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John-Paul Smith, head of strategy at Pictet Asset Management, has had a long track record in making timely calls in markets. He was one of the first to warn of an impending Russian debt crisis in 1998 and he built a strong reputation as one of the leading analysts in emerging markets. After joining PAM in 2001 as head of emerging markets, Mr Smith took on his current role at the start of 2006. PAM manages some $100bn of assets.
Mr Smith describes himself as a value-based investor with a strong contrarian streak. In spite of that, he says he shares prevailing bullish consensus for the next six months or so, at least regarding developed markets.
“First equities are cheap relative to bonds, which is good in its own right but should also encourage the continuation of private equity and LBO (leveraged buy out) activity,” he says. “Ongoing de-equitisation should continue in the face of rising demand for equities in particular from retail investors who have scarcely participated in the post 2002 bull market, at least in Europe, Japan and the US.” | Continues below |
Mr Smith answers your questions below.
You are cautious about commodities but the global economy is now enjoying an unparalleled synchronised upturn. Don’t you think the gold price is telling us that capacity constraints might be on the horizon leading to higher inflationary expectations.
Alan Boorer, UK
John-Paul Smith: As always Alan, you’ve identified a key issue and based on your track record as an international and commodity fund manager, I should probably defer to your view. For what its worth, I do think that there is a body of opinion, let’s call them the Austrian school, which has lost faith in fiat currencies especially the dollar largely due to perceived mismanagement by the Fed, who have according to this theory facilitated the creation of too much liquidity.
They also take an explicitly negative view on the economic prospects of the US as the worlds largest debtor nation. I don’t subscribe to this view because I don’’t think that the vast expansion of Asian manufacturing capacity, which has helped keep a lid on inflation, is over yet. Don’t forget we had constantly growing demand for materials throughout the late 1980s and 1990s without generating much in the way of cost plus inflation across the developed economies.
Moreover I think that the US as the world’s prime repository of intellectual capital (the present administration excepted) is in a position to sustain such imbalances for some considerable time, as the rate of return on this capital and on US investments abroad should continue to comfortably exceed the yield on US bonds. I therefore think that one of the big surprises of the coming months will be a US Dollar which is stronger against the European currencies if not the Yen, which appears even more undervalued. Against this apparently Panglossian backdrop and amidst falling prices for oil and base metals, I believe that the gold price will begin to unravel and that’s even before the retail investors, who have been such big buyers of gold ETF’s, look to sell their holdings.
What is the primary reason, in your opinion, an institutional investor should consider investing in infrastructure assets? Are such assets, from toll-roads to water companies, as stable and predictable in terms of their returns as analysts assume?
Atif Ansar, UK
John-Paul Smith: The primary attraction of infrastructure should be to institutions with long term liabilities who want to purchase assets with long term predictable cash flows. The risk profile of such projects is obviously higher in the initial or construction phase although in practice the construction company will normally bear most of the risk, subject to agreement.
Delays to cash flow are likely to prove more problematic to the investor than simple cost overruns. The secondary phase, which will last for many years, is when the returns are harvested in line with the operational agreement. The direct risk here is very low; even in the event of a politically driven change of circumstances, not unknown even in the UK, there is normally a provision for full compensation, unlike the risk exposure of an equity holder as illustrated by the Eurotunnel episode.
The real issue over the long term is more likely to be one of pricing and liquidity leading to a potential opportunity cost in my view. At a time when equities have rarely been cheaper against fixed income investments, at least over the past 30 years, is now really a good time to redirect money away from equities towards what are essentially very long term, usually very illiquid fixed investments? A positive view on future inflation might help justify such investments or some sort of inflation plus formula in the tariff structure.
What is your view on investing in emerging markets such as India? Do you believe one should allocate money by countries?
John-Paul Smith: I do not think that this is an ideal time to invest in emerging markets Melwin. There are exceptions such as Taiwan, Turkey and Thailand but overall valuations are challenging, some economies are overheating and as a group the emerging economies and corporate earnings are positively correlated with high commodity prices relative to their developed counterparts.
Whilst India will in fact benefit from the falls in commodity prices, which we expect, the negatives of an overheating economy and high valuations outweigh the undoubted positive secular story there, which is focused on good corporate governance and rising productivity.
I belive that the medium term outlook in China and Russia is even bleaker, with the rise in Chinese stocks reminiscent of what happened to the Nasdaq index a few years ago, although we may be in the equivalent of mid 1999 rather than early 2000 so the market could continue to rise before the inevitable savage correction.
