Where will the FDI flow?
For years the four mighty BRIC nations have grabbed increasing shares of world investment flows. But the coming years may not be so kind. These countries bring up the bottom of the Economic Freedom Index (EFI) for 2012. Compiled by Washington D.C.-based think-tank The Heritage Foundation the EFI measures 10 freedoms — from property rights to entrepreneurship – and according to a note out today from RBS economists, there is a strong positive link between a country’s EFI score and the amount of FDI (foreign direct investment) it can secure. So the more “free” a country, the more FDI inflows it can expect to receive — that’s what an RBS analysis of 2002-2008 investment flows shows.
So back to the BRICs. Or BRICS if you add in South Africa (part of the political grouping though not yet included in the BRIC investment concept used by fund managers). The following graphic shows Russia languishing at the bottom of the EFI, China just above Russia and India third from bottom. Brazil is sixth from bottom while South Africa ranks two places higher.
At the other end of the spectrum is tiny Singapore. Its EFI score is double that of Russia and between 2002-2008 it attracted FDI equivalent to 50 percent of its economy. Russia in contrast saw negative net FDI (outflows exceeded inflows)
What comes next will be interesting. China grabbed the most FDI in absolute terms in the past decade (around $1.3 trillion or almost half the $2.1 trillion flows to the 21 leading EMs) but RBS notes this is slowing. That’s because China’s low-value manufacturing base is becoming less competitive relative to the rest of Asia and stringent restrictions remain in place in many sectors. Corruption, red tape and general business-unfriendliness prevail. ”The decreasing allure of China from a manufacturing perspective means the country is at risk of suffering a decrease in FDI inflows in coming years,” RBS writes. The bank also notes the nature of FDI into China is changing: half the 2011 flows went to real estate.
On the other BRICS:
Research Radar: Very 20th century
Wednesday’s market commentaries are loaded with the buzz around another technical UK recession in Q1 (the first time Britain has suffered what many see as a ‘double-dip’ since the 1970s); guessing about Wednesday’s FOMC outcome; and the European Commission letting Hungary off the hook about its controversial constitutional changes. In aggregate, and probably due to the looming FOMC, markets are fairly stable – world equities, including euro stocks, emerging markets and even Britain’s FTSE are all higher. The US dollar, Treasuries, volatility gauges, gold and even peripheral euro government bond yields are all down a bit.
Following is a selection of some of Wednesday’s interesting research ideas:
- Barclays’ Barry Knapp reckons US and world equities face a dilemma from the endless distortion to multiples and risk premia from monetary intervention and QE that is artifically lowering the risk-free rate akin to the “financial repression” of the 1950s — no one is sure now if equity is cheap or bonds just very expensive. He concludes that best thing for equities in the medium to long term is to avoid further QE but the problem is that stocks will almost certainly suffer in the short run if the Fed takes QE3 off the table. What’s more, Wednesday’s FOMC could be problem for markets initally if the Fed frets about the growth outlook, but a worsening of the economy might bring QE3 sooner than similar bouts in 2010 and 2011.
- ING’s James Knightley says UK GDP numbers mask business survey improvements and better March data and expects the economy to return to growth in Q2 as well as upward revisions to Q1. Flagging up improving business sentiment in the April CBI survey, he says the Bank of England is unlikely to do more QE and reckons any post-GDP rally in gilts or fall in sterling should be short-lived.
- However, Citi’s Michael Saunders is far gloomier in flagging ” the worst recession/recovery cycle opf the last 100 years” and dismisses suggestions that the persistent weakness of the economy since 2008 can be blamed on things like quarterly construction swings. “We expect the economy will continue to underperform, given the headwinds from fiscal drag, high household debts, the EMU crisis and poor credit availability. A less-tight fiscal policy probably would not help significantly, given the likelihood that fiscal slippage would trigger market pressure. A lower pound would help, but the key policy lever is QE and we continue to expect extra QE.”
- Standard Chartered reckons it’s time to book profits on a short EUR/GBP position, as the market looks primed for a correction. “An unexpectedly weak UK GDP report for Q1 has tempered expectations the economy will outperform”
- Societe Generale’s cross-asset team says it remains bullish on crude oil prices due to supply and capacity worries and geopolitical concerns and it targets $135 per barrel for Q3 — a price they say is not priced into futures markets. They say portfolios should be hedged for the possibility that 20-year-high oil/equity correlations will drop sharply and there several ways to gain exposure to rising crude — Brent Sept call option spreads, US 5-year inflation-protected TIPS, long global oil services stocks, long Russia’s rouble and Mexico’s peso and short Thailand’s baht and Korea’s won. Seperately, SG’s Dylan Grice worries about Australia — “What do you call a credit bubble built on a commodity bull market built on a much bigger Chinese credit bubble? Leveraged leverage? A CDO squared? No, it’s Australia.”
