Global markets and investments: Felix Stephen shares his views and examples from Australia

Growth assets are a good investment in the current climate

Felix Stephen is the Manager Investment Strategy and Research at Advance Asset Management Ltd., Sydney, aapart of Westpac, which is one of the big four banks in Australia. He spoke to the Daily FT about the global economy and investment, the climate in Europe, the resilience of Australian banks and growth prospects for the US. Following are excerpts:

By Dinali Goonewardene

Q: How have banks withstood stress in the global economy and how do you see economic prospects for Australia going forward?

A: The Australian Banks withstood the credit crisis or financial crisis during the 2008 period because they didn’t get involved in gearing their balance sheet as much as other countries did. The reason is that these banks used derivative products to hedge their risk rather than to get better returns and the governance process in Australia is very strict. The regulation is very good and the banking system was insulated from this type of activity. Another good example is Canada, a similar situation. We withstood it pretty well. Australia because of its twin deficits is a detonation. The banks have good rating allowing them to borrow in the international markets.

Q: How do you see the Australian economy faring?

A: The Australian economy is a two-speed economy driven by the resources sector and is going at break neck speed because 60 per cent of our resource exports go across to China and China and Japan are our major trading partners. We also have the Middle East. It’s a classic example of how an economy that is driven by the resource hungry world handles one sector so the two speed economy is that. As a result, the domestic sector, the retail sector, is not as robust as the resources sector.  That is some thing we will have to live with. Because the resource sector is so robust the currency appreciates a lot.

When the currency appreciates that tightens financial conditions. We’ll bump along.  But if you see a major slow down in the resource hungry world then we will pay a price. But the Central Bank is pretty dynamic. We are not going to go into a tailspin neither are we going into top gear. We will bump along in the 3 to 3.5 per cent range. Inflation at the lower end under 3 per cent, unemployment will remain at this level. No magic about it we will trending along.

Q: You belong to an indigenous Australian banking Group – St. George’s, what are your views on consolidation in the banking sector from a global and local perspective?

A: I can’t see any more consolidation taking place in the banking sector in Australia. You might see some small banks being taken over but largely the four-pillar structure is going to remain. That is basically Common Wealth Bank, Westpac, ANZ, Nab and the little regional banks will play their role. I don’t think there is much happening in that sector. The consolidation phase in a global sector will also happen very slowly.

I think the shock that we had in the 2007, 2008, 2009 period brought about consolidation or mergers of these companies. Banks with weak balance sheets were taken over. Overall the banking sector will struggle for some time because their balance sheets are still not good enough and mostly the regulators are forcing them to have better reserve requirements and liquidity measures.

Q: The bond market indicator sometimes used as a predictor of recession shows the US economy has a 60 per cent chance of contracting within 12 months - what are your views?

A: I don’t believe that. I’ve been in bond markets for quite a lot of my life. There was a time when the  bond market was a reasonable predictor. Currency markets and bond markets have been a reasonable predictor of the economy. I think that has been lost due to lots of reasons; the key reason is that the world is in a risk on risk off regime. So when in periods of high risk aversion, the bond market tends to

rally and yields start coming down because people rush into bonds as a safety measure, it pushes it to extreme levels.

The perception that the bond market is telling you what the economy is going to be is wrong. The world is more volatile and in a risk-on, risk-off period when people are risk averse they push their money into sovereign debt, particularly in countries like the U.S, and Japan and so on. But that’s pure risk aversion. Overall, my thinking is that the U.S economy is not going into a recession. It will probably have soft two to three quarters and then gradually come out of it. The whole world in fact is going through one of those periods.

The way we read it is that the world has gone through a mid cycle pause which turned into something more aggressive for external factors. Like the Tsunami and the earth quake in Japan, the turmoil in the middle east, the problems in the EU, the problems  between the republicans and democrats in the US, all those things caused a typical mid cycle pause to be more exaggerated and what is happening now is that there is a pretty powerful tail wind to support growth.  That is the financial condition. In other words, when bond yields fall it makes the cost of borrowing cheaper.  

