Wrong turn?

There are some questions that fund managers are keen to answer and talk about, and others that they are not. Many managers will provide market forecasts for the year ahead – although it is rare for them to be held to account for their accuracy. Some will offer generally upbeat assessments of widely discussed problems or potential dangers, such as the falling dollar, rising oil prices or a house price crash.

Then there are the questions they are afraid to ask. This category is in many ways the most interesting. Generally, these questions take the form of assumptions that are often made but rarely questioned, as discussing them threatens to undermine some of the key premises about investment.

This article will examine four such questions. Although separate, they are related to each other; indeed, some are linked to more fundamental problems.

Q: Is world economic growth as strong as it currently seems to many forecasters?

A: No. The way it is often calculated flatters global growth forecasts. Fast-growing developing economies are often given a bigger weighting than they deserve.

According to the Internatonal Monetary Fund, the world enjoyed its fastest growth rate for 30 years in 2004, with emerging markets leading the way. China and India played a key role by providing a substantial share of global output growth.

But such statistics are misleading. This is because they are generally worked out at on a purchasing power parity basis rather than at market prices. Although this seems a technical distinction, it makes a substantial difference to predictions for global growth. Purchasing power calculations adjust gross domestic product to take account of the varying costs of different items in one country compared with another. For example, a burger in India costs far less than one in Britain. India’s GDP is therefore revised upwards to account for the greater purchasing power for a given amount of spending.

The problem is that can be misleading when looking at the world economy. It is useful for comparing living standards, but not for examining how different national economies interact. For instance, when Britain trades with India or invests in the Indian market, it does so at market prices. So it makes sense to measure the impact of countries on the world economy at market prices. This makes an enormous difference; for example, China accounts for about 13% of the world economy on a purchasing power parity basis, but roughly 4% at market prices. Global growth is likely to be about one percentage point lower when calculated at market prices (see chart on page 19).

As it happens, the underlying calculations on purchasing power are also open to question. For example, according to Albert Keidel, senior associate at the China programme at the Carnegie Endowment for International Peace, those for China are based on rough estimates by the World Bank in the late 1980s. As a result, they could substantially overstate or understate Chinese GDP figures. The shocking truth is that despite China’s importance in the world economy, no one knows how accurate the figures are.

TQ: Is Asia likely to turn into a modern consumer economy?

A: It may do in time, but it will take longer than fund managers generally assume.

One of the ultimate dreams of many fund managers is that Asian countries become mass consumer societies similar to those of western countries. Imagine if every Chinese adult had a car or every Indian had a personal computer. If such development happened it would bolster global markets in many ways: indigenous Asian firms would benefit from being involved in a much larger market, and the world economy would be less dependent on America as a source for global demand.

The problem is that such development is easier imagined than achieved. Only Japan, along with relatively small enclaves such as Hong Kong, Singapore, South Korea and Taiwan, have achieved living standards comparable with the West. The demographic giants, such as China and India, are way off (see table on page 18). Even if the Chinese economy overtakes that of America in about 2040, as many have predicted, its income per head will still be about a quarter of that of the US.

Indeed, the Indian Ocean tsunami was a tragic illustration of the economic marginalisation of much of Asia. Although India (population 1.1 billion) and Indonesia (population 240 million) were both hit, the impact on world markets and the global economy was minimal. The human cost of the tsunami was enormous but it was largely concentrated in remote rural areas. As a result of the disaster, investment bank Morgan Stanley has downgraded its economic growth forecast for 2005 from 6.0% to 5.7% for Thailand. Its prediction for Indonesia is unchanged at 4.5%.

Even India, which has enjoyed a lot of hype around its economic growth recently, has the relatively dynamic sectors concentrated in small parts of the country. If Bangalore or Mumbai had been affected rather than the southern state of Tamil Nadu, it might have been a different story.

