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Carlson: Investors Got Complacent About Emerging Markets

Miriam Sjoblom, CFA

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?

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