Allocation

How to Navigate Markets through the Euro-Zone Turmoil…

As the Euro zone crisis intensifies and global markets reflect investor concerns, we ask ourselves, is a Greek exit from the euro on its way? Crucially, preparations have already begun to protect shareholder interest, companies are robust and policy in the US and China aims to maintain the upward momentum. To protect capital, proactively positioning portfolios has been key. International exposure and dividend yields offer attractive opportunities..

A ‘Grexit’ on its way?

All eyes once again are focused on Greece. An inability to form a government has led to a renewed fear that the country could exit the Euro and the wider European Union. Although only a small contributor to European economic output as a whole, contagion is the real risk. Concerns of further losses for external holders of Greek debt and a more widespread break-up of the euro have driven equity market weakness.

A self-perpetuating situation, investors are demanding more to lend to the likes of Spain and Portugal, driving their debt burdens to unsustainable levels. Furthermore, disappointing data from the US and China over the last few days have further added to the uncertainty.

 

…but preparations are underway

However, preparations have already begun to protect shareholder interest. German and French banks, which were the largest holders of Greek debt, have been aggressively reducing their positions. Some, for example, have cut periphery debt exposure by as much as half since 2010. Banks in the UK have been making provisions since at least November when the Financial Services Authority’s top regulator, Andrew Bailey, told banks: “We must not ignore the prospect of the disorderly departure of some countries from the eurozone.”

On the corporate side, interesting anecdotes have highlighted the proactive nature of company management in the face of this turmoil. Last year, for example, Tui, one of Europe’s largest travel companies, was reported to have requested to reserve the right to pay in a new Greek currency should the country exit from the euro.  Corporate balance sheets are robust, holding more cash than long term averages, dividend yields and the potential for merger and acquisition activity once the macro outlook starts to improve can offer an attractive upside.

Finally, although wavering slightly, the US still successfully avoided falling back into recession. Keenly aware of both external and internal risks to growth, Chairman of the Federal Reserve, Ben Bernanke has made it clear he is not afraid to utilise further tools to protect economic growth. Especially with an election this year, policy is likely to remain accommodative. With respect to Emerging Markets, despite the recent wobble and an inevitable cooling of economic growth, with an estimated 1 billion of the population to join the consumer class by 2030, the long-term case remains strong.

Proactive portfolio positioning prudent

To protect capital, proactively positioning portfolios has been key. Reducing direct European exposure as Europe’s southern members showed severe signs of economic stress from an asset allocation perspective and via underlying fund managers has proved prudent. Fund managers have been able to maintain a zero weighting to Greece and a substantial underweight to the likes of Portugal and Spain relative to benchmark.

As equity markets reached new highs in the first quarter of this year, the substantial rally in share prices in the face of continued structural problems within the Euro zone, was a sign that the risk of a downward correction had increased in the short term. Caution was of course well-founded. A move to lock-in profits and redeploy capital to alternatives and property for a more attractive risk/return potential and hedge against inflation has been supported.

Assets which will help portfolio performance during these volatile market times are good quality companies with strong balance sheets paying an attractive level of dividends.  Furthermore, in times of slow economic growth and persistent inflation, strong franchises with pricing power for protected market share and the ability to pass on increases in supply costs to the customer are very desirable attributes.

 

International exposure and dividend yields offer attractive opportunities

Looking forward, a resolution of key issues in Europe is required to gain confidence to add to equity exposure. Structural reform, greater fiscal consolidation, a focus on growth and long term support are required for stability in the region. At the same time, with a medium to long-term time horizon, it is more important to focus on the geographical location of a company’s revenue streams than where it is headquartered. Investor overreaction can offer buying opportunities with share price corrections providing attractive, cheaper entry points to high quality firms. Furthermore, the yield from dividends these companies pay out can provide a valuable income stream. With many investors holding back capital, the flow of money back into markets, buying into sell-offs at lower levels, could dampen these downward moves and provide a level of support. Therefore, although volatility could continue and market direction remains difficult to determine, it is possible to navigate the turmoil.

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Libya – Oil, Water, Gold – The Real Issues

The oil price has sky rocketed over the past few months. The finger has been pointed at the troubles in Libya and claims of supply disruptions have dominated the press. However, are these claims grounded in fact or are we watching yet another sentiment driven bubble? What are the issues we should be aware of and how should we best invest in the face of such turmoil?