Research Radar: Beyond Hollande and Holland…
Markets have been dominated this week so far by the fallout from Sunday’s French presidential election, where Socialist Francois Hollande now looks set to beat incumbent conservative Nicolas Sarkozy in the May 6 runoff , and the collapse of the ruling Dutch coalition on Monday. Public anxiety about budgetary austerity in Europe was further reinforced by news on Monday of a deepening of the euro zone private sector contraction in April. That said, euro equity, bond and currency prices have stabilised relatively quickly even if implied volatility has increased as investors brace for another month or so of political heat in the single currency bloc. The French runoff is now on the same day as the Greek elections and May 31 sees Ireland going to the polls to vote on the EU’s new fiscal compact. Wall St’s volatility gauge, the ViX, is back up toward 20% — better reflecting longer term averages — and relatively risky assets such as emerging market equities remain on the back foot. The euro political heat and slightly slower Q2 world growth pulse will likely keep markets subdued and jittery until mid year at least. At that point, another cyclical upswing in world manufacturing together with the passing of the EBA’s euro bank recapitalisation deadline as well as the introduction of the new European Stability Mechanism may well encourage investors to return at better levels.
Following are some interesting tips from Tuesday’s bank and investment fund research notes:
- JPM economists reckon finding the reason behind the backup in US weekly initial jobless claims over the past couple of weeks is key to assessing whether a sub-par March payrolls report is repeated in April. It says it’s possible the claims jump move is a seasonal factor as unadjusted claims are closely tracking 2007′s pattern and Easter holidays fell on the same dates in both years. If 2007 was repeated, there would be a sizeable late April drop in claims and JPM looks for some of that on Thursday with a 14,000 forecast drop. (Reuters poll consensus is for a 11,000 drop)
- Following the surprise news last week that dovish Bank of England policy maker Adam Posen is no longer voting for more UK money printing, Barclays FX team said it’s turning more positive on the UK economy and also says sticky inflation may mean the Bank of England’s current monetary stance may be too accommodative. As a result, it lowered its euro/sterling 3-month forecast to 0.79 from 0.84. However, it cautioned about being short euro/sterling until after Wednesday’s Q1 UK GDP report, which it said could come in weaker than expected due to temporary factors. (Reuters poll consensus is for a 0.1% rise Q/Q)
- As everyone watches the FOMC outcome on Wednesday, Bank of New York Mellon‘s Simon Derrick highlights widespread expectations of further Bank of Japan easing and asset purchases on Friday. He reckons the economic arguments for more easing in Japan may be sound but it’s worth considering whether BoJ governor Masaaki Shirakawa may want to start facing down heavy political pressure for endless BoJ easing.
- Rabobank‘s emerging markets team flag their concern about Poland’s zloty, which has been one of the best performing currencies of the year so far. They say the zloty is a high “Eurozone beta” play, seen in the correlation of the eur/pln rate with composite euro periphery sovereign CDS spreads, and as a result will suffer if euro tensions rise further over the next month or two.
March bulls give way to April bears in emerging markets
The dust has settled on a scintillating first quarter for emerging markets but the cross-asset rally of the first three months has already run out of steam. A survey by Societe Generale of 69 EM investors shows that over half are bearish — at least for the near-term.
This marks quite a turn-around from the March survey, when 80 percent of investors declared themselves bullish on emerging markets. What’s more, investors are currently running very little risk and 47 percent of hedge fund respondents (these make up half the survey) feel they are over-invested in EM. (The following graphic shows the findings — click on it to enlarge)
Almost a quarter of the hedge fund and real money investors are neutral tactically on the market, compared to just 4.5 percent last month. Serious optimism has dried up, SocGen commented:
Looking at the distribution of answers, it is quite clear that the mega-bullish investor on EM has disappeared at this point.
The return of worries about the euro zone debt crisis, U.S. growth and a slowdown in China have all contributed to a higher degree of pessimism on financial markets. It’s not all gloom though. Looking at emerging markets over the next 3 months, sentiment does pick up, with 64 percent of investors bullish. So this falling out of love with EM could be a temporary blip.
Only 13 percent of investors were more bearish on a 3-month time horizon than over the next two weeks. That included 83 percent of real money investors that believed in an improvement in the GEM outlook from two weeks to three months.
Pension funds’ hedging dilemma
Pension funds have no shortage of concerns: their funding deficits are rapidly growing in the current low-return environment, and ageing populations are stretching their liabilities.
