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Emerging Markets

State Street positions for weak recovery

Global chief investment officer Richard Lacaille says State Street Global Advisers is overweight on equities from a bottom-up perspective and also on investment grade credit. Just don’t ask him to forecast the gold price.

  • 22 Nov 2009
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Institutional investor State Street Global Advisors believes the global economic recovery will be relatively weak and that fundamental analysis will return to stock-picking in 2010.

Predominantly a conservative, passive investor, the firm typically favours quantitative techniques to evaluate markets in an effort to determine patterns.

On present metrics it finds that equities are fairly valued and in some cases offer better than fair value. It has been overweight on the asset class since last December, and turned overweight on investment grade credit this spring, swiftly followed by high-yield bonds.

Although it has wound these positions back a little, it still has a 2% overweight on emerging markets. It is effectively financing these views by taking an underweight position on treasury bonds and on real estate investment trusts (Reits) in the US.

In an interview in Hong Kong, Richard Lacaille, the firm’s global chief investment officer, told asiamoney.com: “If you are sitting in Asia-Pacific, you feel as though you have got a very sharp V-shape recovery, with economies responding well to government stimulus.

“But although Asia is very strong, and the China story is extremely impressive in terms of growth, it’s not enough on its own to get the global economy back to trend growth. US consumers have still got quite a burden to get through.

“Clearly you have got to be on the lookout for what might challenge the recovery story, whether it is a certain increase in unemployment in Western Europe or the US, or much more significant trade disputes that would challenge the whole globalisation story.

“Assuming they don’t happen, our expectation is that we are in recovery mode and therefore we need to position for recovery in terms of our portfolios, which is why we have a little bit of risk on the table [in equities and investment grade credit].”

State Street has adopted a more active approach to asset management this year and favours a current quantitative bottom-up style when it comes to valuations.

“Clearly stock prices have recently been driven more by top-down factors as people rotated through sectors or took a more macro bet,” said Lacaille. “But this year it looks as if fundamentals are returning.

“A lot of people left active management [during the financial crisis] in favour of passive, so those that are left to pursue alpha have probably got a better chance of getting it now than they have had in the last couple of years.

“In the long-only world, people have gone from passive to active, and I think there is a case to be made for active management, although risk management is also incredibly important.”

In terms of investment grade credit preferences, State Street favours financials and banks over industrials, and it is a pretty similar story in pure fixed income portfolios too, although it is underweight on US agency mortgages.

“Earlier in the crisis people felt a bit less comfortable with understanding the risks in financials and banks, and I think that priced a premium in,” he noted. “We feel we do understand that, and if anything that would be a slight overweighting [for us].”

State Street also has a slight overweight on treasury inflation-protected securities (Tips), which pay a fixed coupon that is lower than regular treasury bonds but whose face value is adjusted to keep pace with changes in the consumer price index. Hence, as inflation rises, so do the interest payments and the face value of Tips.

“I do find there is enormous disagreement amongst our client base,” notes Lacaille. “If I talk to institutional clients in Asia, the Middle East or Europe, there is a stark division between the deflationists and those who worry about the printing of money and how it is all going to end.

“Our take on it is not to deny that we have got severe deflationary forces in the short term [the next three years], but if you have got a 20- to 30-year horizon as a client, you need to think about the long-term inflation rate and what is going to happen.

“Our belief is that the recovery will be relatively weak. You have still got a lot of caution out there, despite the bounce back in consumer confidence. That is not going to make it easy for people to exercise leverage in the wage area and in the labour market.

“So you might see commodity price pressure because the China story is still alive. But for inflationary pressure to come through to inflation you have to have a transmission mechanism that is beyond just saying that commodities are going to go up in price.

“There has got to be a labour market story, there has got to be a mechanism for finding out how that spare capacity in the market is going to be eliminated, because right now it is still out there, even in this part of the world [Asia].

“Now you will get patches of price pressure at the sector level, and possibly at the country level. But we think the danger [of inflation], if there is a danger, is a little bit further out.”

In terms of currencies, Lacaille notes in particular the return of the carry trade, but he also believes that investors are at risk of becoming complacent about shorting the US dollar.

“People are extrapolating current conditions into the future. Currencies have a tendency to overshoot, so it is perfectly plausible that the dollar will continue to depreciate against some currencies, notably the euro.

“However, at some point that is going to change and I think people need to be careful in their currency position by saying that the dollar is always going to be a one-way bet.

“We have been talking to clients about how they can hedge their risk, whether they are dollar-based or non-dollar-based. What you don’t want is to lock yourself into a way of thinking which could be damaging if things reverse quite dramatically.”

State Street is enthusiastic about local currency investing in Asia through the bond market and also directly into currencies “because from an economic growth perspective the returns to investors often manifest themselves through currency appreciation rather than necessarily lower yields on credit or equity markets.

“For clients in Europe, the Middle East or North America, Asian currencies are quite interesting because they give you that secular growth story and perhaps are not so highly correlated with other things in the portfolio.”

In terms of commodities, the firm is following short-term trend indicators, which has led it to precious metals, industrial metals and oil, while it has a negative outlook on some soft and agricultural commodities.

“Within the commodity family it is probably best to be active. I don’t think any investor can be completely confident about the deflation/inflation story. So being active, which brings with it this kind of trend-following approach, is probably more appropriate.”

But one thing Lacaille is not prepared to do is to forecast the price of gold. “You have a story which says that the reason gold has gone up so much is because people are nervous about paper currency and think inflation might be around the corner, which is a fair point.

“But you could make that argument whatever the price of gold. Unlike other asset classes figuring out the fundamental value of gold is very difficult.

“We have it as one of the family of things we have in our commodities product. But I am going to have to disappoint you by saying I am not going to forecast the price of gold. It is just too difficult.”

As at September 30, State Street Corporation had US$1.7 trillion in assets under management, including US$181.8 million in the Asia-Pacific region.

  • 22 Nov 2009

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