07 Volume 6, Issue 7 Allianz Global Investors Insights July 2014 Global View Time To Be Long Alpha Asset-class returns for the first half of 2014 have been surprisingly strong, given the continued lacklustre macroeconomic environment and the significant geopolitical risks that have arisen. Equity returns have been in the region of 5-7 per cent, in line with our forecasts for the full year. Returns from fixed-income Volatility Continues to Remain at Low Levels 2,000 1,800 S&P 500 VIX 1,600 1,400 1,200 1,000 800 600 400 200 0 99 00 01 02 03 04 Source: Datastream as at 17 June 2014. S&P 500 05 06 07 securities particularly emerging-market global-currency bonds have been similar or even higher, confounding our expectations for the gradual normalization of the yield curve. Unlike in previous years, though, I expect asset markets to tread water at best. By in large, growth expectations have disappointed 08 09 10 11 12 13 14 80 70 60 50 40 30 20 10 0 VIX Andreas Utermann Global Chief Investment Officer to the downside and earnings growth has been lacking owing to the virtual absence of top-line growth. While inflation expectations have stayed modest, actual inflation continues to surprise on the downside, supporting the rally at the long end of the bond market. Central banks, notably the BOE 1 have sounded a note of caution that monetary policy could be tightened ahead of expectations. Additionally, the (Cont. on page 2) 01 Global View Time To Be Long Alpha 02 Perspective on Europe Managing the Great Divergence 03 Viewpoint Prime Minister Modi s Election Bodes Well for India 04 Soundbites from Research New ECB Assessment Tools Poised to Improve Euro-Zone Banking System 04 Grassroots SM Research Demand Trends for Gold in India 1. Bank of England
Global View increasing intensity of the conflicts in Iraq and Ukraine conflagrations that are threatening to turn into outright civil war could lead to significant concerns about oil and gas supplies; this could negatively affect sentiment and growth prospects. Valuations on equity and fixed-income securities appear quite stretched caused in all probability by the continued ultraloose monetary policy framework that makes short-duration money-market investments very painful with momentum pointing in the wrong direction. As the accompanying chart shows, volatility as measured by the VIX 2 continues to trend at very low levels. In addition, IPO 3 activity has picked up significantly, which often presages downside volatility in equities. Consequently, investors may want to consider taking profits on both major asset classes and consider maintaining a neutral positioning this for the first time over the past four years. There is still money to be made from dividend investing, growing market segments, and exposure to selected local-currency and emerging-market bonds as well profitability in selected cross-currency trades but the going is likely to prove quite tough over the coming months unless the macroeconomic, earnings and geopolitical environment improve significantly. This is a time to be long alpha more than long beta. Perspective on Europe Managing the Great Divergence Following the ECB s 4 recent decision to strengthen its monetary-policy firepower by adopting a more accommodative stance, fixed-income investors are faced with the unprecedented situation of being subjected to divergent influences from the Fed 5 on the one hand and the ECB on the other. US investors are pondering three questions regarding Fed policy: What is the timing of the first hike? What will be the length of the rate-hike cycle? What level will rates ultimately reach at the end of this monetarytightening phase? Euro-zone investors, on the other hand, have one question: QE 6 or not QE? Clearly, the primary concerns of central banks and investors on both sides of the Atlantic differ, and there is a real risk that 2. Chicago Board Options Exchange Volatility Index 3. Initial public offering 4. European Central Bank 5. US Federal Reserve 6. Quantitative easing these respective interests will continue to diverge. Anticipations of benign monetary tightening in the US have so far had relatively little impact, but there is nonetheless a major risk of repricing if business indicators rally sharply, or if stronger inflation is confirmed. In the euro zone, persistently weak inflation which is not to be ruled out would rekindle speculation that the ECB will implement repurchase programmes among fixed-income securities. In a context in which euro-zone rates despite intrinsic support factors are exposed to higher US yields, we have adapted to this situation by: Setting up strategies based on US euro-zone spreads widening further. Reducing duration through dynamic portfolio management, mainly by buying volatility which is low and therefore inexpensive in order to optimise convexity. Franck Dixmier CIO Fixed Income Europe 2
Viewpoint Prime Minister Modi s Election Bodes Well for India India concluded its general elections in May 2014 and voted in a single-party majority for the first time since 1984. The new prime minister, Narendra Modi, is business-friendly and has established his credentials as an effective manager and decision maker during more than a decade as the chief minister of the western state of Gujarat. He is credited within Gujarat with turning around the power sector, improving irrigation, increasing water availability, focusing on renewable-energy issues, promoting tourism and most importantly decisive leadership. He ran and won the general election on the mandate of development, with a minimum government, maximum governance mantra. Modi s economic plan The new prime minister s economic blueprint will be available with the release of his first budget, which is due by mid- July. Early indications are positive. For example, to boost government efficiency, he already decreased the size of his cabinet from more than 70 members to approximately 45 by grouping related agencies under a single minister. His ambitious plan should help rectify India s persistent problems in basic infrastructure, such as electricity and water supply, while also pressing ahead with more investment in high-speed rail and smart cities with modern telecommunications. 