ECB to Extend QE Eventually, but Not Just Yet

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Slight upside news for inflation, but still well below target

According to HSBC, we are not going to get a new forecast from the ECB on 20 October, but positive news for industrial production in Q3, the possibility of slightly looser fiscal policy in 2017 and a 5% rise in the EUR oil price imply slight upside news for inflation as the ECB prepares for its policy meeting.

For markets, the biggest news since the previous meeting was an ECB official quoted as saying that the “ECB might reduce purchases in steps of EUR10bn”. Some investors are taking the comments very seriously and, on top of the disappointment that the ECB did not extend QE in September, 10-year bund yields have risen around 20bps from their September trough.

Fabio Balboni and Simon Wells believe this small upside inflation news is unlikely to prompt a significant re-assessment by the ECB of its inflation forecast, which is well below target (1.2% in 2017, and 1.6% in 2018). The minutes of the September meeting made clear that the ECB “remained committed” to continuing asset purchases beyond March 2017 and “until the Governing Council saw a sustained adjustment in the path of inflation consistent with its inflation aim”. The sub-target inflation forecasts it made in September were conditional on market expectations of more (not less) monetary easing.

So in their view, it is too early for the ECB to start tapering its asset purchases.

Extend now, later or taper?

Once the technical constraints have been overcome, they continue to expect a six-month QE extension to be announced. Although an October extension might avoid a more heated debate in December as base effects push inflation up, more time may be needed for the ECB’s committees to complete their technical work. Also, the higher yields rise, the less binding the yield floor becomes.

“We therefore expect an extension to be announced at the 8th December meeting. Based on the ECB’s recent comments and inflation forecasts, we expect it to maintain the current purchase rate of EUR80bn per month. To do this, it may need to increase the issuance limit for bonds with Collective Action Clauses, but we also look at other options the ECB might have to explore. It is also possible that the ECB may start to signal its exit strategy from QE, once it thinks inflation is back on track.” They conclude.

 

EFAMA Publishes 2016 Report on Responsible Investment

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In its latest report on responsible investment, the European Fund and Asset Management Association (EFAMA) presents the European asset management industry’s role and involvement in responsible investment and puts forward key recommendations for the future. The report is an update of EFAMA’s previous 2014 report on the same topic.

The growing demand from investors to address environmental, social and governance ‘ESG’ matters in the investment decision-making process has created a global momentum around sustainable and responsible investments. European asset managers, as intermediaries between investors and companies, have a crucial role to play in driving this trend.

Responsible investment has long been a focus for EFAMA. This year’s report sets out EFAMA’s outlook and recommendations on the main questions surrounding responsible investment: the importance of reliable and accurate reporting by companies, the debate about investment performance and responsible investment, the role of legislation and the different selection methods in the responsible investment process.

Peter De Proft, Director General of EFAMA commented: “In the context of the increased focus on sustainable finance at EU level, we believe it is particularly timely to discuss the European asset management industry’s ever-growing role and involvement in responsible investment.”

“There is no doubt that demand for sustainable and responsible investment is growing. This is in part due to the recognition that economic sustainability will impact longer term value creation, however the changing social and ethical values of asset owners and the broader public have also strongly influenced this transition”.

He concluded: “The European asset management industry is determined to continue to play its part in this global effort to solve some of the most pressing issues of our generation. We hope that this report will provide guidance for this collective initiative”.

The second part of the report details country-by-country descriptions of the legal frameworks and various private sector initiatives in relation to responsible investment in different Member States.

The full report can be accessed here.

Smart Beta Questions with Active Management Answers

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The debate on active versus passive investing has evolved following the growth of transparent algorithmic investment approaches such as smart beta. Advocates of smart beta believe that it offers benchmark-beating returns with lower costs than active management. However, smart beta investing is more complex than many investors perceive and requires careful consideration. Despite this, the widespread availability of these alternative passive strategies has undeniably changed the investment landscape.

