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Carlson: Investors Got Complacent About Emerging Markets

Morningstar's 2011 Fixed-Income Manager of the Year John Carlson outlines his strategy for Fidelity New Markets Income going into last year and what he expects for 2012 and beyond.


Miriam Sjoblom: Hi, I am Miriam Sjoblom, associate director of fund analysis at Morningstar. I am here today with John Carlson, who is the portfolio manager of Fidelity New Markets Income and winner of our Fixed-Income Manager of the Year Award for 2011.

Thanks for joining us John, and congratulations.

John Carlson: Well, thank you Miriam. It's really a great honor to win, and I want to thank everybody and part of the global fixed-income team at Fidelity that has helped me get here. So, thank you.

Sjoblom: You've obviously had a very long distinguished career in emerging markets, but let's talk a little bit more about 2011 and why this was a good year for the fund. Just coming into the year, I think, it seemed like a lot of bond managers were more concerned about a recovery in the economy, inflation, and rising interest rates. But you had a different take, and so maybe you can walk us through what your outlook was coming into 2011?

Carlson: Yeah. Sure, I'd be happy to. I came into 2011, and what I saw was a crisis of confidence developing. And I saw a lot of complacency on the emerging-markets side. We were being labeled the new safe heaven; nothing could go wrong. I saw a lot of flows into corporate bonds, and into local currency bonds. And then, I saw people being very negative on the dollar and just this almost obsession with U.S. rates backing up in inflation. And so when I looked at the analysis, I did it two ways. First I looked at the risk-reward, and I said, "OK, if I am wrong…" and I was a deflationist, disinflation. I looked at fiscal austerity, high unemployment, and low capacity utilization rates. I thought, OK, where are bonds going to go from here?

So, if they were right and we got this back up, I thought maybe 25 basis points would be a little sell-off. But if I were right, there'd be this huge rally in the long end of the curve, and that's exactly what developed. So, when I looked at what was going on, I said the risk reward was if you weren't in the long end of the bonds and you're overweight corporates and local currency, then there was much more risk.

Sjoblom: Let's talk specifically about what some of the big moves that you made in the portfolio were. Just in general, it was a really good year for hard-currency-denominated emerging-markets debt versus local-currency because a lot of the local emerging-markets currencies got really hurt. But beyond that, there were things that you were doing that really did help the returns and, maybe you can walk us through that.

Carlson: Yeah. I mean, I think, there's couple of things. I came into the year with the view I just talked about, where I saw too much complacency in emerging markets and kind of denial both in the U.S. that we could ever lose our investment-grade rating and denial that Greece and Europe was in trouble. So, coupling that with my disinflationary view, I extended duration in the portfolio. So, I bought the longer end of the higher-grade credits in Indonesia, Philippines, Mexico, and Columbia. At the same time, in the spring when credit spreads for corporate bonds got very tight, I dropped the percentage from about 20% to about 5% in corporates.

And between all the modeling we do on the research side at Fidelity and in my own travels, I felt local currency was both overvalued in a crowded trade. So, we got out of corporates, eliminated local currency for the most part, and extended duration. And coupling that with good credit selection and great execution by the trading desk, led to the year we had. But it's really a combination of doing top-down macro work and the, doing a lot of on-the-ground kicking the tires with the research team, and then, being able to execute that strategy through the trading desk.

Sjoblom: So, looking ahead to 2012, now after we've had all this volatility and a tough year for local currencies, what's the mood like in the market? How does it differ from the start of the year? And what do you think is the strategy for success going forward?


Carlson: Hopefully, this is the strategy for success. I believe it's going to be a tug-of-war still. On the one hand, you have the central banks easing the monetary reflation. They're doing as much as they can, and I applaud that. But on the other hand, we have these structural issues, such as fiscal austerity, high unemployment, low capacity utilization, and deleveraging, and I think all of those are bond-bullish. So, in the beginning of the year, I think we have more the same, but I think the market participants are really tired. There is a sense of exhaustion in the markets, and you see reform fatigue in the streets as that spills out. Whether it's in Moscow, whether it's on Wall Street, or in Egypt, we are seeing reform fatigue. So, I think it's going to be another year. But I think at some point in the year we are going to go beyond that tipping point, and the air will clear. And we'll see that a lot of things that we've worried about perhaps are worth worrying about, but not to the degree that they have been in the past.

Sjoblom: Obviously, sovereign credit is a big focus of your analysis, sovereign credit analysis. And can you talk little bit about looking forward, where you see some of the dangers and where you see some of the opportunities?

Carlson: Well, I think the year 2012 and beyond are going to be years of winners and losers. And you can see that starting to play out in the marketplace now. I mean, the winners, I think, will be those credits, those sovereigns, that really took advantage of the last 10 years when there was really kind of a sea of calm around emerging markets and the global winds were at their back. They have reduced debt/gross domestic product and have really attracted foreign direct investment. Others will beset by either local problems, geopolitical problems, and there'll be much more of a fallout in those credits.

Sjoblom: Can you talk specifically about any?

Carlson: Sure. I thought you might want the particulars. I very much like Latin America still. I like Colombia, Peru, and Mexico, again, I think, are all doing the right things on the policy side. I think they have really good demographics, attracting a lot of foreign direct investment. In Asia, I like both Indonesia and the Philippines. The whole Middle East region, I think, is going to be much more problematic, so they require a lot of credit work. So I'd probably leave it at that for now. Those in Latin America and in Asia I think will be the first to stay healthy and take advantage of this opportunity to come back as the global economy picks up.

Sjoblom: You started off talking about coming into 2011 and the complacency about the thinking of emerging markets as the new safe haven. But looking longer term at the developments, seeing an improvement in the quality and the balance sheets of some of these countries, and convergence with the investment-grade markets, is there something to this story longer term, this development? And how should it affect how investors think about investing in emerging-markets debt?

Carlson: Well, I think, the structural story is intact for emerging markets. They have the unleveraged balance sheets. They have healthy domestic markets. They've done all the right things in terms of putting institutions in place. So this can carry forward over the longer period, and I think shareholders should look for an opportunity. You are playing growth through these markets. On the debt side, you are also getting a return on your capital investment. I think income is going to be a very big part of why people are looking at these markets. So, I think the growth story continues. You're getting paid while you wait, as I say, you are getting those coupon payments, which I think are very important to basically an aging demographic, and I think shareholders should be looking to have some exposure to this asset class and look for a manager that has a lot of experience and a research team to support that.

Sjoblom: Another question on that front. At local currency funds, there have just been a bunch of new launches in the retail market, and they've gotten a lot of retail flows. Some might criticize how a dollar-focused fund is a bit stodgy in this environment given how things are developing. What would be your thoughts in that?

Carlson: Yes. I am a big fan of local currency. I use it in this fund, but I have a limit on it. So, keeping the shareholder in mind at all times, if one reads the prospectus, this prospectus clearly states this is a dollar-sovereign or quasi-sovereign fund. So, I keep two thirds of the portfolio in those types of securities, and I use corporate bonds, convertible bonds, a little bit of equity, and local currency from time-to-time when I see real value. So, I think, this fund is way too diversified, but in keeping with what the shareholders are buying and what they are reading in the prospectus, despite where the markets are, there's no style drift, and I stay in the dollar markets.

Sjoblom: And this year has certainly shown the benefits of sticking with that style. Thank you so much for joining us, John. I appreciate you being here and sharing your thoughts and congratulations.

Carlson: Thank you, Miriam.

Miriam Sjoblom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.