMENT THEMES
Regulation and legislation
The first key problem is that the South-North Water Transfer project cannot be expected to alleviate China’s The key insight into regulation and legislation surrounding water is that while the Chinese government has
water problems on its own. Hu Siyi, Vice-Minister of Water Resources, has suggested that if the population demonstrated energy and commitment in tackling the problem, this energy and commitment rapidly
of Beijing continues to rise, the project will be unable to provide sufficient water.20 While this statement dissipates as you move away from the centre. Consequently, while there has been significant government
highlights the problem that the project may not in fact be able to transfer sufficient water to meet demand it investment in major water projects, i.e. the aforementioned South-North Water Transfer project and the
also highlights a secondary issues, that the project is solely devised to help meet urban demand and does introduction of laws governing water use and pollution, these tend not to be enforced at a local level.
not address the lack of water in rural areas required for agriculture.
Fig. 3: Chinese water administration
Pollution may also prove to be a further pitfall of the project. Firstly, there is the pre-existing problem of
significant water pollution in the south of China. Secondly, some investigations have indicated that the Lead agency Integrated water resource management, water resource protection planning,
project may in fact worsen issues of scarcity and pollution. For example, studies have shown that diverting water function zoning, monitoring water quantity and quality in rivers and lakes;
issues water resource extraction permits, proposes water pricing policy
water from the Hanjiang River would reduce water flow and effectively worsen pollution.
Ministry of Water pollution laws, regulations/standards, supervise/enforce, water environmental
The South-North Water Transfer project represents, at best, part of the solution to China’s water woes and, Environmental Protection function zoning, initiates WPM plans in key rivers and lakes, monitors water quality
at worst, a major waste of money, time and effort. The project is a clear manifestation of China’s historical
approach to the problem of water scarcity, an approach that has been obsessed with meeting demand Ministry of Housing and
Urban water supply, urban waste water treatment
Urban & Rural Construction
rather than managing it. It seems clear that this approach has failed and consequently future ability to deal
with the problem will be based on the following two governmental responses: regulation and pricing.
Ministry of Agriculture Rural and agriculture water use and agricultural nonpoint pollution
However, it is important to also consider that the majority of government initiatives, to combat water scarcity,
Water Resource Management
Ministry of Land
have, thus far, focussed on building up the infrastructure needed to supply significant quantities of clean and Resources
Water as a resource, land use planning
water across China. While these investments are clearly necessary, in order to modernise the Chinese water Other
system, they do not tackle the issue of demand. The problem underlying is twofold: firstly, that by not agencies State Forest Administration Forests for conserving water sources
tackling the issue of demand there will need to be a continual process of development of new and improved
water facilities which will require continual investment; secondly, the major areas of inefficiency, consumption Ministry of Transportation Ship transportation water pollution control
and pollution, which are industry, agriculture and domestic households, remain unaddressed.
State Oceanic Administration Manages sea area use, protects marine environment
It is expected that when the 12th five-year plan’s contents are announced in 2011 there will be significant
emphasis on investment in water. It is expected that investment in wastewater treatment plants will increase National Development and Pollution levy policy, wastewater treatment pricing policy, water pricing policy,
to around 770bn RMB for the period 2011-2015 and there are expected to be around 300 wastewater Reform Commission industrial policies that affect wastewater discharge and its treatment
treatment plants by 2015.21 100bn RMB is also expected to be spent on improving the piping network. The
Pollution levy proceeds management, manages wastewater treatment charges and
main problem with this move is that while it will increase the amount of water that is available it will not Ministry of Finance
water resource fee policy, State Office of Comprehensive Agricultural Development
provide any encouragement for people to use less water, pollute less and generally consider the resources
that they are using. The State Council Implementation regulation, administrative regulation & order, lead and coordination
It has also been announced that in the 12th five-year plan there will be included a demand to reduce water National People’s Congress Legislation, law enforcement and supervision
consumption per 10,000RMB of GDP by 30% in the period 2011-2015.22 This will undoubtedly require
significant investment in efficiency related infrastructure. Source: World Bank, Water Scarcity in China
The first significant issue contributing to the problems of enforcing water legislation is the fragmented nature
of Chinese water regulation.