Standard Life Investments, the global investment manager, considers the reality of smart beta investing in its latest edition of Global Horizons. The key points evaluated in the paper are:

  • The pitfalls investors should be aware of when considering smart beta strategies, including a lack of clarity in investment objectives and limited sustainability.
  • As the active versus passive paradigm shifts, traditional market benchmarking will be increasingly superseded by outcome oriented mandates. Transparent algorithmic components such as smart beta have a role to play but should not be used as static allocations.
  • Flows in smart beta have been significant and can strongly influence asset prices.
  • This presents opportunities to active investors who take a multi-strategy approach and offers new chances in the area of stock selection

Arne Staal, Head of Multi-Asset Quantitative Strategies, commented “advances in technology, the increasing availability of data and the rapid growth of smart beta strategies results in a fast-changing and expanding opportunity set for investors. However, they have more complex evaluations and choices to make, and a wider range of associated costs to assess against desired outcomes. An awareness of the pitfalls in utilising transparent algorithmic investment strategies such as smart beta is increasing but not yet widely discussed. We advise investors to approach smart beta investing with similar levels of due diligence as they would for active managers. Most active managers deliver a combination of smart beta and pure alpha. Those that consciously position their business model to build portfolios through security selection and active allocation to a broad range of strategies will be best placed to achieve better outcomes for clients and benefit from this evolution in asset management.”
 

Italy’s Constitutional Referendum – Opportunities Amid Volatility?

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In a constitutional reform referendum on 4 December, Italian voters will weigh in on some key proposals, chief among them the abolition of the Senate’s legislative power. According to Nicola Mai, portfolio manager and leads sovereign credit research in Europe for PIMCO, this would leave the lower house (Chamber of Deputies) as the key legislative body, a move proponents say will streamline Italy’s political system, clear a path for needed reforms and ensure a clear winner in the next general election.

The specialist believes Prime Minister Matteo Renzi’s pledge to resign if the reform fails has made the vote highly politicized, and the attendant political uncertainty has fueled nerves among market participants. Polls suggest the vote is too close to call, and the high proportion of undecideds (around 30%) compounds the uncertainty.

Potential scenarios

“While we believe a failure of the referendum to pass would hurt the country’s long-term political stability and reform prospects, we view the key risk to markets to be the election of an anti-establishment euroskeptic government – an outcome we think is unlikely irrespective of the referendum’s outcome (with a “no” arguably making the possibility even more remote).” In brief, at PIMCO, they envision the following scenarios:

  • A “yes” vote: Better for the markets. Italy would adopt an electoral system that delivers a clear winner, and Renzi would likely stay in power until the legislative term ends in 2018. At that point, it may become a close contest between Renzi and Beppe Grillo’s anti-establishment Five Star Movement (M5S).
  • A “no” vote: Politics as usual. Renzi would likely resign, but we would not expect new elections to be called (this because the Senate would retain legislative power and be elected with a proportional electoral system, which would probably deliver a hung parliament). President Sergio Mattarella would thus likely push for the formation of a transitional government – perhaps led by Renzi himself – tasked with implementing a new electoral law before proceeding to new elections. This scenario would feel like an old-style, “muddle through” political development for Italy, and would also hurt Grillo’s chances to win an election outright.

Longer-term caution, short-term opportunity

“We are cautious when investing in European assets over the medium term. Our secular investment focus on capital preservation is especially relevant for the region, where the macro outlook is underwhelming, political risk is elevated and compensation for that risk is slim.

In the near term, however, volatility in peripheral spreads and European risk assets could rise in the run-up to the referendum, and risk would likely underperform in the aftermath of a “no” vote. This could create opportunities to add risk at more attractive levels, especially in peripheral sovereigns, which remain anchored by the European Central Bank’s quantitative easing. We would be more cautious about Italian bank exposures, where vulnerabilities persist and where a “no” vote could further increase execution risk for banks’ ongoing recapitalization plans.” He concludes.

