Local bonds for local people
When does a long-term structural shift become impossible to ignore? For index providers, the resurgence of the East and the rapid expansion of local currency debt has thus far proved difficult to accommodate. Asian domestic bonds now form the fourth largest bond market after the US, EMU and Japan, but they are still under-represented in bond indices, and so attract lower levels of investment. For example, whilst Asia ex-Japan now accounts for 7 percent of the global domestic bond market, compared with 16 percent for Japan and 24 percent for EMU, it is only 0.7 percent of the Citi WGBI index, compared with 27 percent for Japan and a whopping 43 percent for EMU.
“This new asset class has been growing at a phenomenal rate – it is now bigger than Germany, but it is very little known outside the Asian markets,” says Rajeev de Mello, head of Singapore operations at Western Asset Management. China, South Korea, India and Taiwan are currently the biggest markets, and de Mello says that ratings are improving all the time. In 2007, the Asian corporate bond market alone grew by 20 percent, with the South Korean market expanding by 22 percent and the Chinese market by 38 percent, although this was from a lower base.
But size is not necessarily an indicator of liquidity. Anthony Michael, head of fixed income, Asia, at Aberdeen Asset Managers, says that the most liquid local government markets are South Korea, Hong Kong, and Singapore, whilst the others are more variable. It also remains difficult to access some markets. “China has been involved in a fairly large exercise to manage its currency, and to mop up excess liquidity though the issuance of government bonds. So you’ve seen a substantial increase in the size of that market, but access is difficult for offshore investors,” he says.
To gain access, foreign asset managers need a Qualified Foreign Institutional Investor licence, and although the quota has recently been increased to $30 billion from $10 billion, Michael says this is peanuts when you consider the size of the market. “China doesn’t want to encourage more capital inflows at a time when it is already facing massive offshore inflows and there is pressure on the currency to appreciate,” he explains.
De Mello agrees that accessing many of these markets remains the big challenge. “Hong Kong and Singapore are very easy, but it is more difficult in China. In South Korea you just register with the government and it takes about a week, but it is difficult in India.”
But foreign investors are increasingly prepared to wrestle with bureaucracy because Asian issuers are benefiting from improved economic fundamentals. A large number of markets are now in surplus, and currencies are expected to appreciate as productivity increases. For a dollar- or sterling-based investor, an investment in appreciating Asian-currency denominated bonds gives a greater return when translated back into dollars or sterling.
Inflationary pressures
However, there are some risks to be aware of, not least, rising inflation. “Rising interest rates are not good for bond prices, which is why we see this more as a currency play,” says John Beck, co-director of international bonds, Franklin Templeton Fixed Income Group. “But in Korea interest rates have risen already, and it is running a current account deficit rather than a surplus. So here we have government bond exposure rather than currency exposure, as the currency is unlikely to appreciate, and interest rates are more likely to fall.”
Michael is also concerned about inflationary pressures. One of the biggest problems for many of the Asian economies is the rising price of food and energy, which make up a larger proportion of the CPI basket in places like the Philippines than they do in developed markets. But if food costs come down in H2, this will give central banks more freedom to ease.
“We look at the Philippines, Thailand, South Korea and possibly India as having the potential to ease,” says Michael. “Even China should ease up on its tightening policies. So there are some good rallies to be had in some of these markets.” But he adds that Indonesia’s bond market recently sold off by a couple of hundred basis points just on near term concerns about inflation.
Once through this inflationary period, Aberdeen believes the currency story is still a very good one. Michael’s highest conviction in the currency space for the near term is for the Malaysian ringgit and Singaporean dollar to perform well. “We’re short the Korean won but we’re long the Korean bond market as Korea is probably more exposed to slower (US) growth,” he adds. “Some of the more open economies, like Hong Kong, Korea, Singapore, and Taiwan, will slow faster than economies like India and China where exports make up a smaller proportion of GDP. So we think the game is to be long markets like Korea, Hong Kong and Singapore for now, but to be short the won against an overweight bond market position.”
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Make Room! Make Room!
From Thomas Malthus to the Club of Rome, every hundred years or so the human race is given a dire warning as to what will happen if it continues to multiply at its existing rate. According to these doomsayers, we will become too numerous for the planet to support us, and whilst we have not quite arrived at Soylent Green extremities, agricultural commodity prices have been sprinting up over the past 12 months, triggering food riots in many parts of the developing world.