If you look at the world financial conditions, which are loose in an aggregate sense, because bond yields have fallen and Central banks are keeping policy loose.  That will act as a tail wind to gradually get this healing process going. What we are going through is a healing process of the shock that hit the system in 2007 and 2008.  And it’s a painfully slow healing process. Because the problems were so great the healing process is slow and painful. So people who are risk averse will say we are going into a depression or something like that. It’s not really so.

Q: Greece is in a debt spiral and Prime Minister George Papandreous’s austerity measures have proved vastly unpopular. Italy saw 1 per cent growth. What are your views on the prospects for the Euro and the future of Europe?

A: There was a time when I belonged to a group of people who believed that the European Union would collapse. I’ve been writing about it and talking about it saying the EU will collapse in 2010. The EU, which is what I would call more a political and social union rather than a true fiscal or monetary union, is actually morphing into something else. But the most important thing is that the Lisbon treaty which was enacted and passed in 2009 does not give any country (there are 27 countries in the Union) an easy way of getting out of the Union.

That is done purposely. It is more costly to the Union to see a country like Greece get out. The obvious answer is to keep them within the group and solve their problems. The problem is the haircut, or the amount banks have to bear for the debt that they are holding and that is the most important thing. Overall, the painful process of healing a flawed system would make the Union stay together. My biggest problem is whether there will be political will as you go later into years of 2013 and 2014, and whether the younger generation of new political leaders in Germany and France will have the will.

The Lisbon treaty under which the Union functions does not have an easy exit clause in it for any member. Anyone wanting to exit the system has to get permission from all 26 countries, there are 27 countries and that has to be ratified either by the parliaments of those countries or they have to have a referendum.  

If Greece opts to leave, no one is going to lend them money. The entire banking system will collapse. They will have social turmoil, so Greece wouldn’t go. And the Lisbon treaty also doesn’t have a clause to get the other Union members to expel anyone. The functioning is through the Lisbon treaty. The leaders know that. All they’re doing is to get Greece to comply with the agreements that were reached on 21 July for them to cut their fiscal deficit and work towards having a primary surplus. But if you think about it, there are so many countries that have flouted the regulations.

Greece because of its excessive debt, is paying a huge price. They will save the system. The Union was formed to prevent countries from going to war. That is why it is a political and social Union. But the new leaders have no ideas about the war. Whether they have the political will to keep the union going that is the biggest question. I wouldn’t be surprised if they lose their keenness, the political clout that they have, to do it.

I think Europe will always be a problem child, which weighs down on the world. And how it sorts its self is very hard to tell because we are dealing with politics. If you’re dealing with something else it becomes an easier one to answer. We don’t know whether each individual country will make decisions which are beneficial to their own country. It highly complex and you are taking of 27 nations. It’s a very hard thing and it will continue to morph into something else. That is what I have been saying but no one knows what it is.  

Q: How do you see economic conditions in Europe and Japan affecting global growth? Do you see growth being derailed?

A: I think Japan will continue to grow in some part. Japan depends a lot on Chinese growth and external exports and so on. It will continue to grow in fits and starts. Japan is not a major contributor to global growth. Europe is important to global growth. But the key here is, I think there is a huge shift that is taking place around the world and that is what we call the great convergence – the opposite to the great divergence where developed nations started growing extremely fast and the developing nations were left behind.

Now the reverse role is in play. The developing nations are the ones that are setting the tone for the world and because of a highly inter-related and interconnected world, they can not work in isolation. But if you have modest growth in developing countries then the developed world will then function efficiently because they will be looking within them selves to grow from within. Rather than having the model where they look to grow through exports, now they will be looking to grow with a combination of exports and domestic demand driven growth and that is how these countries will grow.  Overall, the new world order you are looking at is a world order where the emerging world plays a huge role.

Countries like India and China, Mexico, Brazil and Poland etc., will play a bigger role in the new world as we call it. Where the developed world is important, I think the developing world is going to be even more important. Because they have the demographics that suit them, the balance sheet, they have cheap labour, all the factors of production, that will help a country grow are there with them.

Q: Do you see a flow of capital to emerging markets, which are showcasing higher growth than developed markets? Do you see developed economies resisting this?

A: It’s an interesting question because I follow capital flows extremely closely. Capital flows into developing nations is going at a hectic pace, basically, coming from the developed countries. How it happens is that the Foreign Direct Investments or countries from the developed economies establishing their production centres in these countries. The key to this is not FDI’s or production, it is the flow of capital or portfolio flows, as you would call it.

