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Issue 33 Autumn 2013 Adapt to survive Negotiating an evolving fixed income market ALSO IN THIS ISSUE Death by a thousand cuts an economic overview PLUS Emerging markets: the best time to invest is when you least feel like doing so 02 Welcome to the Autumn 2013 edition of Investment Matters, our magazine for advisers and investors in the Aberdeen OEICs. Aberdeen Asset Management PLC is a global investment group managing £202 billion of assets as at 31 August 2013. Founded in 1983, through management buyout, we focus solely on our core skill: asset management. This means that we stand or fall on whether we can genuinely add value to client wealth over the long term. Having succeeded in weathering the Global Financial Crisis, our still fragile global economy now charts a course forward in what remains a turbulent and trying environment. The good news is that most major regions have now finally emerged from recession. With these challenges in mind, in this edition of Investment Matters Mike Turner, Head of Global Strategy and Asset Allocation, looks at the outlook for markets as well as the global economy. Oliver Boulind, Head of Global Credit, looks at why fixed income still has a crucial role to play in investors’ portfolios. Ian Cowie, columnist at the Sunday Times, takes a close look at the emerging market story which has come under close scrutiny over the past few months. We then take this theme a little further by providing in-house views from both the Today, our clients access our investment expertise across three main asset classes: equities, fixed income and property as well as through tailored solutions. We have over 2,000 employees across 32 offices, including investment hubs in Edinburgh, Hong Kong, London, Philadelphia, Singapore, Tokyo, Sydney and Stockholm. Our headquarters are in Aberdeen, Scotland. equity and bond side of the emerging market equation. And with the football season now in full flow Jeremy Whitley, Head of PanEuropean Equities, compares the art of active investing in Europe to football management. Finally, with Abenomics still fuelling a buoyant Japanese economy, our Head of Japanese Equities Kwok Chern-Yeh sends us a postcard distilling his view from Tokyo. The investment and economic landscape may be tricky but in any environment there are always attractive opportunities for those willing to look hard enough. We hope that you enjoy reading the articles included within and that they provide useful insights in your quest for healthy investment returns. Martin Gilbert CEO, Aberdeen Asset Management We recommend that you seek Financial Advice prior to making an investment decision. Before making an investment, retail investors should read the risk warnings detailed in the Aberdeen UK OEIC Range Key Investor Information documents (KIID) which can be obtained at www.aberdeenasset.co.uk or by phoning our Customer Services Department on 0845 300 2890. Investors unsure about the suitability of any investment should take professional advice. Please visit our UK website at www.aberdeen-asset.co.uk The value of investments and the income from them can go down as well as up and you may get back less than the amount invested. Contents economic & Market OVERview Mike Turner provides an update on the macro environment adapt to survive Oliver Boulind on surviving fixed income markets 04 06 Emerging markets: the best time to invest is when you least feel like doing so Ian Cowie Despite slowing growth rates the potential for Lionel Christiano expansion remains Messi Ronaldo Devan Kaloo and Brett Diment Argentina 03 Portugal selecting a footbalL squad is like good investing Jeremy Whitley, Head of UK and EuropeanTransfer Equities value Transfer value 08 Gareth 09 Bale Wales Transfer value £88m Sergio Busquets Juan Mata Cesc Fàbregas Transfer value Transfer value Transfer value Spain £39.5m Spain £39.5m Andres Iniesta Falcao Edison Cavani Neymar Spain Colombia Transfer value Transfer value Uruguay Brazil £85m Transfer value 12 Thomas Robin Müller van Persie Spain Germany Holland £39.5m Transfer value Transfer value £57m £39.5m 10 08 Wayne Rooney Hulk England Brazil Transfer value Transfer value Transfer value Transfer value Eden Hazard Luis Suárez Frank Ribery Mesut Özil David Silva Transfer value Transfer value Transfer value Transfer value Transfer value Mario Götze Germany 10 £105m A postcard from Japan Kwok Chern-Yeh 04 12 £53m £39.5m £48.5m Belgium £37m £44m Uruguay £39.5m France £37m06 £37m £39.5m Germany £37m £39.5m Spain £35m 04 Economic & Market Overview Death by a thousand cuts Mike Turner, Head of Global Strategy & Asset Allocation and lead fund manager of the Aberdeen Multi-Asset Fund The reaction of markets this summer to the Federal Reserve’s comments on future monetary policy, particularly the tapering of bond purchases, has been perplexing for investors. So far this year, US and UK government bond holders have absorbed negative returns and increased volatility. The 10-year US Treasury yield may well have hit its low in July last year. Since then yields have risen by over 100 basis points and from here will probably grind slowly higher as the Federal Reserve gently reigns in its asset purchase programme in the months ahead. The speed and quantity of the reduction in accommodative monetary