EQUITIES: The swinging pendulum

Pocket watchWill stronger developed markets bring emerging markets back from the depths? Have US equity prices shot up to dangerous levels? Investment managers across different sectors answer Funds Europe's questions. Edited by Nick Fitzpatrick.

The context for equity markets at the start of 2013 is quite straightforward from a high level view. The pendulum appears to have swung back from emerging markets to developed markets in terms of where the opportunity for growth is, at least in the near term.

Factors behind this swing include:  a recovering Eurozone that even includes the hardest-hit countries of Spain, Portugal and Greece; current account deficits in the emerging markets; and, of course, the not quite so invisible hand of Federal Reserve tapering.

“The crises that the Eurozone saw from 2010 to 2012 are unlikely to be replayed in 2014. The agenda has moved on: the Greek exit from the Eurozone is now largely forgotten,” says Jeremy Lodwick, of Mirabaud Asset Management.

First off in our poll is Greg Bennett of Argonaut Capital Partners talking about Europe ex-UK. He is optimistic for earnings surprises, even at the banks of some of the worst-hit countries.

And what about the US? Have equity prices become dangerous?

The fundamentals are sound, presenting no problems for an entry point, says Jay Feeney at Robeco Boston Partners.

However, Amundi’s global head of equities, Romain Boscher, says the pre-eminence of the US economy leads people to underestimate its risk and that tapering of quantitative easing could weigh on price/earnings ratios.

The following comments from asset managers were collected in mid-January.



Which European sectors are you most optimistic for?
We are particularly optimistic on the earnings for those sectors most exposed to the domestic European economy. Top of this list would be the banking sector where we see scope for significant positive earnings surprises, driven primarily by a fall in provisioning charges as a result of the pick-up in economic growth.

However, stock selection is crucial, especially in terms of capital ratios and the extent of provisioning. Interestingly we find that some of the most compelling opportunities are in peripheral Europe, in countries such as Italy and Greece, where the regulators have been particularly strict, and hence many of these banks have both surplus capital and high levels of provisioning. Good examples include Intesa Sanpaolo (Italy) and Piraeus Bank (Greece).

What piece of good news relevant for European equities has most captured your attention in recent days?
The January European manufacturing PMIs [purchasing managers index]. Of particular note were those for the peripheral countries – Italy, Spain, Portugal, Ireland and Greece – which all came in above 50, signifying an expansion in activity. Greece was the only country below 50 at 49.6, but given where its economy has been, this is an extremely positive result. Importantly, these PMIs add further evidence to support the belief that the peripheral countries will emerge from recession in 2014. Indeed expectations are that all peripheral countries will post positive GDP growth rates this year. This is exciting news for European equity investors as the transition from recession to growth can be a sweet spot as it is often associated with positive earnings surprises and upgrades.  In this phase, domestically orientated cyclical stocks should be the prime beneficiaries.

This is the antithesis of that which has dominated the majority of European equity investing over the last few years.



Are Eurozone corporates in good enough health to validate the idea of a recovery in the region?
European companies are, for the most part, in robust good health. The corporate sector was not the root cause of Europe’s economic and political problems. The responsibility for the Eurozone crisis and the subsequent recession lies with profligate national governments in Europe and the inadequate governance structures for the single currency. These issues are being addressed but the corporate sector is largely uninvolved.

A healthy corporate sector is a great thing to have, but the real recovery depends on government-led reforms – less tax, more employment flexibility, less regulation, smarter austerity measures. There is not much progress in this direction so we do not anticipate much of a recovery in 2014.

What are the biggest risk for Eurozone equities?
The biggest risk to Eurozone equities, in our view, is quite simple and quite fundamental. Valuations are riding high after two years of vintage high teens returns. Earnings need to grow in 2014 for the high multiples to be sustained. We see little scope for multiple expansion. If earnings disappoint, markets will correct downwards – not catastrophically so, in our view, but enough to jeopardise the continuation of the bull market that has prevailed since late 2011. So the biggest risk is the relatively mundane one of a mismatch between investors’ earnings expectations and the ability of companies to deliver on those expectations.

Bull markets make investors complacent and overly optimistic – corrections, painfully, bring us back to reality.



Is the present level of US equity prices a dangerous one?
No. Equities look more or less fair at 15-16x 2014 estimated S&P 500 earnings per share of $115. Against a backdrop of improving economic momentum in the US, we don’t think this entry point exposes investors to significant downside risk outside the scope that equity investors normally must assume.  

The weakening situations in various emerging economies will create more volatility for equity prices, but fundamentals for US equities seem pretty solid to us. We would say that large companies are priced somewhat more favorably than smaller stocks and that within small cap we see signs of exuberance in the pricing of some speculative businesses. US equities still look like they embody a 7-9% total return potential.