The portfolio capital flow is that the world embraces emerging economies and asset markets as the next best thing to sliced bread. But the problem with emerging economies is that they are not transparent. Financial markets don’t have depth. They are not transparent and because those markets are small the inflow or out flow of capital makes those financial assets extremely volatile. Exaggerated movement. In a long-term sense, in developing economies there is this risk of transparency and lack of liquidity, these prices are at a discount to the developed world.

Over the past few years, they were at par. Which means the risk you take for investing in these countries is huge but now it has gone back down to discounted. Portfolio capital flows will again go in search of yield and returns. Then during a period of shock, if you have a shock to the system it leaves these countries and goes back to the home country using massive volatility or drop in prices in the emerging world and that pattern was quite evident since January-February this year. Over a longer period, portfolio capital will flow with foreign direct investment and other companies setting up their operations. This will continue for a long time. In a macro sense yes but in a micro sense volatility is huge.   

Q: Can you speak on alternative markets to stocks and how they are faring? What would be a good investment mix and what time horizon should we be looking at to show sound returns?

A: In a risk-on risk-off regime, the long-term capital flows that people were used to, is not play any more. We are now in a world where investments have to be more nimble. In other words, it has to be nimble enough when the portfolio manager or when structuring a portfolio you are shifting away sometimes from growth to defensive assets and back again. Time after time, you will get one of these assets becoming extremely cheap or extremely expensive. When that happens, the strategy would be to gradually accumulate the cheaper asset.

When you look at it in the current context, global equities are extremely cheap whether you are looking at any matrix. Price to book value or price to earnings, either way you look at it, is extremely attractive. The yield on offer that is the earnings yield on most of these equities is far superior to the bond area. What we call the equity risk premium. What happens is that equity risk premium during turbulent times goes in to a very high level and then it’s a mean reverse. To me, when you look at the world now it now, it tells me growth assets are the way to go. The world is in a panic mode.

It’s all the psychology of an investor. The world is in panic mode and they have battered growth assets like equities so it’s a time to buy. But you have to be extremely selective. You have to be nimble to buy the cheap asset when it is there. Then you have to be selective in taking the sector within that asset class. The most expensive asset class to me today is sovereign debt. I always ask the question is sovereign debt a truly defensive asset class?

The answer is no. Because what happened is that household debt which ended up in the hands of the banks has now ended up in the hands of the sovereign. So that they can default, they can restructure. So the end holder does not get a truly defensive asset class. And it’s gone beyond that because it has become so expensive beyond what we perceive to be fair value. At this point, we are at the mid point of a cycle and we want to pick up growth assets. As you get to the end of the cycle, or close upon, you do this shift. You get out of growth assets and go into defensive assets. That brings us to a very important question - what is the business cycle?  

You had a period where business cycles were long. And those were the Goldilocks period. The supply side, the factors of production, the cheap labour. We are now in what I call sharp short business cycles  or regimes. These cycles are most likely going to last four to five years. So if you think that we started this cycle somewhere in mid 2009 this business cycle is most likely going to end around 2013 or 2014.  Which means you pick your growth assets now but get ready to off load them sometime in 2012-2013.  But you have to be extremely selective and you have to go right across the world as well, geographically, sector wise. That is how you put a portfolio together.       

Q: Do you see opportunities for tie-ups with local businesses in Sri Lanka?

A: This is partly why I am here. I do a global trip - the Northern hemisphere during early spring and during this time, I do the South. I do it for two reasons - one is to try and understand what is happening in this part of the world and also to see whether there is any opportunity to get into a joint venture. We are looking at, for instance from our bond portfolio, the Sri Lankan market. Our equity managers are looking at the Sri Lankan equity market.  They will pick and choose the entry points and so on. There is a great opportunity given for instance that in Australia we have a large superannuation fund industry  or mutual fund industry which is over a trillion dollars. It’s a highly sophisticated industry. Countries like Sri Lanka, where you have wealth management, grow and can benefit a lot out of a tie-up with us or some sort of joint venture because the expertise is there in Australia. In fact, I have visitors from Asia coming to see how we do things. Because our level of expertise is so high.

Pic by Upul Abayasekera