Morningstar's annual investment conference came at a particularly exciting time this year, with a new UK government finally agreed mid-conference, the EU and IMF having agreed just days previously to a near-$1 trillion rescue package for Greece and other indebted European economies, and global stock markets on a daily rollercoaster, our broad range of investment luminaries addressed all these hot topics and more.
To keep you in the know, I kept a live blog throughout the conference, updating you on our fourth annual event, with key messages and insights from all the presentations, as well as individual interviews with presenters.
Below, you will find coverage of the first day of our 2010 event. For coverage of the second day, please click here. Links to video interviews will be added shortly.
Day 1 - Tuesday May 11
Welcome Address Geoff Balzano, CEO, Morningstar UK
Equity Cycles - Despair, Hope, Growth and Optimism - Where Are We? Peter Oppenheimer, Chief European Equity Strategist and Co-Head of Economics, Commodities and Strategy Research in Europe, Goldman Sachs
One of the first presentation slides shown by Peter Oppenheimer, Chief European Equity Strategist at Goldman Sachs, illustrates the organisation’s GDP growth forecasts: 4.8% for the world as a whole in 2010 and the same in 2011, with China providing the main push—11.4% expected this year and 10.0% next. Goldman forecasts 1.4% growth in the UK this year, increasing to 3.3% next, while Europe is seen expanding at an annual rate of 1.8% and 2.5% in 2010 and 2011, respectively. All of these forecasts are higher than consensus, Peter points out. Goldman is less bullish on the US, however. While consensus is for GDP growth of 3.1% and 3.0% this year and next, Peter’s organisation is looking for expansion in the region of 2.7% and 2.5%.
Goldman’s top-down model suggests strong profit rebound in 2010 and 2011 across Europe. Sales are expected to expand with higher world GDP growth, while margins pre-exceptionals are seen reaching peak levels by year-end 2011. 2010 and 2011 EPS estimates are likely to be revised up following surprises, Peter says.
Questions from the floor: First question is regarding the growth rates in the UK versus Europe--surely one would expect US growth to be stronger than in Europe?
Peter's response: It’s important to separate the investment opportunities from the growth rate. The trend rate of growth is higher in the US, the main reason being population growth, so you would expect US growth to exceed that of Europe. But at this stage in time, Goldman is moderately cautious on the US economy as it has already experienced relatively strong economic activity due to the massive fiscal stimulus. As stimulus fades, the economy needs something else to continue to support growth so the question for the US is really: what’s the outlook for consumption? Even assuming improvements in the US weak housing market and high unemployment, Goldman only has a moderate outlook for the US economy. Europe has its own problems but northern European countries are recovering increasingly well. Peripheral and southern European countries are recovering much slower, generally because they’re dealing with such high levels of debt, as in the UK, but this isn’t the case in Germany, for example. Germany’s recovery is actually very strong, in fact it is experiencing one of the strongest rises in manufacturing output in its history, partly thanks to end demand (in emerging markets, for example) remaining quite strong. Germany and France disproportionately make up a much larger share of European growth.
Risk Management: Lessons from the Credit Crisis Ed Fishwick, Managing Director and Co-Head of Risk and Quantitative Analysis Group, BlackRock
Years ago, if a girl at a party asked you what you do, you’d say “fund management”, Ed says, but you wouldn't mention you were in risk management as that was considered very boring. Now however, you say you’re in risk management as it’s actually become very exciting!
Ed kicks off with a little story: While he was holidaying in Queensland in Australia, two guys said they were going to swim across a local estuary, where swimming was forbidden due to the presence of crocadiles. Despite the authorities being up in arms, the whole village came out to watch, so Ed and his family joined too. The two guys swam across and were fine. Ed’s young son observed: “well that wasn’t so risky after all.” A story that has haunted Ed ever since. Interesting highlight of the perception of risk.
There are six key lessons to learn from the credit crisis: 1) the paramount role of liquidity; 2) assumptions are just assumptions; 3) garbage in, garbage out?; 4) the sources of risk change quickly; 5) you can’t cram for crisis—risk management isn’t something you can quickly get into; and 6) volatility is only half the story.