The difficulty in developing mass consumer societies also helps explain the massive imbalances between America and Asia. Huge purchases of US treasury bonds by Asian central banks should not be explained away as simply a foolish policy. Many Asian countries, notably China and Taiwan, are keen to prop up America as it is a key export market for their goods. The Asian subsidy for America is in many ways an easier option than developing domestic consumer markets. China’s currency peg with the dollar is also a way of bolstering exporters by keeping prices relatively low.

Q: Is the business cycle normal?

A: Definitely not. In fact, it is amazing that nearly everyone assumes economic life is continuing as normal.

Classically, economic life consists of cycles, each spread out over several years. Such cycles can be broken down into several phases; these include a period of growth, a contraction and a recovery.

When fund managers invest, they often try to judge where the economy is in the cycle. Merrill Lynch even tracks such estimates as part of its global monthly survey of fund managers – the current consensus is mid-cycle. Such calls are important as they have a bearing on how fund managers invest. For example, during an economic contraction it probably makes sense to weight a portfolio towards more defensive sectors. In contrast, cyclical stocks tend to do better in periods of expansion.

What few seem to have noticed is that the economic cycle no longer seems to be acting is it did in the past. The contraction period has become less pronounced and the expansion phase less dynamic. This changed pattern was apparent in the slowdown of the early 1990s and the subsequent recovery. It was even clearer in the muted economic contraction of the early part of this decade. Britain is a particularly striking example of this trend, with an unprecedented 13 consecutive years of continuously rising economic growth.

At first sight, the muting of economic contractions might seem welcome. Such downturns can be painful for companies – with many forced to restructure or even go out of business altogether – as well as leading to higher unemployment.

The problem is that such downturns, unpleasant as they are, help to create the basis for a new round of economic expansion. This is what Joseph Schumpeter, one of the most famous economists of the early 20th century, referred to as “creative destruction”. In other words, recessions are part of a cleansing process in a market economy. Firms are forced to restructure to become more efficient or they go out of business.

Some experts have attributed to smoothing of business cycles to greater co-operation in the world economy. Notably, Asian support for the American economy, by buying US bonds, has maintained the economic cycle for longer than normal. From this perspective, the world is in some ways still stuck in an earlier economic cycle. But there is a strong argument that more fundamental forces are also at work.

The end of the Cold War seems to have subtly but fundamentally modified economic life. Industrial militancy is no longer an important barrier when companies consider how to restructure. If they wish to shed workers or cut wages, it is easier for them to do so. This has many advantages for firms as it makes the restructuring process easier. However, it also seems to mean that the changes that do occur are likely to be less thorough-going.

Although Britain is in many respects ahead in this trend, it exists throughout the developed world. Growth is stable but sluggish at the same time. Although this means less pain in the shorter term, it also implies a more sluggish global economy in the longer term.

Variations in economic output have more to do with financial instability than recessions in the classic sense. The bursting of the technology bubble earlier in the decade is the clearest example so far of this trend. In fact, it would be more accurate to call it a financial bubble in the technology sector. Finance flooded into the technology sector in the hope of a strong return, then surged out again once sentiment changed.

Fund managers are often all too eager to discuss prospects for the year ahead. However, the important questions are unlikely to be debated unless they are forced on to the public agenda by circumstances.

What the fund managers say
James Teasdale canvasses a group of fund managers on their views for 2005 Jim Leaviss, M&G head of retail fixed income. Bonds performed well in 2004 and there is no reason to believe they won’t perform as well this year. We expect the best performance to come from European government bonds, because of continued low inflation. We expect the dollar to continue to weaken and do not expect the US bond market to be supported by continued intervention from Asian central banks, so American bonds look less attractive.

Some corporate bonds look relatively expensive compared with government bonds. We will move to a more defensive position, from corporate to government bonds, and shift our exposure up the ratings scale for corporate bonds.

Richard Plackett, manager of MLIM UK Smaller Companies and UK Special Situations funds. There are a number of reasons why equity markets will perform well in 2005. Global GDP prospects are strong, fuelled by the continued expansion of the Asian economies, and takeover activity is on the up.