policy is uncertain but the direction is not. Indeed, after a 30 year trend of lower bond yields we appear to be at an important turning point for the asset class. In the debate about whether this represents a ‘great rotation’ out of bonds, the fate of fixed income investors could be ‘death by a thousand cuts’ as gradually bond yields rise and prices fall as they adjust to the changing monetary and economic conditions. Mixed economic messages Over the summer months we received mixed signals on the economic health of developed markets. Starting with the US, statistics covering industrial surveys and manufacturing orders remain positive yet consumer confidence, housing starts and building permits have all come in below consensus. Higher long-term bond yields have negatively affected mortgage applications, raising concerns over the housing market. The Federal Reserve’s recent downgrade of its growth forecasts, from 2.6% to 2.3% for 2013 and from 3-3.5% to 2.9-3.1% for 2014, also point towards some loss of momentum. In the UK a stronger pattern has emerged and Europe has recovered to a more stable position but is showing only limited evidence of recovery. While in Japan, “Abenomics” has resulted in sharp upgrades to near term economic forecasts. If the gradual reduction of US monetary stimulus can be achieved in a slow and staged manner then improving business and consumer confidence will have an opportunity to feed through to increased business investment and consumption. Normalisation of monetary policy is not without risks however, as the flow of funds from emerging economies back to the US dollar and dollar assets over the summer demonstrated. Likewise, the impact of higher long-term Treasury yields on US mortgage applications, housing demand and spending poses a threat to the domestic US economy and its consumers. Markets will test forward guidance adding volatility to bond prices but we believe the overall direction for yields is upwards. Based on our central scenario, over the next 3-12 months, we expect equities to outperform bonds and for the recent positive correlation in returns to reverse. Equity valuations in developed market equities are not compelling and are sitting around the long-term averages. However, dividend yields and dividend growth in a low interest rate environment support their attraction for investors relative to fixed income and cash. There is a lot of retail cash savings still sitting on the side lines earning next to nothing. In emerging markets, after the recent correction, both bonds and equities appear attractively valued and indeed the recent currency depreciation in some nations could be viewed as an adjustment towards fair value. Looking ahead, the markets will continue to be highly sensitive to Federal Reserve policy induced capital outflows and growth in emerging economies is always likely to be more volatile but it will generally exceed that of the developed world. Both demographics and the scope for productivity growth remain positive in emerging markets and we believe the fundamentals remain attractive over a longer time horizon. 05 September Summary • Globally, monetary policy remains accommodating and key policy interest rates to remain low • Bank credit provision improving and merger and acquisition activity picking up in developed markets • Earnings growth has slowed but remains positive; dividends growing • Equities attractively valued relative to bonds 06 Fixed income Adapt to survive negotiating an evolving fixed income market 07 Oliver Boulind, Head of Global Credit The 2007/08 global financial crisis marked the start of what has been, and still is, a very difficult period for investors. In a bid to ignite growth and spur a recovery, major central banks have flooded the world with liquidity through unprecedented loose monetary policies. Although these actions have benefited economies, they have been at the expense of distorting global financial assets, arguably none more so than those within the fixed income universe. One clear example of such distorting behaviour is the direct effect of the moneyprinting policy that is quantitative easing (QE) which has supressed yields to all-time lows. Now investors are worried what will happen when the taps are switched off. This has forced them to face the ‘great rotation’ debate head on in the interests of shielding themselves against potentially rising interest rates. None of this helps anxiety levels. Therefore, as the bond market evolves, investors must also – those who do not adapt their portfolios are at significant risk. Advocates of the ‘great rotation’ from bonds into stocks would have you believe that the answer is to sell down your bond holdings in favour of equities. This approach is, in our view, far too simplistic for a number of reasons. 1.Demographics: the aging populations of the developed world ensure a steady stream of fixed income buyers seeking to secure reliable retirement incomes. This is true for the private investor whose defined contribution pension pots and additional savings are invested for income. Likewise, in the institutional world, defined benefit schemes view any rise in bond yields as an opportunity to help plug the hole in their funding deficits. 