1) Liquidity is the life blood of a modern economy, the ability to meet immediate obligations is critical to financial survival, many market participants assumed that liquidity was a fact of life, continuous time finance is, after all, just an abstraction, not a guarantee.
Maximising wealth, assuming efficient markets exist, permits liquidity concerns to be addressed as an afterthought—value can be extracted from portfolios through the mechanism of the market; In the absence of functioning markets, cash may not necessarily be generated from wealth…alternatively, the cost of doing so becomes exceedingly onerous; Bonds are much better than you think; Reliable cash flows should be used to meet critical future liabilities—if the portfolio contains cash or cash producing securities, liquidity can be extracted relatively efficiently. Free Riding: when market participants anticipate liquidity, investors can trade products they do not fully understand. Severe disruptions in a complex and opaque product space may hit expert investors the worst since they will tend to have concentrated exposures. Just being smart isn't enough!
2) Serious risk managers always understood the limitations of models; Model based forecasts require assumptions—mean-variance, volatility, correlation, etc; It was always understood that these could be violated in practice, but the last two years show this is at levels previously unimagined (rapidly varying volatility, diversification works until it doesn’t, persistence or trending makes the measurement of risk horizon dependant); Highlights the need for caution in the use of models, and expert judgement in their interpretation and use.
3) Investors need to be more hands-on and develop a visceral understanding of the origination processes and borrowers. Recently, the quality and performance of underlying assets were materially worse than expected—the underwriting process was much worse than ever indicated in the data, originators created loans primarily for sale and retained little, if any, interest in their ongoing performance.
Going forward, investors will need to get more deeply involved in the information cycle. Relying on ratings alone was a failed strategy, previous default and delinquency data was artificially low, even using a more rigorous analytical approach based on taking historical performance data and building and relying only on statistical models and stress test is insufficient. The bottom line is Main Street played Wall Street.
4) As more power over the financial system shifts to global political capitals, market dynamics may shift from economic fundamentals or market technical conditions to political considerations. Developed markets may become more like emerging markets. Risk management teams may rely less on economists and statisticians and more on politically-oriented analysts: quants may find themselves getting traded in for politicos. The longer term impact on productivity from an increase in political control over the economy is not known. If history is to be believed, the prognosis is not positive.
5) Effective risk management is an expensive long term investment--professional risk managers with substantive subject matter expertise are critical to have impact. Analytics and information management technology are required for a reliable “information utility”. Risk mitigation is a critical part of risk management.
6) Volatility is only half the story: price has everything to do with volatility, or volatility has everything to do with price. Volatility matters but the price at which you buy stuff and the price at which you sell stuff is really, really important.
An interview with Ed Fishwick, filmed following his conference presentation, in which he summarises the key points of his presentation and talks about the current market environment, can be viewed here.
UK Equity Income: Regaining its Former Glory George Luckraft, Portfolio Manager, AXA Framlington Group
George Luckraft looks into the UK equity income sector—a sector that’s faced headwinds as companies slashed dividends. The economic crisis and banking crisis removed the stigma of cutting dividends, George tells us. His slide of the ‘FTSE Hall of Shame’ shows a very long list of UK companies that have cut dividends—financials dominate the list, while a handful of resource stocks, real estate investment trusts and leisure stocks such as pubs operators also make appearances.
George believes we are going to return to dividend payments being back on the agenda and will likely see more positive surprises that negative surprises.
Big dividend payment weightings on the FTSE:
The current situation is one of economic improvement, balance sheet improvement, strong dividend cover and a return to dividend payments, George says.
Outlook: Going forward, George says there’s obviously a requirement for income, a recognition that dividends are a core feature for equity owners. He sees a period of muted overall return increasing percentage coming from dividend...a return to normal.
Regarding politics, if he had to make a guess, George thinks we might see a minority Conservative government and another election shortly.