“For any government, food shortages are the bottom line,” says Henry Boucher, who manages the just-launched Sarasin AgriSar Fund. “If a population can’t feed itself, the government is unlikely to stay in power.” The problem is that the population has grown by 120% since 1961, but arable land has only increased by 13%, and in the short term, shortages are intensifying due to biofuel policies.
This has created a pinch point in some agricultural commodities, with inventories at record 30 to 60 year lows. Nicholas Brooks, head of research and investment strategies at ETF Securities, says the problem has been exacerbated by higher numbers of extreme weather events and increasing input costs. For example, fertiliser costs have doubled over the past five years whilst operating costs are up 40%.
This tightness of supply coupled with strong demand has driven up agricultural commodities prices, attracting speculative interest. This in turn has increased volatility, often leading to head-scratching amongst commodities commentators trying to account for particular market movements. Even when hard data appears and the market seems likely to move in one direction, it will often confound by moving in the other.
Gone Soft
For example, in the first week of April the US Department of Agriculture released its Prospective Planting Report, a big annual event for the agricultural markets, and an important driver of prices in the short term. In the report, the soybean planting intention was significantly higher than most market participants had been expecting, whilst corn, wheat and cotton plantings were below expectations.
However, the soybean and soybean oil price rose, as the market decided actual plantings will be lower than those reported. This is because corn is so high in price right now, farmers are expected to substitute corn instead, says Brooks. Not surprisingly, this kind of price swing is discouraging asset managers who wish to offer less volatile products.
“Foreseeing price moves in the context of rapid crop rotation, substitution and weather disruption is a mug’s game. It is better to sell a call premium on volatile commodities and occasionally take a modest directional bet,” says Christopher Lindsay, Sarasin’s head of research. Boucher adds that the sheer amount of money going into agricultural commodities at the moment raises some questions. “This is speculative. We need to look at a longer time period and understand the basic drivers before leaping in on that premise.”
And it would be a mistake to think that all agricultural commodities have performed equally well. Indeed, livestock and lean hogs, have been some of the worst performing commodities over the last 12 months. The ETFS Lean Hogs product is down 13.2% in the year to date whilst ETFS Livestock is not much better, down 12.3%. In the last 12 months they are down 34.4% and 24.9% respectively, bumping along the bottom with nickel and zinc.
Very lean hogs
Charlie Morris, manager of HSBC Investments’ Absolute Return Service, who recently sold all his remaining exposure to soft commodities, attributes the poor performance to the fact that as the price of feed goes up, farmers send their animals to market early – the hogs are even leaner than usual. This has led to an oversupply of livestock, pushing down prices, but there is likely to be an undersupply later.
The softs basket, which includes items such as sugar and coffee, has also disappointed, falling back down to near where it was a year ago, after spiking in March. The plummet in price has been attributed to market expectations of a bumper Brazilian coffee crop, way above Brazil’s official estimates.
This kind of volatility has prompted managers like Sarasin and Axa IM’s Sebastien Lagarde, who manages the Hybrid Resources fund, to look at agri-related companies as a way of playing the long-term agriculture theme. Boucher is seeking companies likely to benefit from government incentives to develop new technology that can improve productivity yields, for example.
But as Lagarde points out, finding stocks that haven’t been driven up in price substantially already, is far from easy. This is a problem that afflicts crop science companies and Potash Corp of Saskatchewan, which is up 176.3% in the last 12 months. It can mean searching for micro caps such as Asian citrus, an AIM-listed company that is China’s largest operator of orange plantations, in order to play one specific product.
Sarasin identifies a variety of themes including the monetisation of water – in Australia, water rights are already being sold – and aquaculture to offset dwindling wild fish stocks. Structural angles would extend to buying shares in the Chicago Mercantile Exchange and traders with an information advantage to capitalise on heightened commodity price volatility.
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Time to pay
April 22, 2008 at 3:00 pm (Bonds, Macroeconomic commentary, UK equity markets) (banks, credit crunch, recession, UK equity markets)
Market commentators are fond of historical parallels. As the UK consumer is finally waking up to the fact that one day the bill really does fall due, economists and asset managers are torn between likening this downturn to that of the early 1990s – when house prices tumbled – and the 1970s – when inflation ran amok. I’ll let you know when we get a consensus.
John Beck, co-director of international bonds at Franklin Templeton Fixed Income Group, says that August 2007’s credit crunch is only now hitting the wider economy, and despite the measures that are being put in place to help UK banks over the hump, further pain is likely.
Last week’s breakfast meeting at Downing Street quashed hopes of a quick fix, with the Bank of England offering its collateral swap facility only at a significant haircut, whilst the capital risk will remain with the banks rather than being shouldered by the groaning taxpayer.