2. The rotation away from bonds is likely to be far more gradual than many experts and commentators acknowledge. Global inflation is actually low by historical standards and therefore the upward pressure on official rates should not be as severe as many fear. And so while there may be a change to QE policy, we firmly believe interest rates will remain ‘lower-for-longer’ – until the recovery becomes evidently entrenched. 3. It ignores that many investors still fundamentally need fixed income assets and that much of the ‘rotation’ is going on within the bond universe. The appetite for income is insatiable and investors are moving away from ‘traditional’ bonds – such as UK gilts – toward higher yielding areas of the bond market that offer the potential for enhanced returns in this complex and belligerent ‘lower-for-longer’ environment. 4. Standard risk-modelling tools recommend fixed income as part of a balanced client portfolio and will continue to do so. While this implies an inherent demand for the asset class, it also challenges advisers and clients alike to think about the best way of achieving fixed income exposure now that supposed ‘easy money’ from bonds has been made. 5. Diversification. The fact that bond returns are typically negatively correlated to equities means their inclusion within a portfolio offers a useful balance. What is more, due to the fixed level of income they pay, bonds are generally less volatile than equities and many other financial assets. “...as the bond market evolves, investors need to as well” Irrespective of the challenging backdrop, all segments of the bond market continue to have a role to play within portfolios. It is the emphasis of each particular area that should now come under greater scrutiny and requires a re-think. Investors will naturally need different approaches to seeking out these more diverse, but potentially more rewarding, areas of the fixed income market. Some clients and advisers have the time and expertise to revise portfolios themselves. However, it may make sense for less confident investors to outsource such decisions by using a strategic fixed income solution. Regardless of how it is achieved, the key point is that investors need to add a degree of flexibility into their fixed income portfolios. Further, they need to be bold enough to break away from conventional fixed income solutions, recognising that what worked in the past will not necessarily work in the future. 08 Emerging Markets Emerging markets: the best time to invest is when you least feel like doing so Ian Cowie, Sunday Times columnist 09 Reports of the death of the emerging markets income and growth story proved greatly exaggerated earlier this year. Currencies, bond and share prices in developing countries bounced strongly after America’s Federal Reserve surprised stock markets in September by saying it would continue quantitative easing (QE), injecting liquidity into the economy by means of US Treasury bond purchases. Before then, widespread and mistaken expectations that tapering – or reduced QE – was imminent had weighed heavily on emerging market bond and equity valuations. When investors in developed countries expected higher yields on domestic bonds and rising returns from domestic equities, there seemed less reason to accept the greater volatility and risk inherent in emerging markets. No wonder Federal Reserve hints in May, that tapering might start soon, had led emerging markets bond and equity funds to suffer net outflows of an estimated $20bn and $26.5bn respectively in the three months to the end of August. Against that dismal backdrop, one widelyrespected financial newspaper’s headline reported: “Emerging market growth story dies”. Then, just a few weeks before the Federal Reserve surprised stock markets by sustaining QE, the same newspaper’s headline had advised: “Too soon to buy unloved emerging markets”. Let’s spare their blushes by not naming the pink-faced doom-mongers. Perhaps the kindest thing that can be said is that this cautionary tale of consensus-view analysis demonstrates the truth of Warren Buffett’s observation that there are only two types of experts when it comes to predicting stock markets; those who don’t know and those who don’t know they don’t know. Fortunately, the past is a matter of fact. At the time of writing in the final week of September, the Morgan Stanley Countries Index (MSCI) Emerging Markets index has risen by more than nine per cent in the month to date. That pushed this benchmark back into positive territory by one per cent over the last year, although it remains one per cent lower than its level three years ago. Over the past five and 10 year periods, the MSCI Emerging Markets has delivered total returns of 4.1 and 10.3% respectively. Those figures give some flavour of how this sector fell into and out of fashion during the last decade. More importantly for medium to long-term investors today, do emerging markets offer reasonable value at current prices? One traditional measure of value is to express equity prices as a multiple of earnings per share. Statisticians ThomsonReuters reckon that the Russian stock market is trading around six times earnings, while the average price/earnings (P/E) ratio in China is less than eight. By contrast, Britain’s FTSE 100 trades around 15 while the American market soars away on a P/E ratio of 19. But it is important to emphasise that emerging