Expectations are often more damaging than reality

Libya’s contribution to global oil production is in stark contrast to the column inches it has been awarded in the press. As quoted by the National Journal, the country produces around 2% of the world’s oil. OPEC (Organization of the Petroleum Exporting Countries) has claimed that they have managed to “accommodate most of the shortfall” and instead attribute the rise in the oil price to fears of a shortage rather than any genuine supply issues. Oil reached a 2.5 year high last Friday. This is against a flattish demand side dynamic. Paris-based International Energy Agency and the U.S. government’s Energy Information Administration left fuel demand growth for this year unchanged and OPEC only raised their forecast by a relatively small amount (to 87.9m b/d from 87.8m b/d).

Note - this chart also highlights the Crude vs. Brent trade with the discount at record levels. Source: http://www.tradingnrg.com/crude-oil-price-forecast-recap-for-march-and-outlook-for-april-2011/

EU Sanction: A further boost for the oil bulls

On Tuesday, the EU extended sanctions against Libya to include energy companies, freezing assets in an attempt to force leader Muammar Gaddafi to relinquish power. Phrased another way, by the German Foreign Minister, this is a “de facto embargo on oil and gas”. Approximately 85% of exports are for delivery to Europe and importers will now have the task of finding potentially more distant and/or expensive alternative sources.

The pent-up downside risk

Nevertheless, many are not paying attention to the downside risk to the oil price as we move forward. Libya has Africa’s largest proven oil reserves but 75% of the country’s petrol needs are met with imports because of limited refinery capacity. Any improvement on this front, if a regime change is eventually secured, could significantly reduce imports and boost global supplies.

 Is water the next oil?

In addition to oil reserves, one asset belonging to the Libyan government which is rarely mentioned is an ability to bring water to the desert. With the largest and most expensive irrigation project in history, the $33bn GMMR (Great Man-Made River) project, Libya is able to provide 70% of the population with water for drinking and irrigation. The United Nations estimates that by 2050 more than two billion people in 48 countries will lack sufficient water, making this an enviable asset indeed.

How can the US pay for the Libya intervention?

It is interesting to note, with all the claims being made that the intervention is oil motivated that, Libya has another form of ‘liquidity’.  According to the International Monetary Fund (IMF), the country’s central bank has nearly 144 tonnes of gold in its vaults…

How to best invest: Retain context

The tide is starting to turn, Goldman Sachs has called the top for commodities in the near-term and oil fell by 4.5% on Monday and Tuesday alone (Source Bloomberg) . With this amount of volatility, short term noise can sometimes overwhelm. For a long term investor, looking for steady and stable returns, an ability to cut through the sentiment (whilst acknowledging it’s importance in driving returns in the shorter term) is valuable. Often many factors are at play and it will ‘pay dividends’ to be well-informed as they become wider known and priced in by the markets. Knowledge may be king but preparation will come up trumps.

The Ags Appeal – Commodities with upside potential leaving demand undimmed…

“If there is no struggle, there is no progress. Those who profess to favor freedom, and yet depreciate agitation, are men who want crops without plowing up the ground.” Frederick Douglass

In an environment of high correlation, where can we gain diversification benefits? And with such a significant divergence of returns within the commodities space, which ones look interesting and why? With so much focus on China, which investment opportunities have the strongest demand outlook?

Correlations High

By the end of last year the 12 month correlation between asset classes had risen to a near record high of almost 0.8 against a historic average of 0.5 (according to Goldman Sachs using data from Datastream and MSCI). Whereas the increase in speculators in the oil market led to the commodity being traded inline with other risk assets, the speculators in the agriculture space (now amounting to around 80% of the market) have continued to trade according to weather patterns.

 

Crude oil price (yellow), commodity index (orange) and the msci world index highly correlated, in contrast to agriculture (green). Source: Bloomberg

 

Attractive Supply and Demand Characteristics

In addition to the portfolio construction benefits of investing in this space, the supply and demand dynamics for certain crops are attractive. 3 years of poor yield (due to weather disruptions) has limited the supply of many. China, the focus on the demand side, has just started to import corn (2 – 3% of total consumption but the beginning of a trend) and signed a $1.8bn deal to import soya beans from the US. How strong is this demand? The USDA (United States Department of Agriculture) reported that despite increases in the price of corn, consumption will be left “undimmed”. With the EU proposing to loosen import restrictions, the case strengthens. Moreover, in addition to having a limited “shelf life”, the capacity for storeage is limited. India left a third of their food to rot last summer due to this fact.