The outlook for stocks linked to the British consumer is more difficult as there have been a few profit warnings lately. The market is positioned well for bottom-up approaches, with stock selection being key. I would not put my own money in America. Generally, we are overweight in industrials and underweight in consumer stocks, but it is more about being in the right stocks.

Rod Marsden, manager of JOHCM Continental European fund. We remain optimistic for the European stockmarkets in 2005. Growth has been quite sluggish, but not disastrous. Markets will be worried about currencies, although people are looking ahead to a better currency environment and more stable oil prices by the end of 2005. Valuations are low on a historical basis and look good compared with America. In terms of sectors, we like oil services companies and financials. Region-wise, momentum looks good in Germany at the moment. Better-than-expected cost structures are being reported and productivity should pick up. Overall, we expect a lot of volatility this year.

Shawn Lytle, manager of UBS Global Optimal fund. We remain positioned defensively, taking overweight stances in telecommunications, pharmaceuticals and the food and beverage sectors. This is because we are cautious on the consumer discretionary sector as we believe consumer confidence could weaken in 2005. We are also underweight in the capital goods sector as we have seen no real pick-up in corporate investment in machinery, and we believe that some major players in Europe could suffer as the strong euro makes exports relatively unattractive. This year we also anticipate earnings growth will remain high single-digit, in line with economic growth. We do not anticipate any significant re-rating in global equities.

Roddy MacPherson, Swip investment director of global strategy. We expect the developed regions to show slower growth into 2005 and 2006. We believe interest rates and headline inflation have peaked in Britain. We forecast low single-digit returns for all asset classes in 2005, with bonds performing worst.

We have a non-consensus view that the dollar will perform well this year. From a purchasing power parity point of view, we are at an extreme, with sterling and the euro about 20% too expensive compared with the dollar. We are marginally overweight equities and cash and have shifted from European to American equities. We also have a small overweight position in emerging markets.

GDP growth and market forecasts for 2005
2004 out-turnCentral forecast for end 2005
UK policy rate (base rate)4.75%4.75-5.00%
FTSE 1004814.34800-5100
S&P 5001211.921150-1250
Fund of funds trends in 2005
Adam Lewis takes a straw poll of multi-managers
This year is expected to be a tough year for intermediaries as a result of a painful squeeze on margins. Clients want firms to do more than ever for them while paying less for the service. As a result revenues are falling. At the same time, however, thanks to rising professional indemnity insurance premiums and increased Financial Services Authority regulation, the costs of doing business are rising.

These problems lead Alan Durrant, chief investment officer at Skandia, to argue that this will be the year when adviser firms begin shifting their back books of business to the multi-manager and fund of funds providers. Not only, he says, will it take away a large amount of costs; it will also allow intermediaries to spend more time with their clients.

In addition, he says, such a move would remove the hassle of advisers having to justify every investment decision to the regulator. Already faced with sideways markets, intermediaries are also now having to keep a regular eye on frequent fund manager changes. In recent years, such turnover has been high, and fund of funds managers across the board expect 2005 to be no different.

Bambos Hambi, head of multi-manager at Gartmore, says this is because the high level of merger and acquistion activity within the fund management industry seen in 2004 – which included the merger between Isis Asset Management and F&C – will continue in 2005.

As a result, he expects fund range consolidation to play as large a part this year, as it has done in the last two: “Compared with the past, the pressures of competition mean fund management houses are much less likely to hang onto poor-performing managers, and/or funds.”

The lure of managing hedge funds is another factor to be considered. In the past, high-profile names such as Rory Powe at Invesco, Ian McVeigh at Schroders and Ezra Sun at Newton left their respective jobs either to set up their own hedge fund boutiques or join groups that run hedge money. Durrant says this trend will continue if fund management house do not offer their managers the chance to run long/short money in addition to their existing duties.