Asked why investors should stay in the UK, given stronger performances elsewhere, George highlights that around 75% of the UK stock market gives you overseas exposure anyway: "the best of both worlds." Looking at data on long-term trends, the London market stands out as being cheap, George says.
Regarding BP's current situation, George suspects that plans to increase the dividend are probably off the agenda at the moment given the cost of its clean-up operation in the Gulf of Mexico. However, unless the situation gets much worse, he still thinks BP will pay a dividend and the shares will outperform, though he confesses he's slightly more nervous now han he was not long ago.
Asked to estimate the dividend growth rate of the UK's top ten dividend players, George says sterling's valuation will be the biggest driver. If sterling remains unchanged, he estimates a dividend growth forecast of 3%-4% accounting for inflation.
View on property-based companies: the Bank of England's Quantitative Easing measures were designed to help the property market, to take pressure off banks' balance sheets. Sees better value in the equity market than in the physical market, so some of the smaller property companies he owns are at 20%-30% discount to NAV, which is quite unusual. Property is about management of the property--this is a key for investors.
ETFs: More Positives Than Negatives Bradley Kay, Associate Director, European ETF Research, Morningstar Inc.
Bradley gives a comprehensive overview of the exchange-traded fund market, explaining what exactly ETFs are, as well as ETPs (exchange-traded products), ETNs (exchange-traded notes), and ETCs (exchange-traded commodities). The latter is about as close as you can get to actually buying physical gold or other precious metals and storing them in your home, but a more secure version. For more on ETFs in Europe--what they are--read this article, and for more on their future--read this article.
Among the lessons we can learn from the credit crisis: counterparty risk is real. The first iteration of ETF Securities commodity fund were backed by AIG's credit alone and led to the current, collaterised ETC structure; Lehman Brothers ETNs in the US were the only funds to completely fail from counterparty default. When talking about counterparty risk, you're talking about times of crisis, as that's the only time when a major financial institution is going to default.
Liquidity and regulatory risk are bigger than counterparty risk--very little investor money was lost due to counterparty default during the latest crisis.
We need to recruit a new sort of institutional investor, Bradley says, as heavy exchange traders and retail investors have a natural symbiosis in ETFs. Over-the-counter trading volume does not do much for retail investors. We also need greater transparency as we expand the retail market.
Consolidation in the European ETF marketplace and product innovation: new entrants in a more mature market can only compete on low costs or product innovation. But with some ETFs available at close to zero cost, product innovation is the key. There are plenty of new areas ripe for expansion.
A delegate notes that most IFAs (independent financial advisers) are not qualified to advise on equities, so asks how this fits in with the realm of ETFs? Bradley answers that with ETFs available at such low cost, their popularity will continue to increase and this is likely to lead to regulatory change in order to ensure that IFAs can advise their clients on investing in ETFs.
The History and Economics of Stock Market Crashes Dr. Paul Kaplan, PhD, CFA Quantitative Research Director, Morningstar Europe
Dr Paul Kaplan embarks on a long-term history of stock market crashes in the US, the UK and Japan to put the most recent crisis in perspectives.
'Black Sunday' - September 14, 2008, otherwise known as the Lehman crash:
The bubble burst: The real estate market crashed and prices and fell, when we woke up on the morning of September 14 and Lehman had tumbled, the balloon was well and truly popped and global systemic, i.e. structural, risk became apparent.
Paul describes this latest crisis as a "classic crisis" set up by high levels of leverage everywhere. Economists disagree on this. The term 'black swan' has been used to describe this crisis, a black swan being an event that is inconsistent with past data but that happens anyway. Was this a black swan? he asks. Maybe it was a grey swan? A grey swan describes "Events of considerable nature which are far too big for the bell curve, which are predictable, and for which one can take precautions” - Benoit Mandelbrot (inventor of fractal geometry).
Paul quotes Leslie Rahl, founder of Capital Market Risk Advisors: "We seem to have a once-in-a-lifetime crisis every three or four years.”
Perhaps a swan is the wrong type of bird, Paul suggests. How about a turkey? A black turkey: “An event that is entirely consistent with past data but that no one thought would happen” - Larry Siegel.