markets’ specific circumstances vary widely – even within the well-known grouping of the BRIC economies of Brazil, Russia, India and China. For example, ThomsonReuters calculate that Brazil’s P/E is 16 and India’s nearly 15; both about twice as expensive as Russia and China. Bearing in mind those valuation differences, it is interesting to note that the International Monetary Fund predicts developed economies will grow by an average of 1.2%, while emerging markets will average 5.3% growth this year. Rising national economic output does not necessarily translate into higher returns for bond or equity investors but the long term trends are noteworthy. When the MSCI Emerging Markets index was first formulated in 1988, it included just 10 countries and less than one per cent of the world’s stock markets by value. Today it covers 21 markets and about 13% of global stock markets’ capitalisation. Even that dramatic increase may not reflect the full potential of the underlying economies in which emerging market investors can buy a stake. According to the Economist Intelligence Unit, emerging markets will generate 62% of global growth between 2012 and 2015. Against all that, the credit crunch destroyed dreams that emerging markets could decouple from developed countries and rely entirely on domestic consumption to maintain growth. It demonstrated that we share the same global economic system, where exporters’ and importers’ fortunes remain interdependent. However, while it is no longer fashionable to say so, many emerging markets continue to enjoy competitive advantages over the developed world. These include demographics – their populations are often younger; socioeconomic trends – their middle classes are growing rapidly, boosting consumer spending; culture – they tend to be savers rather than borrowers; and costs – their wages are lower. These facts may prove far more important to long-term investment returns than shortterm fluctuations in financial fashion. It is often said that the best time to invest is when you least feel like doing so, because confidence and prices are likely to be low. Even after this year’s partial recovery, that may remain true of emerging markets. As recent events have already demonstrated, it’s far too early to write the developing world’s obituary. 10 Emerging markets Despite slowing growth rates the potential for expansion remains Devan Kaloo, Head of Global Emerging Markets and Brett Diment, Head of Emerging Market and Sovereign Debt While much has been said and written about the slowing growth rates in the emerging markets, we firmly believe that the developing nations of the world will continue to exceed the growth rates of more established economies in the years to come. Fundamentally, many emerging markets’ growth slowed in real and nominal terms at the start of this year, although not all emerging economies’ growth rates have fallen. In response to this we recently canvassed the opinions of two senior emerging market portfolio managers in order to gain an expert opinion from both the equity and fixed income perspectives What are the broad issues confronting the emerging markets? Devan Kaloo: I believe there are three issues confronting investors in emerging markets. Firstly, China, where do we go from here? The new Chinese leadership has identified a basic problem with the Chinese economy, they have to spend more and more to achieve less and less growth. In short, capital is being mispriced. Capital is being increasingly used for less productive means. This is evidenced by property bubbles and the excess capacity seen in many industries. Recent policy means have been an attempt to re-price capital – which in the long term is positive for China, but in the short term could have adverse consequences to China’s economic growth and health of the banking system. Secondly, what does the unwinding of quantitative easing by the Federal Reserve mean for emerging markets. Well, in the short term it is negative for two reasons. One, equity and more recently bond markets are largely driven by foreign flows. If the plentiful foreign capital flows which accompanied quantitative easing the last 5 years were to reverse, that will result in a further sell-off in financial markets. Two, there are real economic consequences. Many emerging market countries run current account deficits, if foreign capital flows were to retrace, then that puts downward pressure on currencies, stoking inflation and putting pressure on governments to raise interest rates, which will result in slower economic growth. Finally, profitability at emerging market corporates has been declining. Emerging countries are and have been slowing for a few years now. Externally a slower China, weaker commodity prices, while rising inflation and tighter monetary policy has resulted in pressure on corporate profitability. In addition many corporate management teams have been focused on growth, rather than margins, and as a result are less concerned about the bottom line. This is in contrast to companies in the US and to lesser extent Europe, who in the absence of top line growth have focused on profit margins and in a gradually improving environment have seen overall profitability improve relative to their emerging market counterparts. current account deficits such as Turkey are performing