“Legg Mason Sees Growth Opportunities in Brazil, it Offers a Sophisticated Market for International Asset Managers”

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The passage of Directive 550 of the Securities and Exchange Commission (Comissao de Valores Mobiliarios) of Brazil, which went into effect in July 2015, provides greater access to international funds.  Although Brazilian investors have opened up to investing in new asset classes in the last few years, Fernando Franco Franco, Head of distribution for Americas International at Legg Mason, recognizes that the main challenge that international managers face in Brazil is the need to inform clients on the value of diversified investments beyond their preference for domestic fixed income.

The enactment of the Brazilian regulation changed the definition of a qualified investor so that foreign asset managers can now distribute onshore funds to “mass affluent” clients, who before could only be served by local fund management companies with a clear bias towards the Brazilian domestic market. Previously, the Brazilian investor needed BRL 1 million to access a single international investment fund. Currently, Brazilian investors with of BRL 1 million in investable assets, can access structured vehicles outside Brazil that use a local “feeder” fund structure.

“With rising inflation and political volatility in recent years in Brazil, the real rates of return are lower, which represents an opportunity to offer clients European, Asian equities and US equities which may offer higher rates of return,” said Fernando Franco.

“Foreign asset management companies are in the process of helping the Brazilian investor get comfortable with international investments. Following the change in regulation, many US asset management companies have partnered with local fund managers to enter the market. Legg Mason has been present in the Brazilian market since 2005 when it bought Citigroup’s Asset Management business. Citi has had a presence in Brazil for more than 100 years..,” he added.

Legg Mason provides vehicles for investing in global equities, fixed income and alternative assets, such as investment in infrastructure and real estate, which allow clients access to a diversified portfolio through customized solutions.

Some of Legg Mason’s affiliates are Western Asset Management a large, global fixedincome provider; Martin Currie, a Scotland based firm which specializes in the active management of global equities; QS Investors, focuses on the quantitative management of global equities and multi-asset funds; RARE, a firm dedicated to investing in global infrastructure through listed securities; EntrustPermal, a specialist in global alternative investment, and a leader in fund of hedge fund investments, and Clarion Partners, a firm dedicated to investment in real estate.

When Legg Mason established its presence in Brazil in 2005 from the acquisition of Citigroup’s Asset Management business and due to Brazilian regulation, its main presence like other international fund managers, was with offshore clients.  At that time, the main international players in the country were Merrill Lynch, Prudential, which was acquired by Wells Fargo, and Citigroup Asset Management, now Legg Mason, which had a presence in Chile, Uruguay, Mexico and Brazil.

“Brazil offers a strategic opportunity for global asset management companies because it is a mature and sophisticated market with developed private banking, family offices, institutional and retail investment markets. In my view, perhaps only the United States has a higher level of sophistication than Brazil in its distribution to institutional clients,” said Franco.

In addition to Brazil, Legg Mason has local presence in Chile and is committed to growing its presence in Latin America. “We are actively working in Mexico, Peru, Uruguay and assessing opportunities in other countries.”

 

China: Inflated Credit, Rising Defaults

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China: Inflated Credit, Rising Defaults
Foto: Silentpilot / Pxabay. China: crédito inflado y defaults al alza

China’s credit markets continue to expand. In June the International Monetary Fund (IMF) issued a warning to Beijing to tackle corporate debt levels in state-owned enterprises (SOEs), by liquidating the weakest firms and restructurings. Defaults are rising from a low base. More than 20 bond defaults have been confirmed this year – an unprecedented number – as many companies, especially in industries with surplus production, struggle to meet their obligations amid China’s economic transformation.

In August the government acted to dispel the perception that it will always backstop losses for SOEs. An editorial in the People’s Daily, the official communist party mouthpiece, stated that bond defaults by Chinese SOEs should be handled through market-based mechanisms and the legal system. “Guaranteed repayment of bonds raises risks in SOE bonds and leads to higher leverage ratios and a build-up of risks,” the editorial said.