INVESTMENT PERSPECTIVES 2012
Fig. 3 serves to illustrate just how many different groups have significant input into the organisation, administration There are a number of problems with the strategy of increasing prices indiscriminately. Historically, the
and law enforcement for water. In 2007 when Lake Tai was covered by ‘pond scum’ of cyanobacteria, caused Chinese, especially those in rural areas, have had access to water which has been essentially free. Even
by longstanding pollution, and the local population was forced to go without drinking water for a number of now water prices for agriculture is severely subsidised, meaning that in most rural areas water costs around
days the administrative response was very slow. An interdepartmental conflict emerged between the Ministry 0.1RMB/m3, which is clearly not consistent with the fact that agriculture is one of the major consumers and
of Environmental protection and a number of agricultural agencies, who demanded that agricultural projects polluters of water.24 The wider population of China are distrustful of attempts to increase the price of water
that they oversaw in the area were too important to the local economy to close down. This lack of clarity over and while price increases have to go through a public hearing there has been evidence recently that these
water jurisdiction and authority is a significant restraint on the effective management of water scarcity issues. are being packed with supporters of the government and consequently the price increases.
In many cases the businesses which are consuming vast quantities of water and then returning it polluted back One expert has suggested that it is inappropriate to look at China’s water prices in terms of other developed
into the system are the backbone of the local economy, which leads people to question whether they can nations and that they are actually relatively fairly priced compared to what the Chinese can afford. There is
afford to impose any limits upon them. Secondarily it is often the case that key local administrative figures are something of a consensus that increases in price will have the greatest impact on the poor though less of a
also key stakeholders in these businesses, which means that they are in no position to make the decision as to consensus about how far the price of water could be raised. However when China’s water prices are
whether they should enforce environmental legislation which may serve to limit the businesses profitability. expressed as a percentage of net disposable income China still ranks as having very cheap water (fig.4).
The economic growth of China has been staggering but it is clear that this growth has been achieved Figure 4: Global water prices as a percentage of net disposable income
without major considerations of the environmental impact it has. This lack of consideration may prove to be
less of an immediate issue in other areas of environmental impact, but it is proving to be a problem with
regard to water. One solution, practical though completely unthinkable, would be to scale back economic
growth, if only temporarily, in order to deal with the problem. The probability of this happening seems
infinitesimally small but it may prove to be the key trade off: economic growth versus a crisis of water. 8%
Greater regulation, and greater enforcement of regulations, is required if China is to effectively tackle its
water problems. However, this requires both a change in government mentality, moving from trying to meet
demand to managing it, and a change in the enforcement of the laws at a local level, with greater division 4%
between the specific ministries and greater divorce between the figures enforcing and those who hold
vested interests in the economic success of the businesses in question. This represents a sea-change in 2%
mentality and though the Chinese have proved their ability to absorb significant change in the past, the
question is will they be able to repeat this in the future? 0%
It is widely accepted that the only real card that the Chinese government holds is its ability control the price of
water and consequently influence water demand. As discussed above, relatively aggressive targets for the level of
Source: Nomura, Anchor Report: Water.
water efficiency improvement, per 10,000RMB of GDP, have been requested in the upcoming 12th five-year plan.
One of the key tools to try and achieve this is allowing the price of water to more closely reflect its market value.
This appears to indicate that there is still significant scope for the price of water in China to be raised quite
While currently there does exist a certain amount of differential pricing, for example in water scarce Tianjin significantly, in order to better reflect its true economic value. However, this may be more problematic across
water costs 4.28 RMB/m3 while in Nachang it costs 1.98 RMB/m3, water tariffs in China represent only 20% a country such as China where there are great disparities in the distribution of water, and income, which
of the world’s average.23 The pricing of water is divided into bands, subject to increasing price: domestic, could produce greater pressure on areas with low current water supply as high tariffs might encourage
public, industrial, commercial and special. Somewhat strangely the highest tariffs are imposed on the investment in other, low tariff areas. Though it is also questionable whether it would be possible to force
‘special’ category which consists of small businesses such as bars and gyms; on average these areas of abundant water to accept high tariffs.
experience tariffs which are three times those imposed on commercial operations.