A look back at UK market crashes over the last 110 years shows that the current crisis is actually not the worst so far--it ranks fifth (data from Morningstar):
Economic thought and financial crises--why do crashes occur? Wicksell and Fisher claims that over optimism leads to excessive leveraged real investment...eventually reality hits and there is an economic crisis. Keynes, the great British economist, described a confidence crisis, liquidity trap, and market imbalance, thus making government intervention necessary to remedy a recession. German economist Hayek was one of Keynes' biggest critics. He said that it was actually the government that made the situation worse: government and central bank stimulation increase leverage, thus deepening recessions during the inevitable deleveraging. Minsky, who considered himself a Keynesian, said market calm lulls people into underestimating risk and over optimism, i.e. the boom makes the bust. Minsky says some government intervention is needed to mitigate this behaviour.
So what caused this particular crisis? Paul lists a number of factors: Regulators permitted excessive risk taking by allowing excessive leverage; central banks fuelled excessive leverage with expansionary policies; a lack of sound risk management; market participants underestimated risk; academics overly believed in market efficiency; politicians benefitted from excessive short run economic growth; and CEOs focussed on short-term profits, hoping to retire before the inevitable crash.
Steps to reduce likelihood of future crises:
1. Regulatory Reform--transparency, limit leverage, enlarge scope to all financial institutions
2. Risk modelling reform--include scenarios of sudden flight to quality, model systemic risk
3. Reform the financial infrastructure for more transparency--over-the-counter derivatives, off-balance-sheet vehicles
A delegate asks Paul about the Greek bailout, agreed mere days ago by the EU and IMF. Paul points out that when the euro was first being debated, the euro sceptics highlighted the 'free rider' phenomenom, whereby when there's the risk that one government is going to default, the others have to scramble to bail it out. "I congratulate the British people for staying out of the euro," jokes Paul.
Another question: Is government stimulus worsening the situation? Paul's response: It's his personal view that what happens during these cycles is that we get a lot of stimulus, and this set us up for the next crisis. E.g. You need to raise taxes to raise stimulus, but the leader of a country can only raise taxes so much and still stay in office, so they get the central bank to inflate...which lays the foundations for the next crisis. More government expansion leads to more government intervention, deeper and deeper crises, the government 'rescues', prosperity resumes, then we get the next crisis and the government intervenes again and, as a result, becomes bigger...until the government is so big that someone says "enough".
The Political Landscape - Where Now For Our Industry? Simon Brazier, Co-Head of UK Equities, Threadneedle Investments Services
The elephant in the room is the deficit in public finances, Simon says, so he'll be talking about the need for political change in the UK at the moment, the choices available, "maple leaves, shamrocks and Abba"--Canada, Ireland and Sweden, and the "grim reality" (his words!) Simon highlights that these are all his views--he wants to make this clear as he has some pretty strong views.
The budget: "The greatest piece of fiction I've read this year," Simon says, adding that the UK is the most indebted nation in the developed world, as a percentage of GDP, though Greece's numbers may have overtaken this in the last few days.
A tidal wave of debt issuance needs to be funded over the next five years. According to Simon's projections, over the next five years the UK government will need to issue £15 billion of gilts per month, all of which will need to be refinanced, which equates to a Prudential rights issue every six weeks. During the government's quantitative easing, it bought the vast majority of the gilts it issued--investors only bought about £20 billion out of a QE programme of £200 billion.
As consumers, we're one of the most indebted economies in the world. In one quarter in 2008, as consumers, as a whole we spent more than we earned--we didn't pay off our mortgages, we didn't save, we just splurged.
Dealing with fiscal deficit: growing your way out; inflating your way out; or balancing the books.
“Target growth not inflation is the cry. I could not disagree more. This is precisely the situation in which the framework of inflation targeting is so necessary … Without a clear guide to the objective of monetary policy, and a credible commitment to meeting it, any rise in inflation might become a self-fulfilling and generalised increase in prices and wages. And surely the lesson of the past fifty years is that, when inflation becomes embedded, the cost of getting it back down again is a prolonged period of sluggish output and high unemployment. Price stability – returning inflation to the target – is a precondition for sustained growth, not an alternative.” - Mervyn King, Mansion House speech 2008.