What are the key risks for the asset class and how should investors manage them?
The major “known unknown” at the moment is the extent to which emerging markets continue their slide and, if they do, how significant and long lasting the spillover effects will be. The best way for any investor to manage risk, which we define as risk of permanent loss of capital, is through application of time-tested rules: invest in stocks with valuations that embody a margin of safety; diversify one’s holdings; maintain a high-quality bias and don’t try to “catch a falling knife” – that is, double down on stocks with deteriorating business trends and falling prices.



Are the risks that affect US equities understated?
The pre-eminence of the US economy leads investors to underestimate US risk. For instance, there have been 17 budget shutdowns and the debt ceiling had to be raised 75 times in the US in recent decades and, in terms of market impact, the consequences have been considerably less significant than those witnessed when governance issues were raised in Europe.

Even if we are still quite confident on US equities, within the developed market universe the US is our least favourite choice for the 2014 trifecta, behind Europe and Japan. Indeed, US margins are toppish and QE [quantitative easing] tapering could weigh on price/earnings (PE) ratios. In other words, we structurally prefer markets where central banks are still intervening, such as Japan and the Eurozone.

Do you expect that excessive speculation is, or will become, a significant feature of US market activity?
I’m cautiously optimistic but we are at a tipping point, if not a turning point, where the market will start to be driven by EPS [earnings per share] and not PEs. This means that the current rally is only sustainable if we see earnings growth, which, based on our global growth expectations, we think will be the case.

For the first time in a while we have all four major regions pulling in the same direction.

To be fair, in parallel, we must also bear in mind that liquidity is still abundant, with a global monetary base that is growing at its fastest ever pace even taking US tapering into consideration. This means that an alternative scenario to that of a smooth bullish recovery in the US is one where risk asset appreciation, including equities, turns into a bubble. Under such a scenario, boom and bust would be difficult to avoid because, contrary to the position in Europe or emerging markets, today there is little room for further multiple expansion in US equities.



How is your portfolio positioned?
We find attractive pockets of mispricing in a number of sectors. As well as unloved US tech stocks, our biggest sector position is in healthcare, where strong earnings growth is accompanied by attractive valuations, because of ongoing concern about the impacts of patent expiries. We also have significant positions in financials, notably in emerging markets, where there are truly compelling valuations, combined with strong structural growth.

Are risks in emerging markets overstated?
Clearly, emerging markets have been the worst performing region over 2013, and one where we have been underweight over the year, but finish the year in line. Valuations are no longer at a premium to developed markets, and we expect that the worst of the negative economic growth surprises from emerging market countries are behind us, but we still think investors need to be selective. In particular, we’d highlight the following.

First, current account deficits, because in an environment of slowing liquidity growth, countries which have been relying on foreign capital inflows – like Brazil, India, Turkey, Indonesia – are vulnerable.

Also, political unrest, because there are always risks to political stability as populations become richer and better educated and investors need to be selective and include a consideration of these factors in their governance screening.

And debt, but only an issue for China, due to lack of clarity about local government debts and commitments.



How is your portfolio positioned?
Our value focus means that we have recently seen more opportunities in emerging markets, where outflows have put downward pressure on stock prices and where multiples contracted last year unlike in developed markets. Valuations are attractive and we have bought into companies such as Tata Motors in India, Vale and Gafisa in Brazil and China Communications. We currently have 31% of the portfolio directly invested in emerging markets, which is more than double the weight in the index.

Another noticeable feature is that we have 30% invested in a limited number of US companies, versus 50% for the benchmark, as we struggle to find value outside of financials or information technology.
Are present price levels of developed market stocks dangerous?
Although the US market generally is arguably expensive, some of our largest conviction ideas are US companies, a couple of which – Citigroup and AIG – we believe contain significant upside.

The danger is perhaps greatest for passive investors who are most exposed to any correction. We believe that our focus on quality companies which are trading below their intrinsic value offers downside protection as well as the potential for rewards when the triggers we have identified for a re-rating are realised.

Arguably, it is more dangerous to generalise about developed and emerging markets, particularly given the convergence we are increasingly seeing. At Skagen we tend to focus on where a company has its operations or trading exposure, as we believe this is more important than where it is listed. Our largest position, Samsung Electronics, for example, is considered an emerging market company because of its Korean listing even though its fortunes are largely determined by the decisions of developed market consumers.



How is your portfolio positioned?
We are finding attractive opportunities across sectors and regions. In the tech sector, we expect an increase in corporate spending will lead to a recovery in storage and enterprise spending. We expect an increase in interest rates from these historically low rates. Our portfolio is positioned to take advantage of this trend in the financials sector, favouring exchange stocks and asset managers versus real estate and other interest-sensitive names.

Are present levels of developed market stocks dangerous?
Key leading indicators of the global cycle have continued to climb. And sources of growth have become more broadly based across sectors and economies. We believe we are at the first stages of growth where the global economy converges towards recovery.