2 INVESTMENT THEMES
There are three main outlooks of how the water situation will develop in China in the short to medium term. The problem with the water crisis in China is that its solution does not lie in developing some breathtakingly
The best and worst case scenarios appear to be highly unlikely to occur, given that there is evidence that ambitious engineering project, but rather it lies in the ability of the Chinese government to change peoples
the Chinese are taking the issue seriously, but that there are also key areas where performance seems to be attitude towards water, both in terms of domestic and industrial consumption. They have the tools,
very imperfect. legislation and pricing, to combat growing demand, but will that be enough? Is the predominance of
economic growth, a mantra which has and does define modern China, compatible with a society that
Bear Case: No real further change or effort to implement further plans to deal with the issues surrounding
can efficiently manage its water resources?
water scarcity. It is highly probable that this situation would lead to major constraints on economic growth.
It appears very unlikely to occur given the steps that have already been taken.
Middle Ground: Continued progress through tariffs, regulation and infrastructure investment. However,
growing demand through economic growth, population growth and increasing demand for water intensive Companies with exposure to water services
services and products from growing middle class. Most likely this is where China will end up. While above we suggested that there may be major challenges facing any attempts by China to raise water
Bull Case: China is able to circumvent the issues through large scale infrastructure projects and increased tariffs it remains clear that raising the cost of water is the most effective tool that the government has with
regulation. There would probably be some increase in price, though not sufficient to encourage popular which to combat rising demand. Given that it is unlikely that the alternatives will be able to sufficiently
unrest. Very unlikely that we will see this as there is evidence already that current measures will not be able increase supply, or lower demand through greater efficiency, it is likely that there will have to be continued
to produce the desired results. recourse to raising tariffs. The market has most likely priced in low to medium tariff increases, and we
conclude that it is likely to require larger increases in tariffs to accommodate the growing demand.
As it is significantly more likely that China will end up in the middle ground, we have chosen to examine this, Consequently, while there is scope for companies, and investors, to benefit from the increased demand for
as the alternatives seem to offer total meltdown or negligible impact. water infrastructure, efficiency products, the private sector and increasing efficiency for water supply, it is
likely that the best opportunities will be found in companies that are exposed to collecting water tariffs and
Expert opinion is widely divided about how China will deal with the issue of water. In a recent paper on the
can consequently benefit from their rise. While the market expects there to be certain increases in the price
subject the World Bank were bullish on the prospects of overcoming the problems, stating:
of water, CLSA have suggested between 10-20%25 and Nomura expect to see tariffs increasing at around
8%,26 it seems that they may have undervalued how much the price of water will need to increase over the
“But there are grounds for optimism; the Chinese, who have demonstrated immense innovation
next five years if they are to achieve their stated efficiency goals.
capacity in their successful programme of economic reform, can and should take another bold
move in reforming the institutional and policy framework to make it become a world leader in China Water Affairs
water resource management.”
China Water Affairs is a company that is well positioned to benefit from increased water prices. It derives
around 63% of its revenues from water tariffs; consequently it is in a very strong position to benefit from a
While Jorge Fenandez has suggested that he feels China could spend the next century lurching from crisis to
continued rise in the price of water. There is a slight orientation of China Water Affairs to the south of China,
crisis and could be forced to become a net agricultural importer. The situation in China has also been likened
where there is less water scarcity, so we may see smaller price increases in the long term. However, there is
to the environmental situation of America in the mid 20th century, where environmental legislation was driven
a second trend in water prices in China, which is to charge the richer cities more and China Water Affairs
by major crises such as the Cuyahoga River. Where pollution became so bad that no life remained in the river
appears to be strongly positioned to capitalise on further increase in water prices as related to income. The
and large fires periodically broke out on its surface. The bringing of the problems on the river to popular
Group also has exposure to infrastructure and sewage which means that it should experience some of the
attention helped lead to the passing of the Clean Water Act and the Great Lakes Water Quality Agreement.
benefits of increased government spending on water after the 12th five-year plan.