No such thing as a free breakfast
Under the terms of the special liquidity scheme, banks can swap high quality mortgage-backed and other securities for UK gilts and then use these bonds as collateral for loans from other banks. But the banks need to provide the Bank of England with assets of much greater value than the Treasury Bills they receive. And if the value of the assets falls, or are downgraded, the banks will need to stump up the difference, replace them with better assets, or return some of the Treasury Bills. “This is the most expensive breakfast those bankers have ever had,” says Beck.
But as Howard Archer, an economist at Global Insight warns, for the scheme to have the maximum beneficial impact, several other developments need to happen in tandem. These include greater transparency from banks on their losses and exposures to the sub-prime crisis; steps by the banks to improve their balance sheets, such as the rights issues by RBS; and a commitment by banks to quickly reflect any fall in market interest rates in their products and loan rates to customers.
Beck believes the RBS rights issue will be the first of several capital-raising exercises. “With the banks we are potentially at a turning point similar to what we saw with the telcos in 2003, when their debt was downgraded. There was vast excess capacity in the telecoms industry and the bond markets had been paying for it. Now I think we are getting to the point where the bond markets and the regulators have got fed up with the banks, and will only let them raise capital at penal rates.”
Although he sees the move towards raising equity capital as good news for debt-holders, he doesn’t expect an improvement in the economy for some time. “Debt spreads are still very wide for banks and stock prices haven’t recovered. Now we are seeing the consumer impact. The first round was the write-offs from securitisation. Now the write-offs on loans to consumers are coming.”
You are now entering a recession – please take care
Not surprisingly, UK equity managers are gloomy. “The economic data has been much worse than expected and the credit crunch has been deeper and more long lasting than we expected six months ago,” says F&C’s Ted Scott, manager of the UK Growth & Income Fund. “My view now is that the UK will have a recession, whereas six months ago there was a chance that we might avert a recession or it would be a pretty shallow one.”
But with the financial system still frozen and banks reluctant to lend, the housing market is beginning to implode under the pressure of unsustainable price rises and higher interest rates. “In the US, house prices have fallen 30% or so and it’s quite conceivable that in the UK we will see a fall of over 20% peak to trough,” Scott argues.
With home-owners struggling to meet their mortgage payments, other spending is expected to dry up. “They will be cutting back quite severely, and that’s going to have a big effect on the economy.” And Scott believes the recession could be more severe if unemployment rises from its current relatively low level of one million.
“Back in the last recession it got up to about three million, so if we start to get a lot of redundancies that would make it worse,” he says. “At the moment the problems are confined to the financial sector but if it’s a wider economic problem we could find that lay offs increase sharply.” With the credit crunch still ongoing, he draws a comparison with the 1970s and the UK’s secondary banking crisis, which took place against a backdrop of rising inflation and oil prices, pay freezes, and the three-day week.
Mark Lovett, co-CIO of European equities at RCM, is also pessimistic, but adds that RCM has been quite negative on the UK consumer since the beginning of 2007. “We’ve been concerned about the ongoing pressures on disposable income and the fact that the savings rate is so low, and how that will affect consumer spending.”
He sees the UK growing at below trend for two or three years, with a sharp V-shaped recovery in 2009 or 2010. “We don’t think this is something that will be resolved quickly, and below trend growth will probably be quite healthy in terms of unwinding some of the consumer debt and the low savings rates that have been so prevalent.”
Bear-market rallies
Ironically the market has roared ahead in the last month and is up nearly 10%, but Mark Lyttleton, manager of Merrill Lynch/BlackRock’s UK Dynamic Fund, remains wary. “People are saying that the worst has happened and that this is reflected in the valuations already. And now they see some solutions to the credit crunch. But it’s not just about getting the banks to lend to each other, it’s about all the losses they have made, and actually announcing them,” he says.
“If you’re prepared to take a two-to-three year view, there is probably some value in some of the bombed-out UK discretionary names. The problem is the news flow is going to get a lot worse before it gets better. So you have to decide how much of that is in the price and whether you can afford to wait. There will be some speculative rallies when some of these sectors will bounce back up, but I’m playing it quite cautiously.”
And although the markets have recovered in the last fortnight, and the VIX has been less choppy, Lovett does not believe that this reflects a change in confidence levels. “The average market participant is still very nervous because of the lack of visibility about the economic environment, and I expect volatility to remain high through the rest of 2008,” he says.
If you want to read more about how UK equity managers are positioning their portfolios to weather the slowdown in consumer spending, please visit:
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