CIO LETTER MAY 2013 Redrawing the Investment Map I m excited to write to you fresh from the Colloquia Series Forum that we held in April in China. Set against an insightful backdrop in Beijing, the conference Redrawing the map: New risk, new reward brought leading lights from Central Banks, sovereign wealth fund and academic communities together with Pioneer Investments investment experts. Giordano Lombardo Group Chief Investment Officer In partnership, we discussed, debated and explored the global economic challenges and their implications for investments. At our last Colloquia Series Forum in Iseo in 2011, one central theme was the vast shifts taking place in the global economy. In the last decade - and especially since the global financial crisis of 2008 - the world has evolved in ways that are unpredictable and often unsettling for investors. Two years on from that event and five years on from the crisis, in Beijing we had the opportunity to reflect on where we stand today and what, I believe, it means for investors. I d like to frame my view by posing three questions. Since the Global financial crisis of 2008 the world has evolved in ways that are unpredictable and often unsettling for investors 1. Is the world a more or less stable place than at the start of the crisis? 2. What is the right investment strategy for the market conditions that we face? We need to consider which asset classes should allow us to capture the opportunities this environment presents us with. As part of this, we need to consider the merits of investing in risky assets in general and in the emerging markets in particular. 3. What are the investment techniques that will allow us to manage the risks of our chosen strategy? Answering to the first question, I believe that the world is more unstable now than it has been for the previous four decades, and perhaps since the 1930s. And the primary cause of this instability is DEBT. There is now considerably more debt in the developed world than in the past and the efforts to reduce it (the so-called deleveraging process) has negatively impacted growth and economic prospects for many countries in the medium term. How will the developed economies be able to address this explosion in debt? This must eventually happen as we run out of room to borrow more and debt cannot increase ad infinitum. The empirical evidence shows that after total debt reaches the 250 to 275% debt to GDP level, it starts to decrease. 1
Developed Markets Debt-to-GDP Evolution Source: BIS, IMF Financial Stability Repot, October 2012. Data as at 30 June 2012. Developed economies need to address the explosion in debt that has occurred over recent decades That may sound encouraging, but obviously the debt reduction can happen in a number of ways. The most positive is the inflection point where an indebted country s strong growth allows borrowers to pay down their debts. The most negative is outright default. Inflation that steadily erodes the real value of the debt over time lies in the middle, constituting a subtle form of default in which many bondholders may remain ignorant of their losses. How will it happen this time? Growth, default or inflation? This is the trilemma for developed economies and for investors. But, let s go one step beyond. But the accumulation of public debt over the last 20-30 years is just a symptom of a more profound malaise, which is the rupture of the intergenerational pact. This is the main issue facing mature democracies today. Developed countries have accumulated enormous liabilities at the expense of future generations. If these countries are struggling to control deficits and reduce public debt now, how will they ever reach the political consensus to deal with the overhang of these future liabilities? And the problem following this breaking of the intergenerational pact is not just debt: the extraordinary high level of youth unemployment in most developed countries and in particular in Europe is another dangerous source of instability. The second leg of the instability story is the printing of money by Central Banks. They took exceptional steps to prevent a deeper recession during this financial crisis. The liberal printing of money has seen the balance sheets of all major Central Banks expand. As a case in point the Federal Reserve s balance sheet is four times the size it was before the crisis. Admittedly, these actions have averted a depression in the US and probably prevented the breakup of the Euro. However, enormous Central Banks liquidity has unintended consequences, one of which is asset price inflation around the world, in bonds, equities, commodities and so on. The key point about the effect of Central Banks action is the unequal way that this flood of liquidity has been distributed because when liquidity is created, it s impossible to control where it goes and who benefits from it. This has favored, for example, prime property market such as Paris and Hong Kong and New York, where there is already a concentration of wealth. This inequality can be seen at country level, with the core European countries that have benefited far more than countries on the periphery, and at an individual level with increasing wealth concentration in few hands. 2
As with youth unemployment earlier, we have to concern ourselves with whether any rising inequality has the potential to create greater social unrest than it has done so far. Now the issue is related to the exit strategy from these monetary policies (when it will happen, in which form and with which effect) and to the effects of Central Banks actions on currency debasement. A trend, already in place, that I believe will last for a long time. In Europe, there are reasons to be optimistic, around 75% of the planned fiscal consolidation in the Eurozone has already happened Another major source of instability is Europe: here the question now is whether the political glue keeping the Eurozone together will hold or not. We think so, but with some bumps down the road. There are reasons to be optimistic: around 75% of the planned fiscal consolidation in the Eurozone has already happened, labor costs in peripheral countries are becoming more competitive, converging towards Germany levels, and also current account balance are under adjustments. And we cannot forget the fact that a lot of political capital has been spent in the euro in the last decades. Despite these positive factors, we still face two major issues in the Eurozone: First, European nations cannot achieve much progress on policy without acting together, rather than at each other s expense, especially on the goal of restoring growth in an area plagued by a profound recession. Second, we need to see progress on those projects of future integration which were announced last year, in particular the Banking Union and stronger fiscal integration, but which are now progressing very slowly. The risk is that European leaders become more complacent, encouraged by the positive behaviour of financial markets, and may start to back-pedal on said announced plans for further integration. Despite a long list of instability factors, we believe it s rational to be long risky assets, and equity in particular. This list of instability factors - debt, inequalities and unpredictable effects of unconventional monetary policies, is by no means exhaustive. Nonetheless, coming to our initial second questions, we believe it is rational to be long in risky assets and equities in particular. There are three reasons behind this belief. The first (and weakest) reason is that markets are driven by the music of liquidity and we, as investors, should dance while it s still playing. The tune we dance to today is the sound of financial repression. Real Rates on 10-Year Government Bonds in Developed Markets Source: Bloomberg. Data as at 31 March 2013. 3