The question that will define whether China is capable of overcoming the current crop of issues around water
There may also be opportunities for investing in companies with exposure to infrastructure and water
is whether the growth in demand, from economic expansion, population growth and increasing standard of
efficiency. Companies such as China Everbright International could be a major beneficiary of government
living, will be more or less than the gains made from increased efficiency and management of demand.
policies for wastewater treatment. However, given that there is much more transparency regarding how the
Secondarily there is the question of whether it will be possible to have environmental legislation enforced
government plans to approach infrastructure, efficiency and recycling it seems likely that this will be more
on a local level. And thirdly, if they achieve these targets, what impact they will have on economic growth.
appreciated by the market.
INVESTMENT PERSPECTIVES 2012
Framework for looking at water risk
This area has proved to be more complicated than previously expected. Approaching the issue from afar it Below is a list of industries with significant exposure to water risk:
appeared as though it would be possible to construct a model based on a company’s exposure to
Apparel: Cotton production is very water intensive and there are issues related to waste water pollution,
geographic areas of water scarcity. It had been hoped to produce a map, based on various pieces of
resultant from chemicals used in processing.
research, which incorporated pollution, water supply and groundwater depletion and then grade companies
against this based on their operational sites and the proportional business weight of each of these sites. Semiconductors: Requires very large amounts of very clean water. There are obvious scarcity and
However, for a number of reasons it appears as though this approach will not prove to be successful. pollution risks here.
Food and Beverages: Risks in both the procurement of the ingredients, shortage of water could lead to
Firstly, there is often little disclosure of the proportional production at each of the sites a business operates.
food shortages and rising prices, and also in the production process which frequently require significant
Secondly, revenue is not split out by each site. Thirdly, policies relating to water and efficiency may exist on a quantities of potable water and can lead to further water pollution through fertilizer use.
site by site basis and consequently not reflect the risk assumed for the specific area. Biotech/Pharma: Can have significant waste water issues.
When these are considered together it means that while high level understanding of water scarcity, risk and Forestry Products: Pulp and Paper manufacturing is especially water intensive and polluting.
pollution can be valuable in providing insight into the general themes, there is a lack of the requisite Metals/Mining: Cannot be relocated. Issues of local water availability and the impact of mining processes
resolution if the data is used in a more focussed manner. Consequently, it is not appropriate to expect on local water quality, from tailings storage.
moving from the general to the specific and back to the general again to provide valuable information.
Electric Power/Energy: Needs consistent supply of water and hydropower production is directly linked to
The general understanding we have of water issues in China does not have the resolution to be applied on a the flow of water through the plant.
site by site basis and consequently if we try to model a company’s total water risk based on the assumed
In the following table are the water scores we calculated for different areas in China. We created a map of
water risk of its sites we are likely to get results that do not reflect reality. Kimberly Clark has undertaken a
water scarcity and pollution in China and then ascribed every area with a score to reflect the severity of issues
similar exercise, in an attempt to model the water risk of its global manufacturing sites. It found, however,
there. The score was calculated as the sum of individual scores out of four for: groundwater depletion, polluted
that the conclusions that it drew from its high level analysis were not supported by the evidence found on
water, and per capita availability (Table 2).
the ground. This seems to support our understanding that high level generalisations cannot be applied to
Despite the limitations of the high level view of Chinese water there is still value in the data. It can still help to
provide background as to which geographies are most at risk and consequently where tariffs may have to
rise further or greater investment will be required. It is also probably valuable to understand where water risk
lies on an industry by industry basis and this may serve as an area to explore when analysing a company
and its management of water risk. However, in spending some time trying to model company’s water risk it
was apparent that there is very little disclosure on Chinese companies management of this risk.
Consequently, engagement will probably prove to be the most valuable means by which to gain a greater
understanding of water risk.
2 INVESTMENT THEMES
Table 2: Regional water risk scores References
Province Ground water depletion Polluted water Per capita availability Water risk score 1 Peter Gleick, China and Water, in Peter H. Gleick, Heather Cooley, Michael Cohen, Mari Moriwaka, Jason Morrison and
Hebei 4 2 4 10 Meena Palaniappan, The World’s Water 2008-2009: The Biennial Report on Freshwater Resources (Washington, 2009)
Beijing 4 2 4 10
Tianjin 4 2 4 10 2 Christine Loh and Guo Peiyan, CLSA Blue Books: Falling up! Water pricing must meet true costs (2010) p. 15.
