The hike in oil and commodity prices is having a big impact, not just on company valuations but on how fixed interest managers rate emerging market debt
International Investment brings together the views of four leading fund managers, two covering European equities and two on emerging market debt, to highlight the opportunities and threats to their asset classes during 2006. Taking part are John Botham, European fund manager at Hendersons; Dominic Wallington his counterpart at Invesco Perpetual; Sarvjeev Sidhu, global head of emerging markets debt at Aegon; and Greg Saichin, head of emerging markets bonds at Pioneer Investments.
Can you give us a brief outlook on European prospects as things stand?
John Botham (JB): We still see some upside into 2006. The markets are not trading that expensively and earnings growth and earnings revisions continue to be positive. We would caution though that what upside we see is probably front-end loaded over the next six months because our concern really relates to the lagged impact of higher interest rates and oil prices slowing the global economy down. So good times for now but watch out in the second half of next year.
Dominic Wallington (DW): We have had three years of up markets and that is pretty much the longest we have ever had. But it still doesn't look overly expensive.
What are your views on the two core economies of Germany and France? The former has just had an election and the latter some serious rioting.
JB: For the vast majority of the companies we invest in, those issues are not very relevant. The German electoral confusion has had an impact on some companies that are very domestically exposed to Germany, such as retailers, but the bulk of the German equity market is reliant on exports. In France, more relevant than the riots per se has been a sense that the government has become somewhat less market-friendly over the past 12 to 18 months.
DW: I do think there are the beginning of signs of some domestic demand within Europe, which is one of the reasons why Germany, France and a number of other economies including Italy have begun to surprise a little bit on the up side.
Both of you seem to be fairly overweight in financials. Is this an example of a thematic play or is that very stock-specific?
JB: From our perspective, the insurance sector has been an area we have been overweight in for quite a period of time. We have been quite impressed by some of the change that has occurred in management in a number of these companies. We have been overweight in names such as Zurich Financial Services and Allianz, and these stocks have begun to deliver over the past few months. They still don't look particularly expensive relative to the market or in a historic context so we still feel quite comfortable there.
DW: I have been very keen on French banks. I thought they were surprisingly cheap. You can get a 4% yield from BNP, which relative to bonds at 3.5% seems ridiculous to me.
How have you played the oil price and the energy theme in your portfolios?
JB: We have been overweight oils from spring until the start of October 2005 when we reduced somewhat. We haven't had what I call the real racy refining stocks. We think the oil price will stay quite high, north of $50.
Our concerns about the sector are twofold. Firstly, it has done very well and the good news on earnings is well known. Secondly, investor expectations in the long run in terms of oil price have crept up.
DW: I felt for a long time that the oil price would rise quite aggressively but would be pretty volatile. We have moved into a different world. There are huge population blocks that are industrialising at the moment.
We have been underweight oil because we feel nationals within Western economies have lost their old influence. They basically have to beg and accept very high taxationagreements with oil rich governments.
How does the current yield on US treasuries compare with emerging market debt yields?
Sarvjeev Sidhu (SS): The 10-year Treasury is currently slightly shy of 4.5% while emerging market debt yields are closer to 6.80%.
What is the average long-term return that can be expected from emerging market debt on a 10-year annualised basis?
SS: I think the expectation is going to be in the high single digits, at least for the next couple of years.
Is emerging market debt overvalued or undervalued in your opinion?
SS: The current spread of emerging market debt is at an historical low, but the region has experienced underlying structural changes. Along with Brazil, Mexico and Russia dominate the market and both now have investment grade sovereigns with Brazil a double B-rated sovereign. In future, I think we will continue to see rating upgrades. Our expectation is that in the first half of the year, we could see maybe another 15 to 25bp of tightening.
On a three-year view, what is the tightest emerging market spreads can be over Treasuries? Is it 200bp, 150bp?
SS: If you assume we are entering a benign interest rate environment where the Fed and the major central banks continue on a co-ordinated interest rate policy of tightening and that there is robust growth, then I think emerging market debt will reach 175bp over the next three years.
Greg Saichin (GS): Emerging markets as an asset class used to trade wider than a comparative speculative asset class, such as US high yield bonds. As the composition of the index has changed towards a higher quality it is starting to behave more as an asset class, where people are following the underlying rating.
Have the countries making the bulk of the emerging market index improved in quality or are they looking good because commodities are going up?
SS: Most of the emerging countries have abandoned fixed exchange rates and instituted structural reforms. They have adopted fiscal responsibility laws. We have also had a better quality of information available from a number of them. So I think there certainly is a structural change in the emerging market sovereigns from 10 years ago.
GS: In general, the pattern is that they have improved fundamentally. There are some exceptions where a large component of the constituents are oil producing countries and, as we well know, oil has gone through a period of increased prices for a number of years now. So the revenues from oil obviously tends to blur how transparent the finances are in a country.
What are the Asian opportunities from an emerging market debt perspective?
GS: We have always been underweight the Asian region, simply because Asia has always been running historically positive current account balances. So it has been a net lender of capital as opposed to a net borrower.
Most of the financing that has been taking place in the region has been of an equity nature. From a relative value perspective Asian spreads, be it corporate or sovereign, have always been trading at a premium versus Eastern European or Latin American ones.
SS: Asia is largely a two-tier market. You have the highly rated investment grade countries like Thailand, Malaysia, Singapore, Hong Kong and South Korea. Then on the high yield side you have Indonesia, the Philippines and Vietnam. We tend to focus on sovereigns in the big countries.
What is the outlook for China?
SS: China is a very restrictive and difficult market with the exception of the issued sovereign bonds that are available. But a lot of debt is largely held by Chinese banks buying out of their subsidiaries in Hong Kong.
GS: We form a relative value perspective and have always thought the Chinese sovereign issues were extremely expensive.
European markets not expensive and not dependant on economic backdrop or politics.
Oil price to stay high but could be hard for large western oil companies to profit from this.
Emerging market sovereign debt has scope to strengthen further.
Rising oil and commodity prices improve finances of emerging market nations while fiscal reform is a further positive.
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