|High-Yield and EM Bonds
|G7 Sovereign Bonds
What and where to invest in 2012
Much of 2011 has centred on concerns over the Eurozone debt crisis, resulting in a particularly weak equity market. We are well aware that problems in the Eurozone will not be fixed overnight. Austerity will take years to work out, and despite the criticism of various short-term ‘band-aid’ measures (tantamount to ‘kicking the can down the road’), we view these measures as necessary to buy Eurozone nations adequate time and liquidity to embark on longer-term plans. Our expectations are for the Eurozone to remain intact (failure to do so would have severe and expensive repercussions), and despite the region being our least preferred, we think exposure to European equities (many of which are large global companies which currently sport attractive valuations) is still necessary for portfolio diversification.
Moderating commodity and energy prices should alleviate some of the inflationary pressures seen in 2011, allowing for central banks to shift monetary policy to a more accommodative stance in 2012, with a key focus on growth. Given their differentiated demographics, emerging markets will be expected to post superior rates of economic growth, which will translate to stronger (and yet sustainable) earnings growth. Thus, our forecasts are for emerging market equities to deliver superior rates of return compared to the developed markets, increasing their attractiveness to global investors. Among the emerging markets, China – a critical component of global growth – appears poised for a good year, as crisis-low valuations and a potential turnaround in monetary policy set the stage for a strong performance.
Within the fixed income space, riskier segments of the bond market offer more value; investors should underweight developed sovereign bonds given their low yields which are indicative of rather poor long-term returns. Emerging market bonds remain a long-term structural play on the convergence of developed and developing market bond yields. Some of the highest yields are currently found in the high-yield bond space, where spreads are suggesting unrealistically-high levels of potential default rates.
As indicated by retail fund flows so far in 2011, investors have chosen to favour bonds over equities despite yields having fallen to historically low levels, while multi-year low equity valuations have not garnered much investor interest. Our recommendation is for investors to do the opposite: increase exposure to equities which have the potential to deliver strong double-digit returns over the next 3 years, while lowering exposure to fixed income which has become an increasingly expensive asset class as low yields offer little protection against both inflation and interest rate risk.
Preferred Asset Class: Equities
Our valuation-driven approach to investments entails maintaining our ‘overweight’ stance on equities vis-à-vis fixed income securities for 2012, a view which we have held since 2009. Global equities currently trade at low valuations as investors shun this asset class, while historically-low yields remain a feature of the global fixed income market. Though bonds have generally outperformed equities in 2011, we find substantial value in most equity markets under our coverage, while only select segments of the bond market offer healthy long-term returns at present. Earnings yields (the inverse of the PE ratio) for most markets remain significantly higher compared to their respective government bond yields. Some markets have even recorded dividend yields which are higher than the yields of longer-dated government bonds; an indication of the deep relative value of equities. A key risk to our view is a significant deterioration of financial stability in the Eurozone, led by an exit or an uncontrolled default by one or more member countries which could precipitate similar conditions seen in the 2008 global financial crisis. Given the interconnectivity between financial markets and the global economy, there may be substantial negative implications for global economic growth. However, this would likely be temporary with most economies returning to growth thereafter.
Recommended Global Equity Funds: Aberdeen Global Opportunities and RIC World Equity II ClJ USD
Most Favoured Equity Region: GEMs
Global Emerging Markets (GEMs) is our most favoured regional equity market in 2010, 2011 and now 2012. Economic growth is expected to be stronger in the emerging economies compared to developed regions, which should support stronger sustainable corporate earnings growth. However, poor performance in 2011 mainly attributed to external factors stemming from the troubled developed economies, has brought down GEMs valuations, even as earnings have continued to grow. Loosening monetary policies to accommodate growth rather than to control inflation should enable key economies like China and Brazil to avoid a ‘hard landing’. PE ratios for major markets like Brazil, Russia, China and South Korea are currently below their historical averages, suggesting that value is abound within the region. A key risk to take note is the unresolved issues in the West that threaten to derail global economic growth and harm the exports of GEMs. Besides that, the pursuit of growth over controlling inflation might lead to inflationary problems in the future. Also, in the midst of global currency uncertainty, protectionist measures that may be implemented by any nation will not solve any issues but limit global trade and recovery.
Recommended Global Emerging Market Equity Funds: Aberdeen Global Emerging Markets, First State GEM Leaders and Schroder Global Em Mkt Opps Fund SGD
Least Favoured Equity Region: Europe
Europe replaces our long-time least favoured region Japan, troubled by a debt crisis that has not been quelled for the past three years. What initially started with Greece has now spread to Italy and Spain as the risk of contagion threatens to spill over into the core of the Eurozone, with France potentially being the next to hit the spotlight. The European economy is at risk of a recession as consumer spending declines and factory orders fall. Structural and political issues are the main cause of the current crisis; solutions to such deep-seated problems require time, while short-term ‘band-aids’ were usually administered on liquidity issues. Given the nature of politics, further damaging action caused by brinksmanship cannot be ruled out. The European Commission has forecasted economic growth of 0.5% and 1.3% for 2012 and 2013 respectively, and our in-house estimates call for a mild recession of -0.6% in Europe in 2012 followed by a return to growth of 1.0% in 2013. Nevertheless, European equities are currently valued at 10.4X 2013 earnings (as of 13 January 2013), a discount compared to its fair PE ratio of 12.5X, rendering the market's equities attractive in our opinion (a 3.0 star rating) over a three-year horizon.
