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Weekly Financial Focus: 20th December 2010

Europe

Divisions widen at summit
Divisions widened within the EU over how to contain the debt contagion that threatens the euro, limiting the summit starting on Thursday to agreeing on a crisis-management mechanism that takes effect in 2013. German Chancellor Angela Merkel balked at boosting or making more flexible use of the EU’s €750bn emergency fund, as EU leaders neared an accord on the mechanism to contain future debt shocks. Strife among Merkel, the European Central Bank, Luxembourg Prime Minister Jean-Claude Juncker, and the German domestic opposition intensified on the eve of the Brussels summit, marring confidence in Europe’s handling of the fiscal woes that forced Greece and Ireland to fall back on financial handouts.

Spain in the hands of Moody’s rating agency
The escalating debt crisis in the Eurozone has come under sharp focus again as Moody’s Investor Services warned it may downgrade Spain’s credit rating. The country’s mounting debt, financing needs and a lack of faith in its government’s ability to tackle the issues prompted Moody’s to place the Aa1 rating, only just downgraded from AAA in September, on review. The euro fell against most major currencies amid fears that Spain will be forced to follow in the footsteps of Greece and Ireland and accept a multi-billion euro bailout from the European Union and International Monetary Fund.

Germany
Germany’s economic recovery will broaden next year as Europe’s largest economy benefits from faster growth in consumer demand and business investment, Standard & Poor’s (S&P) said. Germany’s economy fuelled the euro region’s growth this year as companies stepped up hiring and output to meet export demand, encouraging consumer spending. While economic expansion may slow down as waning government stimulus packages around the world hurt the nation’s exports, stronger domestic demand may still put its expansion on a firmer footing, S&P said.

USA

Fed’s plans unchanged
Improving prospects for the US economy are not likely to divert the Federal Reserve from its plans to buy ¢600bn worth of bonds as long as modest growth does little to dent high unemployment. Analysts caught off guard by the Fed’s downbeat view of the economy on Tuesday were forgetting the central bank’s intense focus on how far the US economy needs to go before reversing the setbacks of the recession and the financial crisis. “We think it’s going to be a very high bar for them not to do the full $600 billion,” said Dean Maki of Barclays Capital. “To cut the program short, they would need much stronger data.” The Fed emphasized in a statement after its Tuesday meeting that while the economy is making progress, it is not growing fast enough to bring down unemployment.

USA & China
The US and China agreed to pursue free trade in areas from agriculture to technology, but Beijing insisted that Washington needed to loosen its own export controls. Top officials from the world’s two largest economies met yesterday for two days in Washington to try to iron out persistent tensions, not least the value of China’s currency, which the United States says is artificially low. President Barack Obama’s administration, which has been hit hard by economic worries, offered an upbeat take on the talks and highlighted China’s willingness to restart talks on resuming US beef imports. The US said China also pledged to remain “neutral” on the technological standards for third-generation telephones along with smart grids, so as to permit market access for American companies.

Brazil
Brazil will cut taxes and provide incentives to stimulate the domestic corporate debt market and supply longer-term credit for infrastructure investments needed to host the 2014 World Cup and 2016 Olympics. As part of the measures announced yesterday by Finance Minister Guido Mantega, the state-run development bank will set aside BRL10bn ($5.8bn) to purchase longer-term debt issued by corporate borrowers, helping provide liquidity to the secondary market for the paper. Individual and foreign investors purchasing bonds with maturities of at least four years and linked to infrastructure projects will be exempted from paying taxes on their earnings. Institutional buyers will see their tax rates reduced to 15percent from as high as 34percent currently.

Spotlight on: the reliability of ‘macro’ performance indicators
By Gareth Maguire, the Hansard Group

The economic outlook or history (measured, for example by its Gross Domestic Product (GDP)) of a region is often understandably used as an indicator to likely future performance. Many fund promoters will frequently use such macroeconomic data as a key selling point in their promotional material. For example, you may see that the manager of the latest ‘Brazil Equity’ fund is extremely positive about his fund launch because ‘Brazil’s GDP is forecast to increase threefold in the next 5 years’. However, for all of the credence attached to such high level data, how much does the economic fortune of a region translate into returns on its local stock market – and therefore your client’s fund?

The adage of remembering to choose funds based on the companies, rather than the countries that they invest in, is one that many investors often forget. This is understandable given the extensive media coverage that regional funds are given, few could have missed the recent success stories of the BRIC economies, for example.

However, several high profile emerging market asset managers have recently acknowledged that there is little or no direct correlation between regional economic growth and stock market returns. They have also conceded that the fund management industry has often used the argument for marketing purposes.

The marketing of emerging market funds has long centered on rapid, seemingly endless economic growth. This intensified following the onset of the global economic crisis, when emerging markets enjoyed rapid economic growth while many of the developed countries struggled to emerge from recession.

Countries with strong long-term economic growth prospects, many fund promoters claim, offer investors higher stock market returns because there are more compelling investment opportunities in those markets.

Philip Poole, the global head of macro and investment strategy at HSBC Global Asset Management, says the argument that rapid economic growth will translate into higher stock market returns is “intuitively appealing”.

China and India, for example, have grown rapidly in economic terms in recent years. “This should have been good for stocks but stock markets have not delivered the best equity returns,” Poole says. Colombo (in Sri Lanka) and Egypt, on the other hand, have grown much less in terms of GDP but seen much higher stock market returns.

Recent data from the World Federation of Exchanges, the trade association of 52 publicly regulated stock, futures and options exchanges, confirms Poole’s argument. For example, the past ten years have seen positive growth in GDP for China, whereas only six of these years have reported positive gains in the MSCI China index.

Paul Marsh, a finance professor at the London Business School, says the whole growth argument is “very weak”. As co-author of the influential ‘Triumph of the Optimists’, Marsh has studied 19 different markets and evaluated over 100 years’ worth of data. Together with Elroy Dimson and Mike Staunton, Marsh came to the conclusion that if anything, there is a “slightly negative correlation” between stock market returns and GDP growth.

Virtus Investment Partners, an American investment management group, last year also published a research paper entitled, ‘The Myth of GDP and Stock Market Returns’. It states that “over long periods of time and when adjusted for inflation, stock market returns are negatively correlated”.

It would appear then that the above points to a contrary view of the conventional opinion that strong economic output equals strong fund returns, thus turning the following conclusion from the ‘Credit Suisse Global Investment Returns Yearbook 2010’ on its head; “the prosperity of companies, and the investors who own them, will clearly, at any point in time, depend on the state of both national economies and the global economy.”

Taking the above into account, research would suggest that when composing a portfolio of funds, further consideration should be given to market fundamentals and the constituent investments within the fund, as opposed to simply where the fund invests.

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