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Magazine Issues » November 2015

GLOBAL EQUITIES: Summer madness

Crowded beachFederal Reserve policy is confusing global equity investors, who ditched emerging markets in the summer but are also uncertain about the US, writes Hugo Cox. Meanwhile, Europe may still hold value.

The summer’s globaL equity market rout started in emerging markets – and it’s there that the impact has left the deepest mark. “As bad as the 2013 taper tantrum” was how the Institute of International Finance (IFF) summed up the flood of investor withdrawals from emerging market assets. 

This left fund investors underweight in emerging market stocks and fixed income relative to average levels since 2008. Euro area and US investors led the purge and flows out of Chinese equities were the steepest. 

Worryingly, institutional investors – a group that has proved less skittish than retail investors in the recent past – exited emerging markets in large numbers. “Institutional selling has been substantial and much larger than that seen during the taper tantrum,” says Emre Tiftik, financial economist at IIF in New York. 

The fact that they have lately been squeezed into a narrower range of investment options is one reason these investors were spooked, says Matthew Beesley, head of global equities at Henderson Global Investors in London. “Market participants have crowded into a few successful trades, a trend that [the US Federal Reserve] has encouraged with years of low interest rates.” 

Broadly speaking, years of support for prices from quantitative easing and the more recent anticipation of a US rate rise pushed investors steadily back into US equities and prompted them to go underweight in emerging market equities (which have, notes Beesley, underperformed developed market equities for the past
three years). 

But much of the appeal of these trades reversed over the summer, according to Beesley, notably following China’s loosening of the yuan-dollar peg on June 20. 

The dollar fell more than 3% on a trade-weighted basis between August and mid-October – and the S&P 500 lost 5.4% over the same time, falling more than double that during the worst days of August. 

Concerns rippled through to Japan – a large exporter to Asia – and to Germany, another large exporter. Ripples also reached the broader Eurozone.

Perversely, given their dependence on China, emerging equities have been beneficiaries: the MSCI Emerging Market index gained 12% between late August and mid-October. 

The reversal has threatened investors’ picture of the US as being an “isolated case of stability and relative strength”, says Aaron Balsam, senior analyst at US-based William Blair, a US multi-asset house with $63 billion (€55.5 billion) of assets under management. This idea was buttressed, Beesley says, by the belief that “the US causes world recessions rather than the other way round”. After all, the last four recessions originated in the US. 

But, they note, with strong valuation multiples relative to historical averages, future US equity gains now look harder to achieve, especially given renewed concerns about global growth. 

Importantly, the Fed’s decision to leave US rates unchanged in its September meeting seems partly a response to the concerns about global growth, some fund managers believe. This is new, because the Fed’s explicit dual focus has been on employment and inflation, and the emergence of this third pillar has come at the cost of its credibility, says Martin Connaghan, global equities manager at Aberdeen Asset Management. 

Considering whether a company has missed its earnings forecasts isn’t the Fed’s job, he says, and wonders why the forward-looking objective of the US central bank has been substituted for a fixation “on the next six weeks”. 

Given a healthy US economy characterised by low unemployment, on any traditional metric the Fed should be raising rates, says Mark Hargraves, European equities manager at
Axa Framlington. 

Investors seem unbothered by the recent reversal in US stocks, judging by IIF flow figures. Although the figures go up to early September, before the Fed meeting, they suggest that, despite fretting about US monetary policy, investors are happier there than in emerging markets. 

“Slowing trend growth, falling commodity prices, disappointing earnings, rising corporate debt levels and, in many cases, domestic political tensions have all reduced the appeal of emerging markets,” the September IIF report says. Outflows, the authors note, trended with other indications of fundamental underperformance: notably declining equity valuations, ratings downgrades – most memorably the S&P downgrade of Brazil government debt to junk status in September – and rising credit default swap spreads over the past quarter. 

But it’s worth noting the important differences between this year’s ‘summer madness’ and the 2013 taper tantrum. 

The taper tantrum was triggered by a lack of liquidity, says Garth Taljard, head of multi-asset product for Asia at Schroders. Amid anxieties about the prospects of US interest rates, investors repatriated money back to safe-haven developed markets, funding the moves by selling riskier emerging market assets. 

So emerging market assets across the board were sold off, and many of the strong historical correlations between asset classes – even those between developed market equities and government bonds, Taljard notes – broke down. 

The latest sell-off, however, is founded on ‘a growth shock’: worries about a slowdown in China spread to fears for economic growth across the rest of the world. Investor selling was more dispersed. Equities were sold off, as were commodities, but government bonds broadly gained. 

An important legacy of recent events for European institutional investors is a degree of caution around global equities, believes David Walker, of the European institutional research practice at Cerulli Associates, a research firm. 

“For many Continental European institutions, equities mean ‘risk’, even if the allocation is diversified globally,” he says. 

This has been brewing. A greater focus on risk is partly a response to shifting regulatory sands. Holding equities spells demanding capital-reserving requirements for EU insurers under Solvency II from next year. 

But recent events have entrenched this risk-centric thinking: buying equities through low volatility strategies such as ‘minimum variance’ has been a significant theme for institutions in recent months. Regardless of how widely the strategy is diversified, predictable outcomes and low volatility is what European institutional allocators will be looking for, says Walker. 

As though calling in a new era, some fund managers say we are into a structurally lower phase of global growth. Balsam, of William Blair, is clear that compared with the past couple of years, investors should expect a wider distribution of prices and returns from global equities. Sentiment, he feels, is the leading cause for this. He contrasts the US, Japan and Germany, which look expensive compared to value found at Europe’s periphery – notably Spain and Italy. 

But despite four years of broadly negative news, says Hargraves, at Axa Framlington, European equities have undergone a process of re-rating, with some of the bargains gone. Valuations, he believes, are broadly fair today. With average price-earnings ratios hovering around 14-15, depending on the metric, “this is roughly in line with long-term averages”. 

Compared with US firms, there is a lot more for Europeans to squeeze out of margins, says Beesley at Henderson.

US firms have become highly efficient since the financial crisis: by last spring, average US corporate margins were 3% tighter than those for firms in Europe and Japan. 

In addition, the growth gap has narrowed between the US and Europe as a faltering European recovery coincides with erratic US GDP figures in recent quarters. Historically, says Beesley, this phenomenon was associated with a narrowing of the margin gap between US and European firms. If this relationship holds up and European firms manage to decrease their margins, then they could generate improved earnings without significantly improved profits. This would be useful, since the European recovery doesn’t seem to be offering much prospect of
bumper profit gains. 

“This means that Europe has more room for manoeuvre than the US,” says Balsam.

In emerging markets, the story is very different, with prices much lower against historical averages. But cheap prices come at a cost, says Hargraves. He fears poor corporate governance and weak capital allocation. 

Other managers are happy with the return that accompanies these risks. Connaghan has large holdings in Brazilian companies, despite the corruption scandal at national oil firm Petrobras. 

“Corporate governance comes down to the company,” he says. The record of many firms in Japan is mixed, he adds. And the recent woes of Tesco suggest continued problems in the UK market. 

Besides, recent business practices in developed markets create a governance issue. “Issuing debt to buy back stock or maintain dividends isn’t a sustainable business model,” he says. 

It seems that managers’ confidence is bruised, even in the developed equity markets they have come to rely on, where some question the soundness of corporate economic management. At the same time, others wonder about the competence of the US central bank, which now appears to add other countries’ economic health into its policy decisions.

©2015 funds europe