But a recent survey of pension funds trustees by French business school EDHEC has found that their biggest worry, cited by nearly 77% of the respondents, is the risk that their sponsor — the entity or employer that administers the pension plan for employees – could go bust. Yet 84% of respondents fail to manage the sponsor risk.
So how do you hedge against such a risk?
You could buy credit default swaps of the sponsor company or buy out-of-the-money equity put derivatives to seek protection. But both options are costly and illiquid. Moreover, it might send a negative signal to the market: after all, if the company’s pension fund is seen effectively shorting the company in an aggressive manner, investors may wonder “What do they know that we don’t?”
Erwan Boscher, head of Liability-Driven Investing and Fiduciary Management at AXA Investment Managers, says:
“Using market instruments like CDS and out of the money equity puts were suggested as a way of hedging sponsor risks, but we seldom see them implemented because of the cost, liquidity or reputational risks for the sponsor.”
Quarter-end rebalancing: A myth?
With world stocks up more than 10 percent since the start of the year, it must be tempting for investors to cash in their gains before the quarter-end/fiscal year-end. Or is it really?
JP Morgan, which analysed equity buying of institutional investors including pension funds, insurance companies and investment funds in the United States, euro zone, Japan and the UK, finds that there is no empirical evidence of quarterly rebalancing by pension funds or insurance companies.
Below are the charts showing their findings on the amount of equity buying as a share of equity holdings in each quarter against the difference between equity return and the return on total assets. If pension funds and insurance companies do not rebalance at all, the amount of equity buying should be unaffected by the relative return of equities against total assets. And this is the result they found in Chart 1.
The regression line is horizontal suggesting no impact from returns to equity purchases.
Russia’s new Eurobond: what’s the fair price?
Russia’s upcoming dollar bond, the first in two years, should fly off the shelves. It’s good timing — elections are past, the world economy seems to be recovering and crucially for Russia, oil prices are over $125 a barrel. And the rise in core yields has massively tightened emerging markets’ yield premium to U.S. Treasuries, offering an attractive window to raise cash. Russia’s spread premium over Treasuries hit the narrowest levels in 7 months recently and despite some widening this week it is still some 75 basis points below end-2011 levels.
Initial indications from the ongoing roadshow are for a two-tranche bond with 10- and 20-year maturities, possibly raising a total of $3.5 billion.
But market bullishness notwithstanding, investors say Moscow should resist temptation to price the bond too high, a mistake it made during its last foray into global capital markets in April 2010. Fund managers have unpleasant memories of that deal, recalling that Russia unexpectedly tightened the yield offered by 25-28 bps, making the bond an expensive one for investors who had already placed bids. The bond price fell sharply once trading kicked off and yields across the Russian curve rose around 25-30 basis points. Jeremy Brewin, a fund manager at Aviva said:
Russia has a slightly disappointing reputation.. We all ended up paying a tighter spread than we expected. Everyone is concerned they will get pulled in too tight again.
James Croft, head of emerging debt trading at Mitsubishi-UFJ agrees:
The demand for Russian risk is such that getting this bond away should be no problem. The only impediment that could make the transaction harder is investors’ wariness, based on the negative experience of the last deal back in 2010.
Dear Ms. Rao,
A recent claim successfully put forth by the Russian Government before two French courts (see below) could have drastic financial implications for the Russian State’s budget, stemming from the existence of billions of unpaid russian sovereign debt.
We believe credit rating agencies and emerging debt managers should follow developments in this matter very closely.
The current investment grade ratings enjoyed by the Russian Federation are based on a negligent analysis of inaccurate financial data.
The public accounts of the Russian Federation’s financial position make no mention of (and therefore actively dissimulate) the existence of due debt issued or guaranteed by the Russian State prior to 1917.
It has been put forth to the French Senate (Sénat, Commission des Affaires Etrangères de la Défense et des Forces Armées, rapport no. 150 – 1997 – 1998, projet de loi relatif au règlement définitif des créances réciproques entre la France et la Russie, annexe au procès verbal de la séance du 3 décembre 1997) that the 1997 value of this debt was in excess of 40 billion US$.
If the leading credit rating agencies adjusted the Russian Federation’s public accounts, as they should, to include an additional liability of US$ 40 billion this would no doubt lead to a change in their opinion on that State’s capacity to repay debt, and so to the ratings they issue.
While credit rating agencies and the Russian Federation have both argued wrongly in the past, and still do, that debt issued or guaranteed by the Imperial Russian State is not a full faith and credit obligation of the Russian Federation, they may not be able to do so in the future because recent claims sucessfully put forth recently by the Russian Federation have drastically changed the situation.
