Uncertainty laps at the bows of the investment industry in the wake of last year’s turbulence. But although the year will not be plain sailing, few experts predict a global recession, writes Frances Hughes.
Getting ready to be tested in 2008? The consensus view of fund managers is that you should be. Having started the year with a squeeze on credit, a slowing housing market and low expectations for earnings and growth, fund managers’ optimism has weakened.
Indeed, expectations for economic growth and corporate profits in 2008 were among the worst ever recorded by Merrill Lynch in its global fund manager survey published last month.
Earnings growth is set to become a scarcer commodity according to the survey respondents, with 80% seeing it as unlikely to reach double digits this year. A net 62% expect the global economy to weaken over the coming year, while a net 60% expect corporate profits to deteriorate, the most pessimistic response in almost a decade.
Even expectations for China’s growth have fallen, with 25% of managers expecting it to slow. In November only 4% of respondents said the Chinese economy would weaken.
Despite this pessimism, however, few expect a global recession. Only 13% of survey respondents expect a global recession in 2008. Most say the rest of the world can decouple itself from the American subprime crisis.
The survey says managers’ strategies are centred on equities being cheap, especially in relation to bonds. They are also based on the belief that growth assets, like emerging markets equities, will outperform value assets such as financial services.
Tom Elliott, global strategist for JP Morgan Asset Management, however, predicts long-dated gilts will outperform equities over the coming year. “It’s going to be a tough call between UK gilts and the stockmarket,” he says. “Gilts will do well from weakening economic activity. But a lot of blue chip stocks have exposure to emerging markets. On balance I’d say long-dated gilts will outperform.”
The fact blue chip companies are more likely to have exposure to emerging markets is a huge positive, according to fund managers. Elliott predicts blue chip FTSE 100 stocks will be relatively protected by their exposure to Asia, but expects more domestically focused stocks to struggle.
Furthermore, balance sheets and cash flows in large cap companies tend to be more robust than mid and small cap stocks. In a credit crunch, that becomes even more important, says David Bowers, joint managing director of Absolute Strategy Research and consultant to Merrill Lynch. A net 83% of Merrill Lynch survey respondents expect large caps to outperform small cap stocks in 2008.
Indeed, not only is the preference for larger cap companies continuing into 2008, but so is investors’ love affair with emerging markets. This is despite a sharp rise in the number of fund managers who forecast a slowdown in China’s economic growth.
According to the Merrill Lynch survey, emerging markets are still seen as having by far the best profit expectations globally this year. However, although investors remain overweight in emerging markets, they have reduced the size of the overweight. In addition, asset allocators are closing their underweight American equity bet.
John Greenwood, chief economist at Invesco Perpetual, stands by his forecast that America will avoid a recession this year. He says the first few quarters of the year will feature a dramatic reorientation of growth, away from housing and consumer spending towards exports and capital expenditures.
Likewise, Elliott at JP Morgan, says American large cap companies are benefiting from strong exports because the dollar is so weak. JP Morgan is long American large cap stocks as a result.
Greenwood adds that despite the crisis in the American housing market, American GDP growth has held up well. This is because of both non-residential investment and the strength of American exports.
However, whether or not America falls into recession over the coming year, there is a strong belief among many fund managers that emerging market economies can decouple from the American economy. Bowers of Absolute Strategy Research says investors are not prepared to let go of the decoupling story.
“Emerging markets is the default overweight call most asset allocators have,” he says. “It’s a strongly held belief that China and emerging markets can decouple from an American slowdown and a credit crunch.”
According to Bowers there are three main concerns regarding emerging market performance in 2008. The first is that weaker demand from America could affect the Asian supply chain. Secondly, there is the possibility that credit problems could spill over into eastern European markets. Thirdly, even if the decoupling theory holds true in the coming year and emerging markets prove resilient to whatever happens in America, inflation is a risk for emerging market countries pegged to the dollar.
“If you are pegged to the dollar you are pegging yourself to US interest rates,” Bowers explains. “Interest rates could be too low to be comfortable, with regard to inflation.” He adds that some currencies may have to revalue against the dollar, leading to exchange rate volatility.
The increased resilience of emerging markets is not a new theme within the investment industry, but some say 2008 will represent the sternest test to this point of view. Furthermore, emerging market investors are casting their nets more widely. According to the Merrill Lynch survey they are increasing their exposure to countries such as Russia and Brazil. A net 79% of survey respondents are overweight Russia and Brazil.
Elliott at JP Morgan says it is because of both political and economic improvements that emerging markets continue to look attractive. “You’ve got a good fundamental story because of political calmness and prosperity,” he says. “Latin America is becoming a democracy and the whole of emerging Europe is becoming democratic and stable. It’s political and economic.” Elliott does say, however, that he is nervous about some emerging market valuations in the near term.