Against this backdrop we remain confident that global equity markets can continue to perform. Global financial conditions remain accommodative, pent-up demand is starting to lift consumer spending in the US, and December’s budget agreement more than halves the degree of fiscal restraint in the US in 2014 versus 2013. While uneven, the data suggest the Eurozone recovery remains intact.

Underpinned by still-strong credit growth, rising production and exports, China’s growth is somewhat stronger than we expected. In many emerging economies, export orders are beginning to rise. There remain important risks to the outlook. The weaker-than-expected US December employment report may have been distorted by poor weather, but the continued erosion of the participation rate is discouraging. Political and financial vulnerabilities in selected emerging economies in the meantime also pose potential risks, particularly if buoyant global financial markets correct.



After an exceptional year in 2013, where are small caps now in the business cycle?
Unlike 2013, where valuation change was significant, 2014 is likely to be a year of more moderate total returns where earnings growth and upgrades dominate.

There is still plenty of cyclical upside in earnings to come from a recovery in investment-related spend where activity levels are well below the norms.

Although UK domestic cyclical stocks have caught a lot of attention this year, with early upgrades in the house builders, UK economic activity in many sectors remains depressed relative to previous norms.

We have only seen one half-year of results evidence supporting a broadening out of the growth to the wider economy. Overall, housing transactions, consumer durable goods spend and commercial construction have all just started to pick up.

Internationally, recovery in corporate confidence and investment intentions in western developed markets indicate that GDP recovery is likely to lead to increased corporate spend. This would boost spend in areas such as advertising, recruitment, branch expansion and investment in capital equipment. Returns will also be enhanced through corporate strategy.

What are some of the biggest risks to the small-cap sector at present?
It is important for the small-cap sector that interest rate expectations, as expressed in bond yields and money markets, do not rise too quickly. Therefore central bank policy will continue to be monitored closely, particularly Federal Reserve tapering of bond purchases, macro prudential commentary from the Bank of England and how interest rate expectations move as unemployment falls. With valuations at higher levels, the market will punish earnings downgrades more.


As developed markets recover, can we expect emerging markets to follow?
As developed markets recover, emerging markets may follow, though only reluctantly. It is the consumer spending binge in developed markets which sparked the growth of huge export industries and earnings in GEMs [global emerging markets], and unless labour force participation resumes its earlier buoyancy, export accounts of emerging markets will not provide the kicker they once did. If Wall

Street’s or Mayfair’s enthusiasm spreads to Main Street, then a new cycle of consumption might commence, attracting exports from emerging markets, but this is not our base case.

Against this potential tailwind is the headwind of higher rates in the West, sucking capital out of emerging markets. Given, however, that deflation seems a greater risk than inflation at present, this also seems to be a distant prospect. Added to this is the renewed global focus on efficiency and automation, which will prevent any wage price spiral from occurring in the short to medium term, and perhaps long-term. Thus, although we expect no export-led boom, we also do not fear the taper. Domestic economic management is key in emerging markets, along with execution of clear strategies at the company level.

Should the MINT – Mexico, Indonesia, Nigeria and Turkey – countries feature strongly in portfolios?
The MINT countries have little in common with each other, other than forming a refreshing acronym. Inexperienced at acronymic analysis – our early attempts led us to favour Russia, Ukraine, Brazil, Belarus, India, South Africa, and Hungary, but that turned out to be RUBBISH – we rely on micro and macro fundamentals for our investment approach, which leads us to favour the cheaper markets in our area: China, Russia, Korea and, potentially, Turkey.


What explains the fall in emerging market equities in the past year other than tapering?
Emerging market equities faced a few headwinds in 2013 as macro-driven events dominated investor sentiment. The Fed’s tapering dominated the headlines in the first half of the year and became the rationale for underperformance. This is only partly justified, in our view.

The tapering talk coincided with sharp depreciations in the currencies of countries with macroeconomic imbalances and thus explains a large part of the negative US dollar-based returns of markets like Turkey, Indonesia, and Brazil, but on balance emerging countries responded with appropriate macroeconomic policies.

Improved macroeconomic management has been one of the pillars of emerging markets growth. The fundamentals underlying emerging market equities remain positive in the long run but faced some significant headwinds during the year.

Are emerging market risks overstated?
Yes. After a difficult year of returns, we believe many emerging market equities have been oversold, as fundamentals continue to strengthen. We expect earnings growth to recover as the global growth cycle picks up. This is beneficial to large-cap global cyclicals, which often derive a majority of their revenues overseas. Valuations in emerging equities are trading at more than 40% discount to developed markets, yet benefit from strong domestic fundamentals, growing consumer demand and a recovery in foreign demand for products and services.

As valuations become too cheap to ignore, we expect investors to return in earnest to the asset class.

China has taken significant steps to support its growth cycle, get inflation under control and reform its financial system.

©2014 funds europe

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