particularly poorly. Countries such as Indonesia, which is a big commodity exporter to China, Mexico and the Philippines, which have account surpluses, are also performing poorly. I believe that some of the moves speak more towards a repositioning of the underlying fundamentals of these countries On the other hand, emerging economies have considerably lower debt levels. Prudent fiscal management and economic prosperity led many emerging market governments to repay debt and reduce budget deficits. The improved fiscal balances have resulted in greater stability, making emerging economies more resilient in the face of financial turbulence and at the same time improving their standing in the international financial markets. In addition, the healthier backdrop has led to an improved political and business environment across many developing nations. Meanwhile, debt in the developed world has been rising for many years, which in turn has created a debt overhang, limited fiscal flexibility, lowered growth potential and increased investor risk. What is the current state of emerging market debt? Brett Diment: On the fixed income side, I’d echo similar themes in emerging market debt that Devan touched on for emerging market equity. We’ve seen a fairly large selloff in the debt markets over concerns about US policy, Chinese growth rates, concerns over unrest in countries such as Turkey and Brazil, and other issues. We went into the sell-off with levels that were particularly high in some of the world’s bond markets and some that were actually quite stretched. The sell-off was fairly indiscriminate. Countries with rising What is the outlook for emerging equity markets? Devan Kaloo: We remain upbeat on emerging markets over the longer term, but there remains a real risk that conditions remain tough in the short term. The reasons for our relative optimism can be explained with reference to the three issues identified earlier. The Chinese government, like politicians everywhere, are unlikely to want to take the pain of restructuring implied by addressing the deep seated issues in the economy. As a result any marked slowdown in the Chinese economy will likely be met by further Selecting a football squad is like good investing... 11 stimulus – which for the moment they can still afford. It is unlikely then that we shall see a major slowdown in the Chinese economy. Whether or not the Federal Reserve decides to unwind quantitative easing now or later, the impact is being felt in these developing economies. But the adjustment process to this changing environment is a 1 – 2 year event, not a 5 – 10 year process. This is because the adjustment is fairly rapid and there are no significant structural issues within these economies. Economies will slow, imports contract and exports increase with the weaker currencies, closing current account deficits and easing inflationary pressure allowing domestic interest rates to start coming down sooner rather than later. Perhaps most importantly, the change in direction of capital reminds emerging market policymakers that they are in global competition for capital – which should provide the catalyst to push forward with reform. While at the corporate level we are already beginning to see our management respond to these tougher terms by focusing on margins, reigning in expansion plans and ensuring they have the balance strength to deal with any issues. This is very encouraging and ultimately is the most important reason to be positive on emerging markets – the company’s remain sound, well-managed and with improving profitability this should lead, eventually, to share price performance. Given the recent poor performance there is also value to be had. What impact will a strengthening US dollar have on emerging markets? Brett Diment: I believe that in the short term a stronger US dollar is likely to cause capital flows out of emerging market assets and into the US dollar and dollar denominated assets. In this scenario, the currencies of emerging economies with current account deficits or large export exposure to the US economy are likely to fare particularly badly. A long term appreciation of the US dollar will however likely signal an improving fundamental backdrop in the US. I would highlight exporting economies as those which are likely to benefit in this situation, such as South Korea and Mexico. ...it requires more thought than simply following market values Jeremy Whitley, Head of UK and European Equities Lionel Messi Christiano Ronaldo Gareth Bale Andres Iniesta Falcao Spain Colombia Transfer value Transfer value Transfer value Transfer value Transfer value Sergio Busquets Juan Mata Cesc Fàbregas Transfer value Transfer value Transfer value Argentina £105m Spain £39.5m Portugal £88m Spain £39.5m Wales £85m Spain £39.5m Edison Cavani Neymar Uruguay Brazil Transfer value Thomas Robin Müller van Persie Germany Holland Transfer value Transfer value £57m £39.5m £53m £39.5m Wayne Rooney Hulk England Brazil Transfer value Transfer value Transfer value Transfer value Eden Hazard Luis Suárez Frank Ribery Mesut Özil David Silva Transfer value Transfer value Transfer value Transfer value Transfer value £48.5m Belgium £37m £44m Uruguay £37m £39.5m France £37m £39.5m Germany £37m Mario Götze Germany £39.5m Spain £35m Source: www.transfermarket.co.uk If you