Shared growth: Developed, emerging markets look to rise of global middle class
Michael L. Avery Ryan Caldwell
Co-Portfolio Manager Co-Portfolio Manager
Waddell & Reed Asset Strategy Fund – March 2012
The global market environment changed early in 2012, in part as a result of actions taken late in 2011 toward resolving Europe’s sovereign debt crisis. While that crisis continues to cause concern, equity investors are responding positively to improving economic indicators around the world. Mike Avery and Ryan Caldwell, co-portfolio managers of the Waddell & Reed Advisors Asset Strategy Fund, describe their key theme in managing the portfolio and review several issues facing the markets now.
Continuing our emerging market theme
When we look at the next three to five years, we continue to think the main drivers of global economic growth will be centered on the expanding middle-class consumer populations in emerging-market countries. We thus have maintained the key long-term theme that drives our investment decisions for the Fund. The overarching intent is to participate in emerging market growth as those societies develop and increase per capita consumption, so we seek investment exposure to the countries where consumers are increasing the complexity and value of the goods they consume.
We are looking to invest in companies that may benefit from these changing preferences in goods and services among emerging-market consumers. But it’s important to add that we are not advocating broad exposure to emerging markets generally. We think it’s a good time to be more selective, with a combination of investments in companies located in the emerging countries and companies in the developed world that participate in those markets. For example, we invested in European industrial and cyclical stocks in 2011 — at a time they generally were not popular — in part because of their sales into emerging markets. Within the emerging markets, the largest country exposure for the Fund remains in China.
A review of the portfolio offers some examples of holdings that illustrate our key theme:
- Global gaming1 — Holdings include Wynn Resorts and Sands China, along with a small position in Las Vegas Sands. The Macau and Singapore gaming markets continue to grow very rapidly, although we expect that to slow slightly this year.
- Global autos2 — Volkswagen, BMW and Hyundai are taking market share from competitors. Volkswagen has strong market share in the emerging world, including China, and is growing in South America and the Middle East. In the U.S., the Passat model and the Audi make (owned by Volkswagen) also are increasing market share.
- Luxury goods3 — Richemont and Prada are examples of companies benefiting from the fact that high-end consumers continue to spend, even in a slower global economy. Luxury spending in China continues to grow, both at home and as those consumers travel across Europe and North American. In fact, it has been estimated that Chinese travelers sometimes account for as much as half of luxury goods sales in Europe.
We continue to emphasize equities in the Fund, based on several factors. In addition to our view of the opportunities they offer through the emerging-market theme, we think equities remain inexpensive relative to bonds and reflect a more accurate pricing of risk. We also have continued to own gold bullion in the Fund, and its role remains as it has for an extended period: It serves as a cushion — a hedge — against relatively weak and often volatile fiat currencies throughout the developed world. We believe there is a risk that aggressive monetary easing by policy makers could cause mispricing of assets, and consider the gold position a means to manage the related risks.
Tracking economic and sovereign debt concerns
In our view, the U.S. is in the early stages of a new business cycle and we expect continued expansion in corporate capital spending. Many companies have large cash holdings on their balance sheets and are generating high levels of cash flow. That situation is one of the key factors leading them to increase capital expenditures. We find that the key spending decision for corporate leaders rests on their outlooks for their businesses. In our contacts with such leaders, they tend to be confident about their own businesses but remain concerned about the economy overall.
Consumer spending globally looks to us to be on track, driven by high-end consumers. We expect to see spending begin to spread to other consumers as job growth resumes, which will require corporate management teams to have more confidence in the economy. High unemployment and a lack of wage growth have dampened spending at lower income levels, and we expect to see spending improve as these economic factors improve.
The ongoing sovereign debt crisis in Europe has temporarily faded from the top of mind for many investors. Two rounds of long-term refinancing operations (LTRO) and the success of the Greek debt swap have allowed investors to focus on other issues. Fundamentally little has changed; a number of countries still have unmanageable debt levels and will be forced to implement demanding austerity programs. Although Europe’s debt crisis has faded into the background, it is not resolved.
There also are sovereign debt issues to be confronted in Japan and the U.S. Why those two? Beginning in the first quarter of this year, Japan and the U.S. each must refinance about 4 percent of their respective outstanding sovereign debt loads — a significant amount for each country.
Managing for the future
We remain concerned about the ongoing global credit cycle and the long-term impact of policy decisions in primarily the developed world. Faced with slow economic growth, many of these countries are using aggressive monetary policy as a means to recover from the deep hole of the global recession. For example, the European Central Bank has conducted two LTROs because of the sovereign debt crisis; and the U.S. Federal Reserve is keeping interest rates very low and has said it will continue to do so into 2014.
The global money supply has increased steadily and rapidly since 2008. That money — which we can think of as liquidity for markets — has mostly been trapped on bank balance sheets. In addition to general spending, we think it is likely that investment in riskier assets will continue around the world.
Should much of the increased supply of money begin flowing into the economy, it has the potential to create future inflation. The potential for inflation then raises a concern about whether central banks will have the ability to manage inflationary pressures in a timely way, mainly because of the negative impact inflation expectations can have on credit prices. While credit markets continue to attract investors, we still believe equities offer attractive valuations now and provide the potential to generate returns that will help investors outpace future inflation.
In summary, we think we still are in the credit crisis that began in 2008. We remain concerned that key issues have not been resolved, despite the positive reactions of global markets so far this year, and believe that global leaders at some point will be forced to address the same issues all over again. However, those leaders then will face even larger balance sheets at central banks and financial institutions, which may be in trouble once again. We think the Fund’s current focus on equities positions it appropriately for now, and we continue to keep a close eye on events.
1As of 12/31/211, Wynn Resorts Limited was 6.2 percent of net assets in the Fund, Sands China Ltd. was 3.3 percent and Las Vegas Sands, Inc., was 0.4 percent.
2As of 12/31/11, Volkswagen AG was 3.3 percent of net assets in the Fund, Bayerische Motoren Werke AG (BMW) was 1.8 percent and Hyundai Motor Company was 2.0 percent.
3As of 12/31/11, Compagnie Financiere Richemont S.A. was 2.8 percent of net assets in the Fund and Prada S.p.A was 0.9 percent.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through March 19, 2012, and are subject to change due to market conditions or other factors.
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