Jiangsu 2 4 4 10 3 Jian Xie, Addressing China’s Water Scarcity: Recommendations for Selected Water Resource Management Issues
(Washington, 2009) p. xx.
Henan 3 2 4 9
Heilongjiang 2 4 3 9 4 Yong Jiang, “China’s Water Scarcity”, in Journal of Environmental Management, 90 (2009) p. 3187.
Shandong 3 0 4 7 5 Idem.
Liaoning 2 2 3 7 6 Lucy Carmody, Issues for Responsible Investors: Water in China (2010) p. 21.
Jilin 2 2 3 7 7 Jiang, China’s Water Scarcity, p. 3187.
Ningxia 0 4 3 7 8 Xie, Addressing China’s Water, p. 22.
Anhui 0 2 4 6 9 Jiang, China’s Water Scarcity, p. 3187.
Shaanxi 2 0 3 5 10 Xie, Addressing China’s Water, p. 27.
Gansu 2 0 3 5
11 Gleick, China and Water, p. 93.
Inner Mongolia A.R. 3 0 0 3
Zhejiang 0 3 0 3
13 Xie, Addressing China’s Water, p. 16.
Shanxi 0 0 3 3
Xinjiang Uyghur A.R. 2 0 0 2
Guandong 0 2 0 2 15 Xie, Addressing China’s Water, p. 11.
Hunan 0 2 0 2 16 Idem.
17 Loh and Peiyan, Falling Up!, p. 17.
The limitations of these scores have been discussed above. There are also large areas of China that were not 18 Xie, Addressing China’s Water, p. xxi.
covered in the attempt to create a model for water risk. This does not, however, mean that these areas are not 19 http://www.ft.com/cms/s/0/20759602-e917-11de-a756-00144feab49a.html#axzz18fLwM4hY
exposed to water risk. Pollution, especially, can emerge and be dealt with in relatively short periods of time and 20 http://ww.mwr.gov.cn/english/Medianews/201011/t20101116_245679.html
consequently an area that was not previously exposed to pollution could quickly have an issue from the introduction
21 Ivan Lee and Elaine Wu, Anchor Report: Thirsty for more! (2010) p. 29.
of a new industrial operation in the area. Given these issues the scores should be treated with caution if used
for anything other than a broad sense of where water scarcity and pollution are significant issues in China.
23 Carmody, Water in China (2010) p. 41.
Conclusion 24 Loh and Peiyan, Falling Up!, p. 35.
Water is already a significant issue for China and the 12th five-year plan is set to provide unprecedented 26 Lee and Wu, Thirsty for more!, p. 29.
levels of investment into supply processes and drive increases in efficiency. However, these do not fully
tackle the primary issue pertaining to Chinese water; which is demand. While increased efficiency will
contribute to lowering demand it is unlikely that it will be able to completely offset the increasing demand
from both demographic growth and also changing consumer habits. Consequently, though it may prove
complicated and damaging to try and introduce tariffs, in practice they remain the best tool that the Chinese The views and opinions contained herein are those of Rory Pike and Rick Stathers, and may
government has to control demand. Exposure to tariff collection and water supply thus provides the best not necessarily represent views expressed or reflected in other Schroders communications,
investment opportunity for investors looking for exposure to the theme of Chinese water scarcity. strategies or funds.
INVESTMENT PERSPECTIVES 2012
2.11 Why ‘gold plus’ is the way to play
the gold rush
Written in August 2011 Paula Bujia Fund Manager, Gold & Precious Metals
Why the gold bull market should continue
Gold has been in a bull market for ten years and we are often asked if this is a bubble. But in fact the rise in Gold also performs well as a hedge against inflation, and when real interest rates are negative. Like many
gold has been very civilised and it’s still cheap compared to its historic inflation-adjusted high. other investors, we believe we are now entering an inflationary era. Investors are already finding it more
difficult to find assets which offer any positive real return with low risk – with returns from money markets
The chart below shows that in the 1970s gold prices rose a huge amount – by 1,650%. And gold gave its
typically being negative in inflation-adjusted terms. Consequently, private investors have started to turn to
best performance in the latter stages of the bull market. By comparison in the current bull market the price
gold instead, and since gold ownership is still only tiny relative to the proportion of money market fund
has risen by 652% ($250 to $1,880) so far, and in our view there is further to go.
ownership (see the chart below) there is plenty of scope for this trend to continue.