“The first thing for the new government to do is to agree on a convincing, ambitious programme of fiscal consolidation in order to start to reduce the very high deficit and stabilise the high debt level of the UK” - Olli Rehn, EU Economic and Monetary Affairs Commissioner.
Simon highlights Mervyn King's comment to David Hale, supposedly made during a private conversation, the government which emerges successful from the UK election will be so unpopular following the huge steps it's going to have to take to reduce the deficit that it'll fail to be elected again for the next decade. This statement, Simon says, he is certain was strategically placed by Mervyn King to come out at election time.
The Canada solution: Reliance on spending cuts rather than tax rises; public spending (excluding debt interest) fell 10% in absolute terms between 1994/5 and 1996/7; 1994-99 public sector employment reduction of 19% or 45,000 people; focus on welfare cuts, particularly unemployment benefit; 1997-2003 growth in employment of 2.3%, growth in standard of living of 2.8%, real income (GDP/capita) up 20% in real terms nLarge increase in inequality.
The Swedish solution: Balance between tax rises and spending cuts; spending cuts focused on government transfers, pensions, retirement benefits, housing benefits, unemployment benefits; cut all government expenditure by 11%; taxes aimed at income and capital; 2% annual efficiency targets; introduction of private sector competition in to school and healthcare systems.
Lessons from Canada and Sweden: Create a conservative baseline; front load; political message important in order to get people to come with you; need buy in from electorate; spending cuts should maximise incentive to work; tax in the following order--i) negative external benefits (CO2, Alcohol, Tobacco), ii) property consumption, iii) corporates; iv) income.
So what are the Irish austerity measures? Reduced public sector salaries of up to 15%--this is the equivalent of the UK saving £90 billion this year; pension reform; €8 billion of budget adjustment for 2010; welfare reductions - unemployment benefit, maternity pay, child benefit; increased prescription charges; carbon tax; reduced student grants; but…huge alcohol duty reductions..."If you can't have a good economy, "at least you can drink yourself silly," Simon quips.
The UK base case, i.e. what needs to happen: Conservative policies are the driver of economic reform; growth outlook adjusted downwards, deficit profile upwards; political message set with MP salaries/pension cuts; Canadian cross department spending cuts with Swedish style tax rises; Swedish style efficiency targets; VAT up, carbon tax up, housing taxes up; pension reform, welfare reform (unemployment benefit, incapacity benefit) ("this is the civil unrest bit"); capital spending projects scaled down; structural reform of service delivery (schools, hospitals); increased index linked issuance.
UK concerns: A weak coalition or minority government; British compromise leads to muddle through; failed gilt auctions; market forces government’s hand with rising rates; external economic shock; competitive devaluation continues; civil unrest...
But what does this all mean for the market? Wary consumer focused sectors; outsourcers to be net losers; cost of capital to remain high; capital availability constrained; refinancing risk continues; corporate cash crunch still to unfold; M&A to remain a dominant feature.
"Standing here speasking, I've been feeling like David Cameron but I wasn't trying to make a political statement," Simon says, "I've had very severe concerns about the economic environment for some time and now it's playing out--I didn't want it to."
Asked where investors should put their money, Simon says the UK equity market is a "good place" and not just because co-head of UK equities--anyone who knows him will know he's been very bearish in the past.
Sound advice: "I'm not a financial adviser but the only piece of advise I would give would be diversification, diversification, diversification."
"You'll know when things are getting desperate because we'll [the UK] start issuing our gilts in other currencies," Simon adds as an aside, "when that happens, turn the lights off."
Simon followed his presentation with a filmed interview for Morningstar, in which he (thankfully) ended on a positive note and highlighted the areas where he sees opportunities. You can watch the video and read the transcript by clicking here.
For Day 2 coverage, click here, and please feel free to comment on any of the presentations in the comments box below.