“Corporate issues, running too much money, and the expansion of smaller boutiques are all factors that will see more manager rotation this year,” adds Gary Potter, fund of funds manager at Credit Suisse Asset Management.

He argues that 2005 will be another year of significant change, both at the group and the manager level: “Another hefty merger cannot be ruled out, and as a result there should be yet more consolidation. A typical time many managers leave is after their bonuses.”

Fund of funds managers agree that this year will also see increased merger and acquistions activity in the wider stockmarket. Aidan Kearney, head of the Premier Funds service at Artemis, says the level will increase as the corporate sector seeks to replace the consumer in helping the economy push forward.

With some 40-45% of companies’ earnings in the FTSE 100 being dollar-sensitive, Potter anticipates earnings for the British market to come under pressure this year. With this expected to hold back mainline growth in the market, he forecasts the larger companies to look at taking over their smaller and mid-sized counterparts.

With no strong sector themes set to emerge, and volatility set to remain high, Potter says 2005 will be the year of the true stockpicker: “Within the same sector you will see one stock up and one stock down, so it will be those who can identify the right stocks that will be the most successful.”

Indeed, rather than making calls on which areas of the market will perform in 2005, Craig Heron, fund of funds manager at New Star, says it has increased its exposure to funds with high levels of “stock specificity”. This, he says, means holding managers who are true stockpickers: “These days all managers declare themselves as stock-pickers. What we are trying to do is find fund managers who take the bulk of their risk on stock-specifics rather than making calls on one sector versus another, or one market cap versus another.”

GDP per head ($)
United Kingdom36,977
Global GDP growth at PPP and market prices
The ups and downs of depolarisation
Helen Burnett looks at the themes for fund distributors The main theme for distributors in 2005 looks as though it will continue to be the effects of depolarisation. As the new rules governing financial advice are implemented over the first half of 2005, the consensus remains that depolarisation will transform distribution.

Paul Tebbutt, chief executive of Millfield group, says depolarisation is likely to be a slow process for the industry. “I see 2005 as a year of transition. This will not be a fast journey, but will start to gather momentum in the second and third quarters of this year,” he says.

“In the first six months of 2005, I don’t think we will see a massive migration of advisers to multi-tie, but we will see an understanding of what depolarisation means to them and their clients,” he adds.

Several advisers and distributors are expected to announce decisions to go multi-tie before the Financial Services Authority’s transitional period ends on June 1. Others, however, are sure to remain independent – still an important word in the industry, according to Tebbutt.

However, according to Holly Mackay, head of wrap proposition at Abbey, depolarisation will increase the need for independent advisers to be part of a platform this year, in order to remain both competitive and whole-of-market.

“If you look at depolarisation from an intermediary’s point of view, the desire is there to remain independent. To do so in 2005 is going to be more difficult than they estimate. Whole-of-market advice is not easy to offer, unless you use a transaction platform. Wrap platforms will be essential to remaining whole-of-market,” she says.

According to Mackay, the first change of the year for advisers and distributors is set to happen on January 14. On that date all intermediaries are required to provide the FSA with the Initial Disclosure Document, stating which product they will provide as well as their fee structure: “The depolarisation issue has been talked about as something that will be occurring in the middle of 2005, but it is something that is only a couple of weeks away.”

Although several banks are expected to adopt multi-tie structures, many distributors insist that there will be demand for all distribution models this year. Mackay says that “there is room for both the single and multi-tie models in the market in 2005. I think people have discounted the single-tie model, but there is a market and demand for whole-of-market advice that will distinguish independent advisers from multi-tie.”

According to Darius McDermott, managing director of Chelsea Financial Services, however, depolarisation may not directly affect all distributors this year. “We won’t be making any changes to our distribution; we will be continuing to do what we always do,” says McDermott. “It doesn’t look like depolarisation will have an effect on us. We are discount brokers, so we are in a very niche market.”