1970s bull market
Total global holdings in gold ETFs versus US money market funds
The 1970s bull market ended after a 1650% rise. 4%
The current gold bull market has seen price rise to
date of approximately 560% (US$250 to US$1,660)
Volcker appointed Gold
Money Market Funds
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
Oil Gold Sources: UBS, ICI; WGC; ETFS; ZKB; Schroders, 31 March 2011.
Source: Thomson Datastream.
Indeed, the rise in private ownership of gold is increasing quickly as exchange traded funds (ETFs) have
There are quite a few driving factors in place behind the continued rise in gold. First of all, it has a ‘safe democratised the asset class, providing easy access – and recently central banks like Mexico, Russia and
haven’ status which is really coming into play amid the uncertainty surrounding the US deficit and US dollar, China, as well as sovereign wealth funds, have been buying gold for their reserves.
problems in the eurozone and geopolitical problems in the Middle East and North Africa. Gold is increasingly This is a change in trend from the last 20 years (when net official transactions were negative), and we believe
becoming seen as an alternative currency, as the euro and sterling come under pressure as well. it will continue as emerging markets have a long way to go before their gold reserves are comparable to
those in developed markets.
Pension fund ownership of gold is also still at low levels, despite the fact that US pension funds have
92 recently been allocating more to gold as a hedge against inflation.
2 INVESTMENT THEMES
The longer-term case Why a gold ‘plus’ strategy?
We think all investors should consider gold as a long-term strategic asset in their portfolios, because it performs Precious metals continue to offer excellent diversification opportunities, the potential for strong returns, a low
well as a diversifier and can provide a form of portfolio insurance. In addition, gold has the lowest rate of annual correlation to other assets, protection against rising inflation, as well as a natural hedge against geopolitical
volatility out of all the commodities. It also performs well relative to other asset classes when there are geopolitical events. Schroders’ Commodities team feels that we remain in a bull market for gold, and that one of the
shocks. The chart below shows the performance of gold when equities have suffered sharp falls. biggest opportunities lies in the ability to manage actively exposure between gold (ETFs and futures), gold
related equities, other precious metals and cash.
Average monthly return during the ten worst falls in the S&P December 1998 to March 2011
6% A diversified approach
4% The historical divergence in performance of ETFs and equities shows there is an opportunity to tactically
allocate between the two. Unlike pure gold equity funds, removing market beta when equities are volatile is
2% much easier when the two approaches are combined.
0% Investing in other precious metals is a much more diversified approach than simply going out and buying an
ETF or a basket of volatile mining companies – and we believe that it is possible to outperform the gold price
-2% in the long run by taking this approach.
Other precious metals
Incorporating other precious metals into the mix can also offer excellent diversification opportunities but the
-8% timing has to be right in order to maximise the benefits.
-10% Because silver is more cyclical than gold, with more than 50% of demand being for industrial use, the price
Gold Gold Mining Index Oil S&P 500 FTSE 100 tends to be more volatile. However, it is starting to be supported by recovering industrial demand
(particularly for solar panels). It also shares some of gold’s defensive characteristics and is seen as
Source: Bloomberg, 31 March 2011.
protection against uncertainty, inflation and currency devaluations.
Importantly, there is an imbalance between constricted supply and rising demand. The traditional producers Palladium and platinum have a higher percentage of industrial usage, and we’re cautious for now. In the
(the US, South Africa, Canada and Australia) have seen declining production for years, as new discoveries medium term, palladium, which is heavily used in the auto industry, will benefit from rising demand from
diminish. South Africa for example is at its lowest rate of supply since 1932. China and other emerging markets. Platinum will benefit from stricter emission control regulations and
supply constraints in South Africa, where 90% of the metal is produced. We would typically hold more of
these assets at a time when risk assets are doing well.
