All at sea? stay calm, keep still

IT'S not often the politicians of Europe and the US are at the forefront of investment decisions, but doubt and despair about the teetering euro remain the elephant in the room for investors.

Even if the latest meeting of European leaders in Brussels results in a deal, debt-laden nations will be saddled with woes for a generation to come.

It may be some consolation for mum and dad investors to know that even Australia's most talented fund managers also have little idea whether they are going to make money this quarter.

They have moved their portfolios into defensive modes and are waiting for signs that the European Union can resolve its problems and that the US and Chinese economies will grow next year.

"It is an uncertain environment and so the best we can talk about for our clients is to say if you want international equities we will try to protect them as best we can and find companies that can grow over the next three to five years but we cannot give any sort of assurance that in the very short term they will not have declining asset prices, which is our view," portfolio manager at Platinum Asset Management, Kerr Neilson told BusinessDay.

Neilson says the global economy is adjusting to a environment in which it is much harder to get credit but in which many economies are still addicted to credit for expansion.

It will be a "sharp switch to 'reverse' from 'forward"', he says.

Neilson is renowned for his contrarian techniques and ability to find a growing company anywhere in the world.

While he is not optimistic for the short term, he believes a lot of shares already have the bad news priced into them. He says there will be "periodic outbursts of optimism" and investors can still make money if they find companies which will be stronger and bigger in three years.

"Most of us tend to think in Western-centric parameters but, if you really do see countries like China, India, Brazil and Russia easing back on monetary tightening, you can get some surprises. They are big economies in their own right now," Neilson says.

While it is tempting to think that everything will get worse, these economies may surprise because "politicians in China are just as sensitive to unemployment as [politicians] are in the West", he says.

This theory is supported by the action the People's Bank of China took last week when it reduced the reserve requirement ratios for domestic banks. This lowers the amount of capital that banks have to hold and increases their lending ability. The St George economics team estimates this could release $US55 billion ($A53.6 billion) into the financial system.

Neilson says the turbulence has not changed his investment method, but it has affected his willingness to buy shares just because the prices are low.

He says his portfolio is "in between being highly defensive and towards defensive rather than being massively optimistic and aggressive".

One concern shared among fund managers is that the governments of developing countries will overreact to rising inflation and try to slow down their economies.

While Europe is creating the turbulence, it is on China's boat that Australia's fortunes now sail. Iron ore sales to China account for 20 per cent of Australia's export income and coking coal a further 15 per cent.

The equities team at Bank of America Merrill Lynch is tracking the Chinese economy as closely as it is the woes of Europe jitters in the euro zone can be endured, but a slowdown in China threatens the resources boom on which the Australian economy relies.

The head of equity strategy at Bank of America Merrill Lynch, Tim Rocks, says he expects production in China will be relatively disappointing over the coming months and quarters.

"The most important single index, the one that matters at the moment, is property sales in China. What we have seen is a squeeze on the financing going to the property developers in China. They have got to get cash from somewhere to continue building, and that is either from property sales or from credit," Rock says.

"If property sales continue to go down, then they will be forced to curtail development, with obvious implications for steel demand, which will filter through to Australian share prices."

Rock says Chinese property prices are more important to the Australian economy than China's gross domestic product (GDP) because of the amount of Australian iron ore and coking coal that goes into infrastructure, apartments and houses.

"If you get a shock in steel, then you will get a resulting shock through to the commodities that matter most to Australia," he says.

Events in China and the US are also on the radar of Mark Delaney, chief investments officer at Australian Super, who manages $42 billion of superannuation.

He says expectations for global growth and commodity prices have been downgraded for 2012 because of unresolved debt problems in Europe and concerns that house prices in China will keep drifting lower.

The Chinese central bank's decision to release more funds into the market was a good start towards easing monetary policy, but they "had tightened monetary policy fairly tightly" and the housing oversupply could take a year to work off.

Delaney also believes that Europe's economic recovery will depend on the US government extending payroll tax cuts beyond a December 31 deadline. If they are not extended, the tax increase could wipe out 2 per cent of US GDP growth in 2012, which would erase the 2 per cent growth seen in 2011.

"The economy will be better if [the tax cuts] are extended," Delaney says.