Recommended Europe Equity Fund: Henderson Hzn Pan Euro Eq A2 EUR
Most Favoured Single Country Equity market: China
Despite delivering strong economic growth, China has been among the worst performing equity markets in both 2010 and 2011. China is our most favoured equity market on a three-year view and we believe that it will see a strong rally as corporate earnings are poised to reach all-time highs by 2013. China’s valuation is extremely attractive and hence its upside potential is the highest among the markets under our coverage. China’s economic growth is expected to remain robust as the key driver shifts from investment to consumption. Poor performance for the past two years was partly due to expectations of monetary tightening which weighed on the property market and the financial sector. The People’s Bank of China (PBoC) has signalled a shift towards an accommodative monetary policy by lowering reserve ratio requirements at the end of November 2011. We believe that 2012 will see further loosening, which will serve as a market catalyst.
The key risks to China include a collapse in the property market, a sharp rise in non-performing loans and a ‘hard landing’. The impact from the property market is the most significant, though property prices have started to moderate towards the end of 2011. So long as the decline in property prices is gradual, we believe that the market’s reaction will be contained.
Recommended China Equity Fund: DWS China Eqty Fund Cl A SGD
Recommended Greater China Equity Fund: First State Regional China Fund
Least Favoured Single Country Equity market: Indonesia
Indonesia was our least favoured market in 2010, 2011 and now 2012. Indonesian equities were very well insulated from the market rout in 2011, recording a 1.9% return in 2011 (in SGD terms). We believe that the market is not cheap relative to other markets, and that it is vulnerable to foreign fund flows and is plagued by slow structural reforms. The difference between the 10-year government bond yield and Jakarta Composite Index (JCI) earnings yield narrowed down to 1% in 2011, which roughly indicates that the returns from risk-free government bonds and equities are nearly the same.
Foreign holdings of equities remained above 55% as of November 2011. There is a risk of an outflow of foreign funds as other markets appear more attractive. Apart from that, Indonesia will need to overcome economic growth bottlenecks such as the government’s insufficient political will to tackle corruption and reform of subsidies, the underinvestment in infrastructure and weak regulations.
Recommended Indonesia Equity Fund: Aberdeen Indonesia Equity
Most Favoured Bond Classes: High-Yield and EM Bonds
High-yields bonds was our most favoured bond class in 2011. The segment returned 6.5% in 2011 (as represented by the Credit Suisse High Yield Index II Total Return), marginally underperforming safer bond classes like US Treasuries and G7 bonds. Even so, we remain bullish on high-yield and emerging markets (EM) bonds for 2012. After hitting a 42-month low in April 2011, the yield spread between high-yield corporate bonds and US Treasuries has widened sharply. The spread-implied default rate was 4.7% compared to Moody’s estimated default rate of 2.9% by end of 2012 (as of 25 November 2011). We think that the risk premium currently priced-in is adequate to cover the potential defaults.
For EM bonds, yields remain attractive and its performance will be driven by the converging sovereign debt ratings between developed and developing markets. We expect interest rates in major developed markets to remain low in 2012, hence increasing the incentive for investors to invest in better-yielding riskier assets, such as high-yield and EM bonds. The key risk is that the yield spread on high-yield bonds is sensitive to the expected default rate and the expected changes in credit ratings. Amidst an unstable global economic environment, high-yield bond prices remain volatile and sentiment-driven. Moreover, fears over the European debt crisis and double-dip recessions in developed countries might spark a flight-to-safety which will be a bane for high-yield and EM bonds.
Recommended High Yield Bond Funds: PRU Mthly Income Plan Cl A and Fidelity Asian HY AMDIST SGD-Hged
Least Favoured Bond Class: G7 Sovereign Bonds
G7 sovereign bonds, our least favoured bond class, returned 8.5% in 2011 and was one of the best performing bond classes in the year. However, we still believe that most sovereign bonds of developed nations are not attractive and will likely underperform in 2012. Yields on 10-year US Treasury, UK Gilt and German Bund hit record-lows in 2011, driven by concerns over a double-dip recession and the European debt crisis. Investors should not look for a repeat of strong returns for G7 sovereign bonds over the next decade, considering that yields have little room to decline from current depressed levels, but have much leeway to increase. In addition, developed economies like Japan and the UK have high public debt and fiscal deficits, placing them at risk of potential credit downgrades in the future.
Recommended Global Bond Funds: DWS Lion Bond Cl A and FTIF-Templeton Glb Bond A(mdis) SGD-H1
Key Investment Themes and 2012 Outlook
The Fate of Chinese Banks if Non-Performing Loans Increase – A Stress Test (Part 1)
The Fate of Chinese Banks if Non-Performing Loans Increase – A Stress Test (Part 2)
Equity Market Review 2011: Only 2 Countries Survived The Drop!
Bonds Weekly – S&P Downgrades 9 Eurozone Countries [13 Jan 2012]
Equities Weekly – Equity Markets Continued Their Good Start [16 Jan 2012]