According to Investec Asset Management, by talking tough on defaults, Beijing seems to be keen to slow the rate at which corporate debt is growing. Currently credit growth is outstripping that of GDP by double-digit percentage points and the authorities are keen to slow this to come more in line to the economy as a whole. The China Banking and Regulatory Commission has also proposed to local banks and financial institutions for a coal and steel debt-to-equity programme to be established to help reduce the debt load.

“This trend may not necessarily be unwelcome, as it suggests China recognises that weaker companies should be allowed to fail. But which companies will default is hard to spot. China’s domestic credit-rating agencies have given an investment-grade rating to 99.5% of all publicly issued bonds. But again there are mixed messages. On 4 August, the National Business Daily published a piece suggesting that banks should act together and not “randomly stop giving or pulling loans.” Rather it suggested that they should either provide new loans after taking back the old ones or provide a loan extension, to fully help companies to solve their problems” the Investec team concludes.
 

CFA Institute Calls for Holistic Approach to Corporate Governance Policy

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A patchwork approach to corporate governance regulation has created an imperfect system which needs a holistic policy approach to meet investor needs.

A new report by CFA Institute, Corporate Governance Policy in the European Union: Through an Investor’s Lens, finds that a silo-ed approach to corporate governance policy is endangering the creation of a unified EU capital market. The report suggests that a joined-up approach to governance policy, encompassing the Capital Markets Union initiative, is now necessary to achieve meaningful reforms.

While corporate governance reform over the past 15 years has been positive, important issues remain unresolved, including fixing the “plumbing” of cross-border proxy voting, protecting the rights of minority shareholders, and strengthening the accountability of boards, among others.

CFA Institute engaged with more than 30 investment practitioners, governance experts, and other stakeholders from across Europe to inform the report. The findings reveal there is much to be done to simplify mechanisms to enhance corporate accountability and realise maximum value from reforms that have already been undertaken. Investors are open to many stakeholder issues, such as promoting board diversity, and paying greater attention to environmental, social, and governance factors. But importantly, investors are concerned there is still inadequate protection against abuse by controlling shareholders, where the principle of one share one vote is essential for the exercise of good governance.

Josina Kamerling, Head of Regulatory Outreach (EMEA), CFA Institute, commented: “Corporate governance is vital to making the EU’s Capital Market Union work – it is central to its ecosystem but has fallen off the financial services and markets agenda altogether.

She continued: “With a renewal of the investor vision for European corporate governance and with proper attention to the governance “ecosystem,” there is a considerable prize to be won in the growth, productivity, social, and environmental responsibility of European public companies. To realise these benefits, a more joined-up approach to corporate governance policy is needed; one which serves investors and which reconciles the shareholder, stakeholder, and open market perspectives of corporate governance.”

Based on the report’s findings, CFA Institute makes a series of recommendations to establish a sustainable balance among the various goals of governance:

  1. Comply-or-explain mechanism- Investors have a critical role to play in making comply-or-explain systems of corporate governance effective in Europe. This role means that they need to press for the rights to allow them to fulfil their fiduciary duties as stewards. It also requires them to exercise these rights responsibly. Companies must accept the need for accountability and embrace comply-or-explain monitoring mechanisms.
  2. Protection of minority shareholders – Urgent measures are needed to uphold protection of minority investors. The recommendation to implement these measures includes:
    •     Promoting better board accountability to minority shareholders through a greater role in the appointment of board members, more robust independence standards and stronger board diversity
    •     Continuing to press for rights relating to material related-party transaction votes
    •     Fixing the “plumbing” of cross-border proxy voting to ensure all shareholders can vote in an informed way and ensuring all shareholder votes are formally counted
  3. Clearer guidance following Shareholder Rights Directive II – The European Commission should promote investor engagement including a guidance statement for company boards and institutional investors, which explains the expectations from the Shareholder Rights Directive II.

You can read the report at the following link.