Challenges to the gold lining – what happens when interest
rates rise? The views and opinions contained herein are those of the Paula Bujia, and may not necessarily
Central banks are a long way behind the curve right now. But even if you think that they will start to raise represent views expressed or reflected in other Schroders communications, strategies or funds.
rates more aggressively, there’s still room for gold to go a lot further.
In the chart showing the 1970s bull market on the previous page, you can see that even when Volcker was
appointed to bring inflation under control in the US in the 1970s, and interest rates started to rise, gold
continued to perform well. It took some time before the opportunity cost of owning gold (in other words,
the rates of return on other assets) became too high.
INVESTMENT PERSPECTIVES 2012
2.12 Adapt – Why success
always starts with failure
Written in June 2011 Tim Harford Economist, Broadcaster and Author
Top-down solutions seldom solve problems
‘Too big to fail’ is a phrase that has entered the lexicon since the financial crisis. However, failure should be Instinctively, according to Harford, when a complicated problem arises, we tend to look to a clever person
embraced and is an important part of the road to success, according to bestselling author, broadcaster and – an expert – to solve it. But Harford says he does not find this default reaction in the face of problems to
economist Tim Harford, who appeared at Schroders’ Secular Market Forum recently to discuss his new be plausible.
book ‘Adapt – Why Success Always Starts With Failure’.
“Research shows that experts’ forecasts are very, very poor,” Harford said. “This is not just a dig at
Harford, a senior columnist at the Financial Times who previously worked at the World Bank, is known for taking economists, but at all social scientists.”
an alternative look at economics in his newspaper columns and on his BBC Radio 4 show ‘More Or Less’.
He says that an expert’s inability to forecast successfully says more about the world than about the experts
While his first book ‘The Undercover Economist’, which sold more than a million copies worldwide, looked at themselves. “The world is too complex, you don’t know what is going to happen and it doesn’t matter what
the role of economics in every day life, Harford’s new book is a mix of popular economics and psychology intellectual toolkit you are using,” he said.
which argues in favour of trial-and-error as a means to economic and general progress.
Lessons from the market
Modern life is complex One of the most effective problem-solving mechanisms in existence is the market, according to Harford.
Harford began with the story of a design student who set himself the task of building a toaster from scratch. He says this is not because business people are much smarter than politicians, as many would have you
After all, at £3.99 a basic toaster costs less than an hour’s work at the minimum wage, so how hard can it believe, but because in the business world there is more failure.
be to make, he asked?
“Companies fail all the time – previously successful companies go bankrupt and fade into obscurity.
The student found that the toaster consisted of 400 components and sub-components, including iron, The economy is not successful despite these failures; it is successful because of these failures,” he said.
copper, mica and nickel, and soon realised that if he were alone in a forest and tried to build a toaster from
He thinks that economic growth is a process of natural selection, in which ideas that are no longer working
scratch he could spend his whole life trying and never get close.
are replaced by ideas that are working. He highlights research which has shown that the way companies
Similarly, Harford reflected on a study which found there are an estimated 10 billion types of products available have risen and fallen throughout history neatly resembles Darwinian selection. The pattern of bankruptcies
in an economy like London, many of which are far more complicated than a toaster. This is compared to which occur during periods of relative stability correlate – although on a different time scale – with patterns
around 300 items which would have existed in a basic hunter-gatherer society many millennia ago. of extinction from fossil records.
This all led Harford to believe that although these studies show the incredible sophistication of the modern It is through this evolutionary process of trial and error that the market solves problems. However, Harford
economy, he also finds them worrying in that their results showed him the system is tremendously complex points out that institutions themselves are not good at accepting errors.
and we don’t understand it very well.
“If we want to solve problems and make changes within this complex system then the sophistication of the
toaster is a symbol of the obstacles that lie in wait,” he said.