In contrast, Michael Howell, managing director of CrossBorder Capital and former head of research for Baring Securities, says investor preference for emerging markets is misguided. He predicts that America will provide the “best bet” for 2008. He points out that exports are four times as important to the American economy as the housing industry and says America’s trade deficit could disappear entirely within two years if the export volumes continue as they are.
A less optimistic outlook for America comes from Legal & General, however. Its Fundamentals report last month announced its recession predictor for the American economy had risen to about 30%. It said this reflected the sharp tightening of lending standards. L&G predicts it is unlikely there will be an environment of strong growth and low inflation in the global economy in 2008.
Indeed, concerns over financial markets and the credit crunch in this year are of paramount importance, especially to IFAs. According to the fund manager and AFI survey published last month by the Association of Investment Companies (AIC) and unbiased.co.uk, the credit crunch is the most commonly quoted worry for 46% of IFAs. This is followed by a lack of consumer spending (19%). Meanwhile, the main concern for fund managers in 2008 is lower GDP growth (33%), followed by credit crunch worries (29%). Elliot says the last six months have been a steep learning curve for financial markets. “Everyone knows what subprime vehicles are, and commercial bank rates,” he says.
“We’re seeing moves taken to shore up banks’ balance sheets. The moves by central banks should help this. But we don’t know what the size of the write-offs to come [will be]. The OECD [Organisation for Economic Cooperation and Development] predicts up to $300 billion (£150 billion). Because of that it’s difficult to know the extent of the problem. The co-ordinated effort of the central banks is reassuring,” he adds. “It demonstrates to the market they are serious.”
As well as further problems in the financial markets, other areas of risk for 2008 include house prices declining further and fears over inflation.
Julian Chillingworth, manager of the £55m Rathbone Income and Growth fund, says the slowdown in housing in both America and Britain will have a negative effect on consumer sentiment. The fact that both economies are slowing is fuelling expectations of interest rate cuts. Both the Bank of England and the Federal Reserve are caught between slowing growth and inflationary pressures. With so much uncertainty ahead, Chillingworth says he is “treading with caution”.
Elliott agrees that people will be more defensive but adds that it could be a lot worse. “The housing market is falling and people will be more defensive,” he says. “We are waiting for interest rates to come down, but there is some further room for the housing market to go down in 2008.” Elliott says that, the worst scenario is for house prices to fall while interest rates and unemployment rise. “At the moment we only have one of those,” he says.
The main theme for 2008 is uncertainty. The investment market is divided as to whether to expect a bounce back or further gloom. There seems to be little clarity regarding American economic performance, emerging market decoupling and the impact of the credit crunch on both financial markets and real economies.
However, Bowers of Absolute Strategy Research says the consensus view is that there is a need for caution but not panic. “People aren’t tearing up their strategic objectives and long-term strategies,” he says. “They are talking about a slowdown. They are not talking about a recession.”
Correction hits all – especially propertyAway from equities, the biggest concern for many investors will be the performance of British commercial property funds in 2008. The funds attracted huge amounts of retail money as investors chased the double-digit returns of 2006, and the trend continued into 2007. Several firms launched property products at the start of last year to capitalise on the growing demand.
But those looking for quick profits from the asset class, rather than portfolio diversification, were in for a shock. Bearish forecasts for the sector hit investor demand and property prices began to weaken. As Fund Strategy reported on December 17, New Star announced that the value of its £1.8 billion UK Property unit trust had fallen by almost 18% in just four months.
Investor outflows gathered pace towards the end of 2007. According to data from the Investment Management Association (IMA), a net outflow of £48m from property funds last October ballooned to £494m in November. Several firms, including New Star, moved the pricing of their unit trusts to a bid basis to discourage redemptions. M&G, meanwhile, placed a 90-day notice period on withdrawals from its offshore Property Fund in November.
Despite the woes suffered by investors, some commentators have given relatively upbeat forecasts for commercial property in 2008. London & Capital, manager of the £350m UK Real Estate fund, says market fundamentals remain “robust” in the medium to long term, if Britain avoids a recession. The firm even looks forward to strong buying opportunities in the first six months of the year.
Mike Hannigan, investment director of property at Standard Life Investments, also expects the market to reach the “bottom of the curve” this year: “This is an aggressive correction, rather than a crash. The underlying economy is still robust, occupancy demand is healthy and there has not been the speculative development we saw in the 1980s. Historically, things over-correct and certain sectors have been oversold.”
Hannigan says the retail sector was particularly affected, as well as London offices, despite a continued lack of good-quality office space. But he adds that no sectors were fully insulated from the adjustment and predicts a broad, albeit slow, recovery in the market in the third and fourth quarters. “Property has taken such a drubbing, it won’t carry on,” says Hannigan. “If, as expected, there are further falls in interest rates, the UK will start to look attractive to foreign investors and property companies.”