HNWI in Asia Face Rising Lifestyle Costs but are Expected to Grow 160% by 2020

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Julius Baer has recently released its sixth annual Wealth Report: Asia, which monitors the cost of living in luxury and wealth creation trends across Asia. The report shows that the cost of luxury living, as defined by the Julius Baer Lifestyle Index, dipped by 1.68% in USD terms in 2016, aggregated across 21 items and 11 cities in Asia. Across the cities under coverage, Shanghai retains the top spot as the most expensive city. Singapore ranks second, swapping position with Hong Kong, which fell one place to third. Mumbai scored the most competitive.

On an aggregate basis and in USD terms, the Julius Baer Lifestyle Index fell by 1.68%, led by a 8.3% correction in property prices on a regional basis. That said, 13 of the 21 items still posted gains for 2016. This demonstrates that for a broad range of luxury goods and services, High Net Worth Individuals (HNWI) in Asia face rising lifestyle costs that continue to outpace conventional inflation.

Dovetailing the twin trends of a rising middle class and ageing populations, Julius Baer has added a high-end skincare item to the Lifestyle Index of goods and services in 2016. Asia makes up 36% of the global beauty market and it is expected to grow 4.5% every year until 2019, far faster than the global market. Within the beauty market, skincare remains the most valuable category in terms of growth potential. The report also features in-depth economic outlook assessments for the key economies in Asia, reinforcing Julius Baer’s long-held view that the region will remain the key driver of wealth on a global basis.

Boris F.J. Collardi, Chief Executive Officer of Bank Julius Baer, said: “This year’s Lifestyle Index demonstrates that there remains enormous demand for luxury goods and services in Asia, but it equally signals that asset price fluctuations can be a potential drag on spending. Getting the right, responsible and forward-looking advice out to clients to manage these ups and downs, preserving and growing their wealth, is our core mission, both for the near and longer term.”

Key findings

Since its launch in 2011, the Julius Baer Lifestyle Index has trended lower, while broadly sustaining the gap over conventional inflation. For 2016, a mixed picture emerges whereby 13 luxury items, such as watches, ladies’ shoes, travel costs and men’s suits, posted gains while eight items, including wine and jewellery, managed average single digit drops. These variations are overshadowed by the property market across Asia, which is clearly coming off the boil.

For the newly added skincare item in the index (a skincare product that retails at above USD 1,000 per unit) the most competitive locations to purchase the item are Mumbai and Hong Kong, with Shanghai being the priciest. With premium travel expected to grow substantially across Asia over the coming years, Julius Baer expects to see continued upward pricing of the travel & accommodation and healthcare segments. At the same time, competition to attract traveling HNWI is set to intensify further, with consumers not tied to specific locations or hotel brands.

Across the 11 cities in Asia under coverage, Shanghai took the top spot in terms of having the most individual items in the index which were the most expensive. Shanghai is ranked as the most expensive city scoring first place for five items (hospital stay, watch, botox, cigars and high-end skin cream) and second for another six (property, wedding banquet, ladies’ handbags, men’s suits, cars and ladies’ shoes). Factors, such as exchange rates, taxes and duties can cause a luxury item to cost significantly more on the mainland than overseas.

Singapore has overtaken Hong Kong as the second most expensive city in Asia as the latter suffers from a slowdown in tourist spending. However, Hong Kong has held on to pole position for luxury real estate with Manila being the least expensive. High-end property in Hong Kong is still about five times as costly as the average for the region.

Tokyo has moved up the most in the city ranking, from seventh to fourth place due to the strengthening Japanese yen during the period under review displacing Bangkok, which fell from fifth to seventh. Mumbai scored the most competitive for the second consecutive year. Taking all the items together, the top three most expensive cities are Shanghai, Singapore and Hong Kong.

As always, movements in foreign exchange rates can have a marked impact on prices such as the double digit moves in the Japanese yen and Indian rupee, among others. Overall, the local currency trends are fairly close to what was calculated in USD terms: most items rose, whereas the weighted average declined due to the drop in luxury property prices.