By successfully claiming ownership, before two French courts (Tribunal de Grande Instance de Nice in 2009 and Cour d’Appel d’Aix en Provence in 2011), of the Orthodox Cathedral in Nice on the grounds that the building had been paid for out of the Imperial Russian State budget and that the Russian Federation was the successor governement to the Imperial Russian State, the Russian Federation has in fact asked the court to acknowledge what defaulted sovereign bondholders have been saying all along: that the Russian Federation is the successor government to the Imperial Russian State and as such is both entitled to claim its assets and bound to pay off Imperial Russia’s debt.
For more on the matter of negligent sovereign debt rating analysis, please visit our website at:
We thank you for your attention.
The Credit Rating Agency Observatory – CRAO
Japan… tide finally turning?
Until recently, when you mentioned ”Japan” in the investment context, you could almost hear a collective sigh of disappointment — it was all about recession, deflation and poor investment returns.
However, sentiment does seem to be finally changing, not least because Tokyo stocks have rallied almost 20 percent since the start of the year, outperforming benchmark world and emerging indexes.
The yen has also been on a (rare) declining trend since the start of February, with the selling momentum accelerating since the Bank of Japan set an inflation goal of 1 percent in a surprise move and boosted its asset buying programme by $130 billion on Feb 14.
A closely-watched survey by Bank of America Merrill Lynch showed record optimism on Japan’s growth among fund managers, with a net 91 percent of Japanese fund managers saying they expected the domestic economy to strengthen. That’s up from a net 47 percent two months ago.
Overall, survey partipants worldwide slashed their underweight positions on Japanese equities to a net 4 percent in March from 23 percent last month. This is the smallest underweight position on Japan since August. According to Gary Baker, head of European equity strategy at BofA Merrill:
There’s quite a change in sentiment towards Japan. If you have global growth then Japan… is a big cyclical region to benefit from that. While investment story is the same, what changed there is the yen weakness… it becomes easier to play the story.
Investing in active funds: what’s the point?
Active vs passive investment is a long-lasting debate: active funds will tell you they deliver alpha (extra returns), but for a fee. Passive investment simply tracks the index so it’s cheaper. The risk is you may underperform your peers.
New research from Thomson Reuters Lipper throws up an interesting twist in the debate: It found that less than half of the actively managed mutual funds in Europe outperformed their benchmarks over the past 20 years.
The proportion of funds that outperformed varied from 26.7% in 2011, 40% over 3 years and 34.9% over the past 10 years. While bond funds fare better over 3 years with 45.4% outperforming, the proportion tailed off dramatically over the 10-year period, falling to 16.2%.
For long-term investors, the fact that an active manager does not outperform in every calendar year is likely to be less significant than whether he/she can outperform over a longer period. However, the result here is equally unimpressive. The data showed that the proportion of equity funds beating benchmarks in terms of rolling returns fell to 39.7% over a 10-year period (and just 17.4% for bonds). Your best bet seems to be in active equity funds investing in Asia Pacific ex-Japan (54.4% over 10 years).
Despite the findings, active funds are a big industry: Assets of actively managed equity funds in Europe stand at just under 1.5 trillion euros, while index trackers have 160 billion euros and ETFs 139 billion euros. In other words, of the equity funds pot, passively managed products make up less than 17%.
State vs entrepreneurial capitalism
The post-crisis world has been in part shaped by the growing presence of sovereign wealth funds, which have become an important source of funding with their $4 trillion assets, replacing private equity and hedge funds. But some people are wondering whether state capitalism really is the way forward, to boost the potential growth rate of the post-crisis world.
Robert Litan, senior fellow at the Brookings Institution, believes that in fact it’s entrepreneurs who would play a key role, and it’s important for policymakers to come up with a mechanism to help them.
Litan estimates that the United States needs 30-60 new “home-run” firms a year with annual sales of $1 billion to boost U.S. growth rate by one percentage point beyond its post-war average of 3 percent. This is double the past 150-year average of 15 firms a year.
“Enterpreneurial capitalism is the defining concept of 21st century economics. The state firm model might work for countries that are behind, but at some point we need entrepreneurship,” Litan told a briefing hosted by Legatum Institute, an independent public policy think tank.
Litan, who is also vice president for research and policy at Ewing Marion Kauffman Foundation, says “crowd funding” is one innovative way to help entrepreneurs.
Currently popular with film, tech and art start-ups, crowd funding is a new capital-raising technique that allows investors to take small equity stakes in new firms over the Internet.