2 INVESTMENT THEMES
Indeed, Harford thinks that people, and institutions as a result, have a deep-rooted yet irrational This domino effect is caused by a tight-coupling of parts within a system, and has also been seen in the
psychological fear of small failures and losses. nuclear power industry in incidents such as the Three Mile Island accident of 1979, according to Harford.
This loss aversion means that humans have a disproportionate fear of small losses; most people would care Such incidents, where safety systems actually exacerbate a problem, have striking similarities’ with the
far more about losing £5 than about winning it, for example. financial crisis. The very concept of Credit Default Swaps (CDS) was introduced as a safety system, yet they
caused an added layer of complexity to the financial system, caused unexpected interconnections between
He cited poker and the TV show Deal or No Deal, as examples of situations where people start making bad,
institutions and increased the tight-coupling in the industry.
risky decisions when they start chasing their losses. Similarly, stock investors often hold on to losing
positions too long due to their reluctance to accept losses, whereas they are normally quick to bank a profit “You are a regional bank in Iowa with reasonable investments, not interested in subprime at all. Then one
when their stock pick is a winning one. day you get a call from a rating agency who say they are downgrading AIG because they wrote CDS on
assets you don’t hold and have nothing to do with you. So they are downgrading all the bonds in your
The main thesis behind Harford’s book is that in order to succeed people must accept that failures are
portfolio as they don’t think AIG can come good on its CDS.”
inevitable. Success comes from being able to quickly learn from failure and adapt accordingly.
“Suddenly the bank has to sell some assets to meet regulatory requirements and all the other banks try to
Too big to fail sell for the same reason. So the safety system suddenly created interconnections; people who thought they
had no connection to certain parts of the market found out they were all interconnected after all.”
He applies his argument to the world of finance, where in recent years governments have gone to great lengths
to avoid the failure of systemically important banks, causing the phrase ‘too big to fail’ to enter the lexicon. Harford also points out that safety systems can encourage risk taking, as was the case in the financial crisis.
Banks such as JP Morgan went to the regulators and asked if they can take more risk now they have the
Harford thinks the politicians were “absolutely right” to bail out banks and recapitalise them, “given the total safety cushion of credit default swaps in place – a situation Harford compared to car drivers asking the
ignorance of what would happen if one of these banks went down”. However, he thinks we should aim to Department of Transport if they can now drive drunk because they have improved their airbags.
build a banking system where failure is possible.
Currently the interconnections between financial institutions are too great and Harford highlighted a number Harford’s conclusion
of disasters in history which illustrated what can happen when risks are not decoupled.
Harford concluded his presentation by saying he would like to see different decoupling insulation
mechanisms which can break the cycle of leveraged collapses.
The dangers of tight-coupling
“I would like to see a diversity of approaches; in diversity you often get robustness,” he said.
A financial crisis from the 1980s which had similarities with the financial crisis of this century was the LMX
spiral from the reinsurance industry. A series of risk-shifting insuring contracts had been drawn up which left He said he liked institutions having layers of contingent convertible capital spread through their
a large number of companies unaware of the interconnections. When a disaster struck, it sparked a domino capital structure, which would serve as a potential airbag in case of a crash. However, he warned that,
effect among these companies, which had all reinsured themselves against losses among each other. if it ended up in banks all holding each other’s contingent convertibles, it could trigger a ‘death spiral’
and a ‘total disaster’ all over again.
However, what really struck a chord with Harford was the disaster on the Piper Alpha oil rig which sparked
the LMX spiral. Previously unseen flaws in a series of safety mechanisms led to a catastrophic chain reaction Ultimately he said institutions in the future need to learn from their mistakes.
and ultimately caused the death of 167 men. “To learn from your mistakes is such a cliché because we find it so difficult to grasp. We are not built to
“One small failure led to a bigger failure, which led to a bigger failure. The safety systems unravelled and accept failure, which is a shame because failure is inevitable.”
even contributed to the problem,” Harford said.
The views and opinions contained herein are those of Tim Harford, and may not necessarily
represent views expressed or reflected in other Schroders communications, strategies or funds.
INVESTMENT PERSPECTIVES 2012
S C H R O D E R S C H A R I T I E S I N V E S T M E N T P E R S P E C T I V E S 2 0 1 2
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