were to select a football squad based purely on the value of players you would end up with a squad looking something like this. In theory, using player value would seem a logical choice to give you the best possible squad. However, the above list contains 11 strikers and nine midfielders but no defenders or even a goalkeeper. Therefore, not only would you have a very poorly balanced team – all attack, no defence and serious exposure to injury risk – but by picking the best players, you are not picking the ones with the most potential. Yet, if you were to adopt a basic passive investment strategy this is essentially the approach that you would be taking – i.e. buying the largest stocks by market weighting. For example a FTSE World Europe Tracker Fund is heavily skewed towards commodities and the financial services, with over 40% of the index made up of these kind of companies. Conventional thinking says that investing passively is inherently less risky. But this is only true with the conventional approach to risk; that is one which looks at tracking error alone. I would argue that the debate is not so much about active versus passive, but about what good active management looks like. Not following a benchmark Football has been dominated by one nation and one team in the last few years - Spain and Barcelona. Both teams have revolutionized football with a ‘tika-taka’ approach which has become the benchmark for all young footballers to follow. Newly crowned champions of Europe, Bayern Munich, have however taken a different approach to this philosophy and decided not to sporadically buy Spanish players in order to replicate the hugely successful ‘tika-taka’ approach. Their new found success has been attributed to their patient approach and individual player selection, rather than their attempt to replicate Barcelona and Spain. We believe the similarities between this approach and true active fund managers are very similar. Active management is not about activity, as is commonly thought, but about not following a benchmark. Simply put, if you want to beat the benchmark, you must deviate from it. Active investing, just like effective football management, is hard work – there are no short cuts. In their pursuit to outperform passive benchmarks, portfolio managers have explored any number of approaches but fundamental to active management is the principle that to outperform a benchmark one needs to deviate from it. Over the long term, share prices reflect underlying business fundamentals rather than the current value of companies. A thoughtful and active approach is key to any success and fortunately for Bayern Munich fans and some investors, both are happy to take this approach. 12 Kwok Chern-Yeh, Head of Japanese Equities at Aberdeen Asset Management Prime Minister Shinzo Abe’s stimulatory policies seem to be working and signs of a recovery after years of stagnation and deflation seem to be underway. The weakening of the yen has also been positive as Japanese goods have become more competitive abroad. More importantly, large companies in Japan reported an increase in capital spending. Two of the three arrows of Abenomics have been implemented, and are showing some signs of worth, while the majority victory in the upper-house elections is a sign that voters are ready to back his plans for economic reform. That said, Abe must prise open protected industries to get the third arrow off the ground. However, we believe that investing in them is not like making a bet on the economy. 121004050 A postcard from Japan Mid-Se ptember marks beginn the ing of t h e ‘k oyo fro in Japa nt’ n and t h e s t a new sea rt of a son. A slow m force sw oving eeps dow n from North a the nd turn s the lea on the t ves Aberdee rees to a n Asset bright autumn Manag ement, colour. Much l resurge B o w i k B e ells Hou the nt Japa se, nese eco the koy n o m y, o front represen 1 Bread a quick ts Street, ly chan London ging , environ ment. UK, EC 4M 9HH Digging further into the companies listed on the stock market is what we are focussed on, and despite the recent rally there is still value to be found in Japan. The country has one of the largest economies in the world and is home to some of the most recognisable companies, many of whom are global leaders in their respective industries. Corporate governance is improving with many of the better-run companies beginning to take on non-executive directors. Abe has also promised to accelerate reforms on governance standards, with tougher regulations on insider trading, a review of auditing firms and a more effective whistle blowing system. Japan’s small and medium sized companies also offer a wealth of investment opportunity. Many are global leaders, dominating niche markets such as industrial robots, bicycle components and medical diagnostic equipment. The most progressive are sizeable entities, with business operations overseas. With a significant portion of revenue derived from overseas markets. These companies have been relatively insulated from the moribund domestic economy for much of the past two decades. Importantly companies now operate in a different environment and assumptions have changed. While there are some businesses and industries that are more expensive than others, we believe that we can still find value in the Japanese stock market.