1) Warren Buffett preaches concentration on a few holdings, others prefer a more diversified portfolio. How many stocks would you recommend an investor with a long and optimistic view on the stock market?
2) Where on earth do you find the single most attractive stock market? And how do you come to that conclusion?
2) If you we’re (perhaps you are) a believer in a continuing growing demand for all kinds of minerals - would you prefer stocks in companies searching and digging for the stuff, or companies developing an selling the machinery and technology needed?
Ola Hjelm, Hammarstrand, Sweden
John-Paul Smith: Difficult questions these Ola, but I’ll do my best.
I think your degree of portfolio concentration should be a function of your degree of expertise, conviction, risk aversion and the time you have available. Clearly a wide spread of investments or collective investment fund is better for the majority of non-professional investors and at this precise moment I would even consider an index fund investing across the US as well as actively managed vehicles in Europe and especially in Japan where I think there’s more scope to add value at this stage in the cycle.
On the other hand if you have special areas of expertise you may wish to focus on stock picking within a particular sector but I’d always advise that you have some money in varied collective investment vehicles for diversification purposes. If you lack the expertise to pick managers, then passively managed funds are always an option though there are points in the cycle when you really don’t want to hold them such as 1999-2001 and arguably Japan today given what we think are very cheap second line stocks.
The single most attractive market is an almost impossible call. If you go back 25 years, how many people would have predicted that France would have been the best performing major market in currency adjusted terms? Nevertheless, as a purely personal view I think that on a five-year time horizon Taiwan should do very well and of the major markets, both the US and Japan should be good investments helped by currencies, which we think will appreciate against sterling and the euro.
I’m not sure that do believe in continuing demand for minerals on all except the very longest of views given that the economies of both China and India are overheating and must slow over the coming years. In any case, demand for minerals has been rising constantly and if one goes back any further than three years, commodities have been absolutely appalling investments relative to equities so I would prefer to invest in other more unfashionable sectors such as tech and healthcare.
Stockmarkets around the world took a tumble during May, 2006. What were the reasons? Are the conditions ripe for a repeat performance any time now?
Subrata Biswas, Solihull, UK
John-Paul Smith: This is the question which we’ve been asking each other here at Pictet over the last few weeks, since even if we are strategically positive on markets, we certainly can’t rule out a nasty correction like last year’s.
The main reason for last year’s fall was sudden concern about a resurgence of inflation in the US combined with rising oil and commodity prices. The situation is a little different this time since we can’t (touch wood) discern any real inflationary shock on the horizon whilst oil prices are still around 20 per cent off their highs, the recent $10 rally notwithstanding.
The main danger this time round is more likely psychological since many professional investors are less bullish than us long term but are nevertheless fully invested, following the markets good performance so any minor economic disappointment could shake them out of the market. Still, we remain convinced that most developed markets will be significantly higher than current levels in Sterling terms by the end of 2007.
Anglo-Saxon stockmarkets are trading at near all time highs yet you refer to the markets as cheap (albeit relative to bond markets). I don’t think you can use the words “cheap” and “equities” in the same sentence unless you believe that Western economies are due emerging-market-like rates of economic growth over the next year. The fact of the matter is that developed country stock markets are trading at near all time highs and private equity as well as foreign corporates are buying left, right and centre. This is typical bubble behaviour in my opinion - common sense will kick in soon. But like you, I expect that the FTSE still has some steam left in it (for a few months at least) while investors search for their Corus. FTSE to hit somewhere close to 7,000 before all hell breaks loose?
Debanjan Ray, UK
John-Paul Smith: If the symptoms of bubble like behaviour are apparent then if we look at valuations, this is more apparent in the fixed income markets rather than developed equity markets.
The private equity “bubble” will not be over until the equity/fixed income arbitrage is brought to an end or political factors intervene in the market. Its true that some developed equity markets are close to all time highs, indeed some of the broader market indices have even gone beyond 2000 levels, but there are still some fairly substantial areas of undervaluation in my view such as domestic Japan, big cap US and dare I say it the tech sector globally.
If our prediction of a major further fall in oil and commodity prices is proved correct this will be a considerable tailwind for most developed market equities (though not a significant portion of the FTSE 100) and history suggests that most bull markets end with a wave of retail enthusiasm, which is certainly not the case at present. The real ‘bubble’ in my view is to be found in investor enthusiasm for commodities and in the hubris one finds now among most investors and even some decision makers in emerging markets ( I won’t say where because I don’t want to be refused entry!).
