Employment, lending key to sustained recovery

Jean-Francois Boulier, CEO of Aviva Investors France, made time last week on his return to Europe from Shanghai, where the firm just held a board meeting. He was in a reasonably upbeat mood, thanks both to the growth story in Asia as well as what he sees as signs that Western economies may be able to enjoy a sustained recovery in 2010.

Although his main job is to run Aviva's business in France - the firm's largest on continental Europe, with some €70 billion ($104 billion) of assets under management -- he also enjoys providing guidance to the portfolios. Before joining Aviva two years ago, he was a senior fixed-income fund manager at Credit Agricole Asset Management. One of the attractions of joining Aviva was to manage both equity and bond portfolios.

Although the chances of Western Europe or the United States entering a 'double dip' recession need to be taken seriously, Boulier says monetary authorities have learned well the lessons from the Great Depression. "Politicians were able to apply known medicine to a known illness," he says, and the policy response was global and coordinated.

Aviva France returned to equities in November 2008 with a basic allocation of 51% equities and 49% bonds -- "too early", Boulier admits. "Yes we were down versus our competitors in the first quarter of 2009 but we were taking a long-term view and we were happy to see good news coming out of China by January."

At the start of the year, it was not clear to most in America and Europe that China could serve as the economic engine for the world, along with other governments' monetary easing, and Boulier says the parent insurance company and some clients questioned his team's relatively aggressive stance. "We advised patience, let the stimulus plans work," he says.

The firm increased equities exposure in the spring and in May launched a recovery fund, with the belief that markets were not experiencing a bear-market rally but a true rebound.

Although Boulier's team feels vindicated by that stance, he realises the complexity of the environment heading into 2010. The recession was synchronised thanks to Lehman Brothers' collapse but the recovery will be less so. The bet for equity investors now is whether employment in the US and Europe will be sufficiently strong to support consumption, which in turn would give more companies the confidence to start hiring.

Boulier says he is hopeful that American employment levels will improve. He compares the current situation to the stagnant 1970s and notes today productivity in some sectors, such as technology, is much higher. Therefore the US labour market should be able to recover more quickly.

He also expects central banks to maintain very low interest rates in order to allow commercial and investment banks to continue to restructure. Prolonged ultra-low rates will push more investors out of holding cash, which should help support equity markets, as well as encourage more companies to borrow again.

Boulier's two indicators are employment and the level of bank lending away from blue-chips to smaller companies. If these two factors improve, Boulier will be confident that the recovery is for real, and will tilt more strongly towards equities.

Within fixed income, he is wary of sovereign debt, given the dire fiscal positions of many eurozone governments. He is not shorting eurozone government bonds, but expects their long-term rates will be forced to rise at some point. "For now we are enjoying the steepness of the yield curve."

He says European corporate issuance remains attractive. In Europe a triple-B rated company's bond is still trading 200 basis points above sovereign debt, and offers room for tightening as much as 50-70bps more. In the meantime, credit offers a decent carry. Financial institution debt is often trading at spreads similar to corporates, which makes it attractive. And Boulier believes the risk of above-average default rates has passed.

Aviva France is therefore long on credit and looking to boost its exposure to emerging-market government debt. Despite the obvious excesses of Dubai, big emerging markets such as Brazil and China remain attractive investments, Boulier says. EMD is a new asset class for Aviva France, but is expected to grow.

Within the equities world, Boulier is hopeful that European corporate profitability in 2012 will return to 2007 levels. If you discount today's profits against current stock prices, the expected return on investment is 10.5%. That represents an equity risk premium of 7% against eurozone sovereign debt. That is generous, given the historical average risk premium in Europe is 4-5%.

Currently Aviva France's basic balanced portfolios are tilted 58% into equities, and are trading within a band of 54-58% of allocation. This includes an off-benchmark exposure to Asia and emerging markets.

Boulier says the board meeting in Shanghai reflects the firm's desire to pay more attention to the region. He believes the balanced funds' international benchmarks will change; today they are largely focused on the United States, but will need to add more emerging-market and Asian exposure.

Aviva France has just begun to outsource China equity investments to sub-advisor Edmond de Rothschild Asset Management. Boulier says the firm rejected keeping this in-house via exchange-traded funds. The benefit of using a sub-advisor is that Aviva can gain access to market information, its external managers' views, and so on. Similarly the firm has mandated Credit Agricole Asset Management to sub-advise on Latin American equities.

Today emerging markets comprise just 2% of Aviva France's equities exposure, but Boulier expects this should rise to as much as 10%. This is combined as well with getting such exposures indirectly via European multinationals. Boulier says he has received research from a broker in Paris noting that, among the top 150 biggest stocks in Europe, within five years they will receive one-third of their revenues and half of their profitability growth from emerging markets.