Markets are driven by the music of liquidity and we should dance while it s still playing. A combination of bank intervention and blind buying by fearful investors has led to unprecedented low yields on so-called safe government bonds. Despite this, investors continue to pile into bonds. Today, key institutional asset owners allocations to equities are at record lows for both US and UK pension funds. It is our view that these investors will look for significantly higher returns than they are getting from investing in government bonds. At some point, they will increase their allocation to riskier assets in order to earn these returns, starting a trend which has been named the great rotation. The second reason is that the cyclical components of the economy are improving. Cyclical indicators suggest that the US economy is expanding, China s rapid expansion is slowing, but it is still leading global growth and that the Euro area, despite the weak economic outlook, is on the right track on structural reforms. However, being long equity is not just a top-down argument. My third argument it that bottom-up, equities have compelling valuation. Also, equity dividends are outstripping bond yields, especially in Europe. As such equities, should be considered a structural source of investor income as well as potential capital appreciation. Emerging Markets are also another area where investors could find opportunities However we believe that it is increasingly important to spot the differences between these economies Moving to Emerging Markets, the question is: are they still the best place to be given their higher path of growth? Yes, I believe they are, but with some caveats. We need to recognize that many Emerging Markets are in a transitory phase, in which they will shift towards lower growth. This should make it increasingly important to spot the differences between these economies. That s why we believe that looking at the specific investment and economic initiatives of individual countries within Emerging Markets is essential as much as adopting a bottom-up approach to identify the most compelling investment opportunities. For example, we currently like places like China and South East Asia. Despite these areas of opportunities, we should acknowledge that the greater economic instability translates into a challenging investment environment. Therefore our third question: what can investors do to manage their risks in an environment that s more unstable? As a global asset manager, our role is not just to debate the future, but to invest money for our clients and have always some exposures to the market. The exposures are related to our base case scenario. Currently it is linked to the idea that the world will muddle through. Growth won t be great, but the economy is going to slowly improve and Central Banks, as we have seen, will continue to play a nice tune. That means looking for assets that offer income and potential for capital appreciation, especially equity. At the same time we acknowledge that the environment is not immune from risks and fat tails, and for us this means trying to adopt the right hedging strategies to protect clients portfolios. I would emphasize right, because we need to be able to detect, in a very specific way, the risks we are hedging: is it inflation, or depression or what else? Besides, we should have reasonable expectations on future returns. In this respect, we anticipate lower expected future returns than those of years gone by, though equities should offer a better return than bonds. Moreover, in the search for higher returns investors may need to enlarge their investment universe outside of the traditional asset classes, looking at opportunities in the private asset spectrum, such as loans. 4
10-Year Expected Real Returns (Annualized) Source: Pioneer Investments, data as at 31 December 2012. Equity markets returns are obtained by the aggregation of the projected contributions to total returns from earnings growth, valuation re-rating and dividends (share buy backs are considered where meaningful). Earnings growth is calculated as the combination of sales growth and margin changes, valuations changes imposes a long run mean reversion on long term CAPE, while dividends are calculated on constant pay-out ratios. Government bonds returns are obtained by the aggregation of the projected contributions of inflation, growth and monetary policy assumptions. Credit returns are obtained by the aggregation of the projected contribution of interest rates curve, implied volatility and default rates. In Commodities precious metal are excluded. Real returns are calculated with local expected inflation. Another investment challenge is related to the increasingly changing behavior in correlations between asset classes. For example correlation between equities and commodities have strengthened, while others, such as the link between German and Italian government bonds, have disappeared. Investors should be cognizant that supposed hedges sometimes aren t and that s why we continuously monitor how correlations are evolving with the aim of ensuring that our hedging and risk management strategies can stand the test of time. We also live in a world of much greater volatility and tail risks which requires a strong focus on risk management Active management, research and risk management are the key pillars of our investment approach We also live in a world of much greater volatility and tail risks. The number of large and very large daily price moves in the S&P 500 during the past decade was greater than it had been in the previous five decades combined. Given this severe backdrop, we need to find ways to capture the upside, while limiting our exposure to market shake-outs. This means investors need to bring some of the risk management techniques employed by hedge funds into the long-only world. So how do we at Pioneer Investments approach this new and more uncertain world? As I said we believe it is rational to have exposure to assets such as equities and emerging market assets with the aim of earning higher returns. This inevitably means taking risks and so we concentrate on adopting an active management approach to explore the opportunities arising and combine it with a strong risk management discipline. We will continue to use our risk budgeting approach that breaks a portfolio s risks down into its constituent parts and determines how much of each type of risk we need to take in order to optimize performance potential. Research will continue to be an important pillar of our investment process. The in-depth experience of our analysts team ensures that they have a strong grasp of the potential risks associated with an investment while they are searching for opportunities. Granted, my findings in this publication have focused to a large extent on the problems the world is facing. But while we can t ignore these problems, I want to state that we are very positive on the opportunity set for investors. The crisis and the resulting instability are not solely something to be managed; they are also a situation that can be exploited by alert investor. One is minded of the Chinese proverb, that explains in every crisis, there is opportunity. We are still in the midst of crisis, but I have no doubt that great opportunities lie ahead of us. 5
Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of 30 April 2013. Unless otherwise stated, all views expressed are those of Pioneer Investments. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: 12 June 2013 6