As an indication of risk aversion, Delaney says he currently has 6 per cent of the balanced portfolio, or $2 billion, in cash (90-day bank bills). This is lower than the 8 per cent cash at the height of the financial crisis, but much higher than 2 per cent allocation when the market was booming in 2006.

Australian Super's balanced fund saw returns of minus 3.1 per cent between July 1 and November 30, compared with a 10.2 per cent return in 2010-11. The highest returns in the six months were from diversified fixed interest and international fixed interest, which were up 5.05 per cent and 5.03 per cent respectively.

The head of retail equities at RBS Morgans, Tony Dennis, likens the current mood in the markets to being on a boat.

"Everyone [is] right over on the negative side of the sentiment boat and we are almost leaning over the rails," he says.

"A few brave or foolish people will initially get optimistic and start to change the balance, then everyone will eventually rush back over to the positive side of the boat," Dennis says.

Inevitably some pivotal event will turn sentiment on its head but, unfortunately, Dennis says, "we do not really know what the event will be until we see it".

"I have never in my time in broking seen a top-down issue dominate an entire market the way the European crisis is at the moment," Dennis says. "I have got no doubt that a solution [to the European crisis] will be reached, it is pretty hard when there are 17 countries involved, but they will get there."

He says that co-ordinated central bank action is the kind of event that can turn a market but that the gloom is unlikely to lift until the money starts flowing around.

The debt crisis in Europe has been going on so long now that it has become a blur of new prime ministers and workers protesting against austerity measures.

Some alarming events stand out, such as the Bundesbank's failure to sell ?6 billion ($A7.8 billion) worth of 20-year bonds last week (it was only able to sell ?3.64 billion worth of the total).

That was the first sign that Germany's bonds were being contaminated by fears that other European countries would default. Since then European governments have been able to sell about ?17.5 billion worth of bonds, but at unsustainably high interest rates.

Debt market consultancy ADCM managing director Philip Bayley says the problem is that politicians have not yet made the decisions that would give investors the certainty they need to lend money at normal rates.

"There are no obvious indicators as to when this is going to turn around. It is a slow-motion train wreck we all know what is coming but we have just got to let the process through," he says.

Bayley says many fund managers are sitting on unusually high cash levels and will only invest if they are "well and truly over-rewarded for the risk that they were willing to take on board".

"As an example, the covered bonds issued last week by ANZ and Westpac. The spreads were much wider than expected. [It was] a good deal for the investors because the banks paid more than they had to pay at the height of the global financial crisis," he says.

Corporations, governments and households will struggle to grow if they cannot borrow money, which is why the hexalateral bank action was so important.

Shifting the global economy from its credit-dependency onto something more sustainable will produce some unexpected opportunities, according to the head of fixed income in Australia at Aberdeen Asset Management, Victor Rodriguez.

He believes investors may soon find it more profitable to buy bonds in a company lend money to the company than to buy shares.

Europe's economic growth is expected to be "anaemic" for many years, and lending to well-run companies with low debt levels could be more attractive than owning equities, because earnings are likely to disappoint in a world with low growth, Rodriguez explains.

He has about two-thirds of the $15 billion he manages invested in Australian federal and state debt, with the rest in corporate debt. He says his portfolio is at present in a defensive mode, which means it is invested in short-term government bonds.

"Once there is clear sense from the European Central Bank and government leaders that there is a commitment to the euro, and that peripheral countries like Italy and Spain will not default, then we will be able to have more confidence that a systemic banking crisis is a remote possibility. At the moment it is a material possibility," Rodriguez says.

There is one exception though, according to Merrill Lynch's Australian supremo Craig Drummond. He points to shares in the big four banks, which have provided investors with a 10 per cent yield in the past year. "I defy anyone, in the current environment, to find a 10 per cent yield, fully franked. With interest rates on the way down, bank shares are one place I would be looking to."

In the meantime, those with shares should avoid selling, according to chief investment officer at AXA, Mark Dutton.

He says depressed markets are only problematic for forced sellers because it turns a market weakness into a permanent capital loss.

"There are a lot of difficult and unpredictable events that are going on at the moment, so the question for investors is, how do you deal with that?"

He suggests investors line their assets up with their needs cash for the short term and leaving long-term investments alone.

"I think this one will be more of a grind. We are not talking about kick-starting an economic recovery, the problem is with the debt overhang and there is no magic solution to large amounts of debt," he says.