However, the consensus short-term view is less positive, with many expecting further underperformance. According to LaSalle Investment Management, the relaxation of yield compression will “dampen short-term returns significantly” in Britain. Meanwhile, Alessandro Bronda, head of investment strategy at Aberdeen Property Investors, expects weaker returns from the retail sector because of overpricing, oversupply and muted tenant demand.
At Scottish Widows Investment Partnership (Swip), Malcolm Naish, the firm’s head of property, expects returns of close to zero for 2008, despite better performance in the second half of the year. Like Bronda, Naish says occupier demand will slow as economic conditions deteriorate, but he expects offices in central London to be affected the most. Both Aberdeen and Swip forecast that income and rental growth will drive returns this year.
Even the outlook for fixed income, an asset class that benefits from a lower interest rate environment, is mixed. Bonds rallied in the second half of last year in response to interest rate cuts by America’s Federal Reserve. However, Jonathan Platt, head of fixed interest at Royal London Asset Management, says both the government and corporate bond markets have already priced in lower global growth. High yield bonds pose the greatest risk, adds Platt, because their yields are insufficient to compensate for the extra risk.
Andrew Tunks, head of fixed interest at Old Mutual Asset Managers, and London & Capital agree and say investors should look to higher quality securities this year. London & Capital also points to the emerging markets as attractive for bonds, and says the region has undergone a structural shift. The firm highlights rising commodity prices and the repayment of foreign debt as positive drivers. While emerging countries are not immune to an American slowdown, it says, any flight to quality may present good buying opportunities for investors.
Investec, which launched a retail share class for its Emerging Markets Debt fund last year, says the region benefited from strong foreign investment in 2007, as investors bought into the decoupling story. The firm expects fixed income allocations to the region to become more widespread, particularly from sovereign wealth funds, which have been set up in emerging market countries. Investec’s favoured positions in December included the local bonds of Brazil, Colombia, Chile, Israel and Turkey, as well as dollar bonds in Argentina and Qatar.
Year of “boring” funds to test stockpickers
Last year was one of innovation in product terms and this trend is expected to continue in 2008. However, according to Robin Stoakley, managing director at Schroders, whereas 2007 saw funds launched for bull market conditions, 2008 will see more funds launched for bear markets.
Stoakley (pictured, right) says given the prediction for markets this year he expects fund management groups to look at launching more defensive-style funds. “These may not necessarily be guaranteed return funds but funds with an element of downside protection,” he says.
Indeed, at the end of last year Norwich Union launched a cash fund as a means of providing investors with income and a high level of capital security. However, Nick Wells, product and communications director at Artemis, says going into cash now would be “barmy”.
Wells says: “We saw the share prices of large and well-run companies fall some 40-50% in 2007. As such we can see real opportunities in these areas.” He predicts it will be the “boring funds” such as equity income, which will prove popular with investors this year. He adds: “This year will represent a real opportunity for genuine stockpickers, and on this basis we think 2008 will be a year of significant momentum for Artemis.”
Stoakley says 2008 will see continued demand for income producing products. He expects to see more groups launch similar funds to its Income Maximiser fund. Wells also thinks more groups will launch cautious managed funds, on the grounds of their ability to move investment between different asset classes.
This year will see the launch of Funds of Alternative Investment Funds (Faifs). The policy statement and final rules for Faifs were to be published at the end of 2007, but they were delayed until February after the regulator identified several taxation problems during its consultation.
However, Mike Champion, head of product development at Schroders, says investors should not expect a wave of funds to be launched this year. He says: “The speed of development after regulatory change is not quick. Look at what happened with Ucits III. A number of the more flexible were launched a couple of years after the regulatory change.”
Meanwhile, 2008 will also be the year of Ucits IV. Unlike the changes its predecessor led to in terms of investment management, says Champion (pictured, above). Ucits IV is more about efficiency. The initial Ucits IV proposals are due to be announced in March and will focus on fund notification, revamping the simplified prospectus, fund pooling, fund mergers and management passports.
“These proposals are not likely to be implemented until at least June 2009,” says Champion. “As a result there will be no short-term impact on what we do.”
Wells adds: “Ucits IV is all about transparency. By having a new simplified prospectus people will know precisely what it is they have invested in. However, Ucits IV won’t create the same radical as Ucits III did.”
In terms of funds to watch out for in 2008, Stoakley says there is much talk in the industry about “the next 11”. The next 11, or N-11, is a shortlist of 11 countries named by Goldman Sachs in December 2005 as having promising outlooks for investment and economic growth. In a follow up-paper to its much publicised 2003 report on Brics (Brazil, Russia, India and China), Goldman Sachs named Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, the Philippines, South Korea, Turkey and Vietnam as the next rung of important emerging economies.
Stoakley also predicts that this year will see a continued focus on absolute return funds, which are non-benchmark aware.