Safety first, as fund managers turn defensive

There are no quick solutions to the Western world's debt overhang, writes Lucy Battersby.

There are no quick solutions to the Western world's debt overhang, writes Lucy Battersby.

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.

It may be some consolation for mum and dad investors to know that even Australia's most talented fund managers 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 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," Kerr Neilson, a portfolio manager at Platinum Asset Management, told Weekend Business.

Neilson says the global economy is adjusting to a environment where it is much harder to get credit, but where 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 in the short term, he believes a lot of shares have already had 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 very significant economies in their own right now," Neilson says.

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

Neilson says the turbulence has not changed his investment method, but 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 the success of China on which Australia's fortunes now depend. 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 Merrill Lynch Australia 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 Merrill, Tim Rocks, said he expects production in China will be 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've got to get cash from somewhere to continue building, and that is either from property sales or from credit.

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

He said Chinese property prices were more important to the Australian economy than China's gross domestic product 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, the chief investments officer at AustralianSuper, who manages $42 billion of superannuation.

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

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

The head of retail equities at RBS Morgans, Tony Dennis, likens the 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 would eventually rush back over to the positive side of the boat.

"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. 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 said the 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 managing director at the debt market consultant ADCM, Philip Bayley, said the problem is politicians have not yet made the decisions that would give investors the certainty they need to lend money at normal rates.

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

"As an example, [with] the covered bonds issued last week by the 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.

Shares in the Australian banks are also the one exception on the equities front, says Merrill Lynch's Australian chief, Craig Drummond, 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," he says. "With interest rates on the way down, bank shares are one place I would be looking, too."

In the meantime, those with shares should avoid selling, according to the chief investment officer at AXA, Mark Dutton. He says depressed markets were only problematic for forced sellers because it turned a market weakness into a permanent capital loss.

He suggested investors lined 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," he said. "We are not talking about kickstarting an economic recovery. The problem is with the debt overhang and there is no magic solution to large amounts of debt."

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