Less Downside Risk to Demand

Finally, comparing the demand dynamic with that for certain metals highlights another key point. Keeping in mind the already high inflation figures coming out of EM (suspected to be higher than published figures in certain cases), some countries will be under pressure to reign back infrastructure spending which would dampen demand for commodities used in construction.  However, with China having 14 million new mouths to feed each year (more than twice Ireland’s population), the question is do you think the higher risk is that China will cool their economy or let any of their people starve?

THE INVESTMENT INSIGHT

In addition to price targets, pay close attention to supply, demand and correlation characteristics of individual commodities. For example, sugar is now trading with a substantially higher degree of correlation to oil and equities – implying it is now perceived as an “energy commodity” with the significance of its use in ethanol production. In contrast to passive, energy focused ETFs, actively picking commodity exposures (or investing with a manager that does so) seems a smart idea. Despite the strong rally so far, agriculture exposure remains attractive…

Emerging Markets – Crucial Points to be Aware of When Investing in the “Region”

What Investor Excitement Is Ignoring….

Inflation is like sin; every government denounces it and every government practices it – Frederick Leith-Ross

One of the most interesting market moves in 2010 was the significant outperformance of US equities over Chinese, despite far weaker GDP growth numbers. What many missed is the fact that it is not absolute values but relative figures / surprises which move markets. With this in mind, is it worrying that the consensus for China’s long term earnings growth is forecasted at 18%? Not much room is left for upside surprises, but there’s plenty of space for disappointment!

Source: "The Surprising truth about Investing in the BRICs" on Nicholas Vardy's The Global Guru, http://www.theglobalguru.com/article.php?id=340&offer=GURU001.

Therefore, it is important to be aware of the issues and risks associated with the region to be able to decide not only what to invest in but how to size the investment accordingly, inline with risk / return targets. As expressed above, it is crucial to judge what you believe is already priced into the markets and what pose as upside or downside potential.

Short-Term EM Risks

Short-term cyclical factors can overshadow long-term structural trends

INFLATION: the index used to calculate inflation in EM has double the exposure to food prices than in the G10 (developed countries). Using the price of wheat as an example – an all time high was reached at the beginning of this month, highlighting the magnified pressure felt in the region which may spook investors. From another angle, fiscal policy in China led to a 30% growth in the money supply (M2) in 2009, increased by almost as much again last year, stoking inflationary fears (since with more money around, it becomes worth less and more of it is required to buy goods i.e. goods become more expensive)

ALLOCATIONS: a record percentage of portfolio managers are overweight Emerging Market equities. The combined net assets of the two largest EM ETFs are now above that for the S&P 500, despite the US equity market being ~4 times the size of the investable EM universe.

Long-Term EM Risks

Long-term demographics may negatively affect the working population

AGE TRENDS: the biggest drop in the young working age population is “set to take place in China,” a result of its one-child policy.

ACCESS TO EDUCATION: Of the top 50 universities, only 3 are based in emerging market countries and the highest stay rate is among Chinese students. This means that in order to get a top quality education, the youth of Emerging Markets may have to study abroad and if they do so, may end up staying, greatly limiting the young, well-educated working class of their homeland.

EM Stock Risks

Do due diligence on the companies you pick – you may not be getting the exposure you want

EXPOSURE: just 14% of EM market cap is represented by domestic-facing sectors (i.e. not all EM stocks give investors exposure to the rise of the Consumer and the “Domestic Demand” growth story, a main reason for investment)

GOVERNMENT INTERVENTION: Within the EM stock markets, government ownership of companies is significant. For the Chinese market, 67% of its market cap is government owned (35% in Russia, 29% in India and 14% in Brazil). Putting this in context, in the US, at the height of the financial crisis, government ownership was about 3.7% of market cap. The importance of this should not be underestimated. It means that at times, within EM, a majority government owned entity may not be acting entirely in the interests of the investors.

STOCK EXAMPLE: Petrobras (PBR):  Brazilian government and its affiliates own about 64% of common voting shares. The offering documents state that “the government, as our principal shareholder, has and may pursue in the future, certain of its macroeconomic and social objectives through us.”

INVESTMENT INSIGHT

Therefore, in conclusion: Be aware –

Short-term cyclical factors can overshadow long-term structural trends

Long-term demographics may negatively affect the EM working population

Do due diligence on the companies you pick – you may not be getting the exposure you want