Asia’s growth is on track

Julius Baer continues to expect HNWI assets across the region to grow to USD 14.5 trillion by 2020, or a growth of 160% in the current decade through to 2020. Specifically for China and India, Julius Baer expects to see HNWI assets of USD 8.25 trillion in China and USD 2.3 trillion in India over the coming four years, re-affirming the estimates the Bank published in the 2015 report.

In Japan, the battle to defeat deflation remains a key policy objective, but the underlying economy shows visible signs of change and adaptation to its unique circumstances. In Singapore, gradual easing of prices in the property markets is a prudent measure that has likely forestalled a more aggressive economic adjustment. For China, overall growth rates will continue to soften, but domestic consumption and service economy data continue to show encouraging signs.

 

Asia Region Funds Passport’s Memorandum of Co-operation Has Come Into Effect

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The Memorandum of Co-operation (MoC) on the establishment and implementation of the Asia Region Funds Passport (ARFP) has come into effect. Representatives from Australia, Japan, Korea, New Zealand and Thailand have signed the MoC.

These five economies have up to January 2018 to work to implement domestic arrangements under the MoC.

Activation of the Passport will occur after any two participating economies complete the implementation.

The MoC also ensures any other eligible economies are able to participate in the ARFP.

The ARFP is an international initiative that facilitates the cross border offering of eligible collective investment schemes while ensuring investor protection.

Australia, Japan, Korea, New Zealand, the Philippines, Singapore and Thailand have contributed expertise as part of a working group in developing the framework of the ARFP and other economies in the Asia Region have taken part in consultations.

The MoC is available on the ARFP page of the APEC’s website.

Earnings Stability, a Positive Sign for Asian Equities

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After five years of steep earnings downgrades in Asian equities, we are now seeing encouraging signs that this trend is abating. While this might partially be a reset of prior expectations that were unrealistically high (be it in the form of reform potential in India, or the take-off of Chinese internet companies), it has also been a welcome indication that companies are starting to be more disciplined around capital expenditure and returns on equity. Coupled with early signs of a pickup in demand, it makes us more optimistic that we will reach a more balanced supply/demand environment, which should translate to an improved Asian corporates’ pricing power in the long run.

While capacity has been abundant due to over-optimism regarding Asia and in particular China’s growth leading to years of ramp up in capital expenditure, we are starting to see signs of better capital discipline.  For the past few years, when China seemed like a growth engine that could not be stopped, companies significantly increased capacity. The dramatic increase in supply outpaced demand, leading to a period of deflation as prices were under pressure and earnings downgraded as a result of margin compression.  Coming from such elevated supply, Asian companies spent the recent years reducing capital expenditure. This can be seen through supply side reform and regional industry consolidations in China which is pushing local corporations to focus on margins and returns rather than topline volume growth. With reducing competition and excess capacity, we are starting to see signs of price tension come back into the system helping companies regain pricing power.

 On the demand side, as companies lack conviction around future demand, they have held on to cash instead of investing in their businesses despite historically low interest rates. Recently though, we have noticed a turnaround, where Asian corporates have started to reduce their cash through share buybacks and increased dividend payments. We have also been encouraged by early signs of an increase in demand as leading indicators such as cement demand, construction, and property sales have started to pick up. 

We think Asia is currently on the cusp of a turning point and that better capital management, more stringent capacity controls and early signs of revival in demand should provide a solid platform for better, more sustainable equity returns in the region.

Bull:

  • The pace of earnings downgrades in Asia has been declining as companies are more disciplined around capital expenditure and as we are seeing early signs of a pickup in demand
  • A more balanced demand and supply environment offer an attractive buying opportunity for Asian equities

Bear:

  • As top line growth resumes, companies and government alike could revert to the bad habits of the past and over expand
  • Demand remains weak and requires further supply cuts which would have a negative impact on employment and by extension, consumer trends

Column by Andrew Swan, Head of Asian Equities for the Fundamental Equity division of BlackRock’s Alpha Strategies Group