7. Gross domestic product 8. Reserve Bank of India 9. Consumer price index 10. Basis points The new government will likely seek more foreign investment particularly in the defense sector simplify tax laws and offer incentives to labor-intensive industries. It will also aim to attract investment in the coal sector to solve India s chronic power-supply problem. In addition, Modi is keen to create a universally affordable health-care system, put toilets in every home and connect every Indian school to the Internet. To help reduce rural poverty, Modi s government also plans to use technology to boost farm yields. Challenging budget numbers Stocks in India hit a new high on a wave of investor optimism about Modi s ability to spark India s economy Asia s thirdlargest, after China and Japan by cutting red tape and boosting growth. The underlying economic picture, however, remains challenging. For the fiscal year ended March 31, the government budget deficit was equivalent to 4.5 per cent of GDP 7. That limits its capacity for new spending without more revenues or making cuts elsewhere. The currentaccount deficit has been restricted to -1.7 per cent of GDP this year vs. 4.7 per cent last year, partly as a result of reduced imports on gold. GDP growth has flattened at 4.5 per cent and 4.7 per cent over the last two years, respectively, although industrial production is giving early signs of revival. The RBI 8 has indicated that further policy tightening will not be warranted while it maintains its CPI 9 inflation target of 8 per cent for January 2015 and 6 per cent for January 2016. The yield of India s 10-year government bonds has already shrunk by approximately 50 bps 10 over the last two months. However, in the near term, even an environmental event such as a weak monsoon could pose a risk because of its implications on food inflation. Raymond Chan CIO Equity Asia Pacific Recovery expected with earnings and domestic cyclicals On the corporate-earnings front, recent revisions seem to have bottomed out, as the recent fourth-quarter fiscal-year 2014 earnings season had more upside surprises. As Modi s policies are implemented, we expect the earningsupgrade cycle to bounce back in a more meaningful way by late fiscal year 2015. Companies have focused a great deal on cost optimization in the past cycle, and we believe any growth recovery will bring in high operating leverage and therefore boost earnings growth. We believe domestic cyclicals should recover while quality names in the consumption and export segment will continue to benefit. Leveraged companies are taking advantage of a much-improved equity market to raise funding that reduces debt. We believe this should provide comfort to the stressed asset quality of India s banks, which appears to have peaked. 3
Soundbites from Research New ECB Assessment Tools Poised to Improve Euro-Zone Banking System The ECB is undertaking a comprehensive assessment of banks, including an asset quality review (AQR) and an EU 11 -wide stress test, as preparation for the single supervisory mechanism (SSM). EU banks have already raised capital or topped-up provisions by approximately EUR 12 95 billion and we expect the sector to strengthen its capital adequacy further. We assume the AQR/stress test will represent the peak in provisioning, and we also expect M&A 13 activity to pick up after the AQR. In our view, the ECB will improve fungibility of capital and liquidity as a result of the SSM and the single resolution mechanism (SRM). This could make crossborder banking in the euro zone much more efficient, and strong banks might acquire banks in the periphery as a result. The rationale for this goes beyond the usual arguments. The logic is that northern European banks with strong balance sheets could use their funding cost advantage and lower the peripheral banks funding cost significantly. The risk would be limited because the ECB has rubber-stamped the balance sheets. From the perspective of the weak bank, their goal is to avoid raising capital at distressed valuation multiples and to Oliver Flade Research Sector Team Head, European Financials access a strong deposit franchise. These new bank-assessment tools could also result in domestic M&A activity, which would drive valuation multiples further. Grassroots SM Research Demand Trends for Gold in India Gold lost its sparkle for many in India after import restrictions were imposed in 2013 to balance the country s currentaccount deficit. Grassroots SM recently spoke with private bankers, major gold jewelers and bullion dealers in India to ask about their current perceptions of gold as an investment vehicle as well as gold for consumption purposes. We also asked them about how much the increase in import duties and new financing rules have affected their businesses. We learned that investments in gold in the first quarter year over year, as well as the general trend through the middle of the second quarter, have deteriorated. The same was true for gold sales for consumption purposes. The hike in import duties and, to some extent, the new financing rules cash only had a negative business impact, particularly for smaller jewelers. However, thanks to widely anticipated legislative changes and new political stability, this negative sentiment will most likely have improved by the end of the second quarter of 2014, especially for jewelers who keep their inventory levels flat to up. Johannes Jacobi Grassroots SM Research Analyst Given that Indian jewelry and bar/coin demand account for approximately 25 per cent of global demand, gaining insights into consumer behavior in India is extremely valuable, said David Finger, Research Analyst at AllianzGI in Frankfurt. 11. European Union 12. European Union Euro 13. Mergers and acquisitions 4
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