What is your view on the South East Asia markets like Malaysia, Thailand, Singapore and Indonesia? Is there value to be found there?
SK Tan, Hong Kong
John-Paul Smith: We’ve long been overweight in the emerging markets of South East Asia and long term I like all the countries, which you have mentioned, but recent price appreciation has taken away some of the value case for Singapore and Indonesia at least.
The stand out now in my view for all it’s well publicised recent travails is Thailand where the banks in particular are arguably the cheapest of any mainstream emerging market. Now Thailand has been something of a value trap for the last three years but like Turkey, domestic investors hold a very low percentage of the equity so any sustained good news might just cause money to flow back to the market.
The Istanbul Stock Exchange has still not recovered from its high in 2006 whereas other emerging markets have. Is the underlying reason behind this the increasing current account deficit? And if so, how long could Turkey sustain it? Finally, once the Yen starts to pick up, at what magnitude will this affect the carry trade for Turkey?
Ali Dicleli, Manchester, UK
John-Paul Smith: Well Ali, you are right about the Turkish market trading down from 2006 levels but the all time high, at least in Dollar or Euro terms was actually way back in 2000! The reasons behind the markets relative weakness over the past year have in my view been primarily political, most notably concerns over the deteriorating situation in Iraq and the prospect of prime minister Erdogan running for the presidency later this year.
That said, economic concerns have been important with interest rates stuck at 17.5 per cent and as you point out one of the largest current account deficits anywhere in the world, which has raised fears over the currency.
You may be surprised to learn that whilst we are aware of all these factors, we are actually pretty upbeat about the Istanbul market primarily because we don’t think that financial markets have yet recognised the massive step change up in productivity which has occurred at both the national economic and individual corporate level, which has taken place over the past four years.
Whilst the market will continue to be volatile and is not for the faint hearted, we envisage significant reductions in interest rates later in the year paving the way for domestic investors who are currently very underweight in equities to move back into equities.
Most private investors have no idea of the political or economic conditions prevailing in emerging markets. Is it not better to ride piggy back and buy large European companies who in turn use their experts to invest there? It seems to me that this approach has the advantage of retaining some direct control and reducing the risks.
John Contogeorge, France
John-Paul Smith: You make an excellent point here John, the brief answer to which is that if you are a relatively risk averse equity investor then yes, it does make sense to buy companies in developed as opposed to emerging markets, though I’d buy US as well as European companies since they will be major beneficiaries of growth in emerging economies.
Most academics and indeed industry practitioners (especially those with emerging market funds to sell) would aver that most investors should have some direct exposure to emerging markets because of the apparently higher risk premiums and superior demographics, which should lead to faster rates of economic growth.
My answer would be that it depends upon your judgement of where we are in the current investment cycle and like the direction giver of Irish folklore ‘I would’nt start from here ‘ after six years of emerging market outperformance leading to stocks in many countries whose valuations have far outstripped those of their developed market counterparts. Whilst there are a number of emerging markets, which we still like, such as Thailand, Turkey and Taiwan, we think that for this year at least, developed markets are likely to outperform the emerging world.
Mr Smith also expects further falls in commodity prices, which should have an extremely bullish impact on both economies and equity markets across the developed world.
“Equity markets in the US and Japan will outperform Europe, partly due to currency movements, though the latter will still perform well in absolute terms. I would expect a fairly sizeable rise in the extremely undervalued yen at some point this year with fairly obvious collateral damage for some of the beneficiaries of the so-called carry trade. But the impact on markets overall should be neutral as both Japanese and most likely US equities, stand to benefit.”
Mr Smith says the key short term risk to markets is a psychological one, namely that there are two many fully invested bears among the institutional investors, who are looking for an excuse to sell equities. The key longer term risks are the build up in leverage away from the quoted sector and the fact that this bull market like all others before it, will end in a spiral of excess.
“My views towards emerging markets are a little more nuanced. There are plenty of cheap markets where domestic investors have not yet started to demonstrate the type of excess, which is normally characteristic of the topping out phase of a bull market, most notably Taiwan, Turkey and Thailand. Then there are the others, including in my view though not necessarily that of all of my emerging market colleagues, three out of the four so-called Bric’s markets - Russia, India and China - where investors have allowed recognition of the undoubted positive secular drivers to overwhelm any real rational consideration of the valuation case,” he said.