After the strong returns of 2017, this year has seen volatility return to equity markets as several risks emerged. While the US economy appears to be strong, talk of synchronised global growth has waned and the investment outlook less certain.
As the US Federal Reserve continues to hike rates on a path towards monetary policy ‘normalisation’, the market will begin to digest the impact of higher yields and withdrawing liquidity on asset prices. For companies trading on high multiples with hefty growth assumptions, the market can be unforgiving in the face of tightening monetary conditions and higher yields. Indeed, US dollar strength and tightening monetary conditions have already impacted emerging markets, where we have seen volatility in particular in the Argentine peso and Turkish lira. Further risks remain in more fragile emerging markets where tighter dollar funding conditions are likely to prove challenging for weaker borrowers.
Beyond liquidity withdrawal, investors face a long list of macro risks. Commodity price volatility, technological disruption, changing demographic trends, escalating trade wars and tariffs, and global debt levels can create challenges for markets.
Going into 2019 against this uncertain backdrop, we believe it will be important for equity income investors to focus on companies that largely control their dividend-paying ability. Investors cannot rely solely on the fortunes of external factors, such as commodity prices, interest rates, or the economy, to sustain dividend growth.
We have already seen significant volatility in dividends in recent years in more capital-intensive areas of the market. These ‘price-taking’ businesses have funded unsustainable pay-outs through the balance sheet using debt and disposals, rather than cashflows.
As Quality investors, we focus on capital-light, cash-generative businesses that are typically underpinned by structural growth. These companies can sustainably return a proportion of their growing cashflows to investors as dividends and re-invest the remainder for future dividend growth. Most of these businesses have continued to grow their dividends.
Figure 1: Growth of MSCI ACWI dividends
Source: FactSet, December 2017. Dividends calculated as total dividends paid in USD, for all companies within the MSCI AC World Index, aggregated by GICS sector. Capital light sectors defined as Information technology, Healthcare, Consumer discretionary, Consumer staples. Capital intensive sectors defined as Materials, Industrials, Energy, Telecommunication services, Real estate, Utilities. For further information on indices, please see the Important Information section. CAGR = Compound Annual Growth Rate.
Considering the macroeconomic and geopolitical risks, and the uncertain investment outlook we have highlighted, it is now more important than ever to invest in companies which are not dependent on cyclical drivers or economic conditions.
We believe that carefully selected quality income companies, with long-term structural, rather than short-term cyclical growth drivers, should be well placed to perform in 2019. We will continue to focus on finding these attractively valued quality income companies, with demonstrably enduring competitive advantages that are able to grow their cashflows and dividends into 2019 and beyond.
We believe the defining characteristic of emerging market equities is the inherent cyclicality of the asset class. Measured as one of 10 asset classes, over 20 years, emerging market equities have been either the best-performing or the worst-performing asset class in 15 of those 20 years. After 2017 – a year full of returns with virtually no volatility – 2018 has turned out to be the opposite: packed with volatility, and bereft of return. This makes us inherently cautious of making bold forecasts of the future.
Figure 1: A cyclical asset class
Source: Callan, January 2018.
The investment environment in 2018 has proven to be very difficult. Politically, a muscular US has rewritten the handbook on diplomacy, although some would argue said handbook was thrown out of the window entirely. The normal colourful cast of characters in emerging markets has also expanded in unexpected ways. Examples include:
Economically and financially, the end of quantitative easing (QE) has finally arrived. As the tide of liquidity slowly ebbs away, we are finding out “who’s swimming naked”, to quote Warren Buffet. Argentina and Turkey were clear culprits in this regard.
Changes in perceptions are more difficult to call, but there are grounds for concern. For ten years markets have floated on the calm sea of QE, with central bankers prepared to assist at the first sign of a twitch in the markets. Investors have unsurprisingly become complacent about risk in this environment, not least that market participants are crowded together in a slew of trades that generally offer less compelling valuations to historical averages. The unwinding of QE will be a difficult and painful experience, and there will be casualties.
Market levels are determined by two variables: economic reality and the market’s perception of that reality. The reality is that two large economies now drive our world: the US and China. The markets clearly are pricing in an economic slowdown in the US. They are fearful that a trade war and aggressive deleveraging may trigger a hard landing in China.
We are convinced that over time economic growth in China will slow, for growth to remain towards 7% per year would imply its economy doubling in size every ten years – likely impossible given the iron law of large numbers. However, we see no evidence of any imminent rapid decline in the Chinese economy.
Going forward, we believe China is likely to become a heightened focus of investor attention. The market has been extremely schizophrenic about China in 2018 and commentators have ceaselessly worried about a dramatic slowdown in the Chinese economy.
What investors have actually done, however, is subscribe to more than US$50 billion of IPOs from Chinese companies (as at end September 2018), 65% up year-on-year. This tally represents a third of all global IPO proceeds, putting China on track for the third-highest capital raising on record. China’s IPO proceeds have now been greater than those in the US for five consecutive years. Furthermore, most of the money raised has been in ‘new economy’ companies – electric cars, Internet Protocol Television or IPTV, smartphones, e-commerce related, etc. China and the US now dominate the technology trends driving our world.
In addition, the opening of China’s domestic equity market (‘A-shares’) opens up a very large, inefficient and uncorrelated investment opportunity which most global investors are only just waking up to. This emerging opportunity will drive significant investment flows over time.
Figure 2: USA GDP versus China GDP
Forecasts are inherently limited and are not a reliable indicator of future results. Source: IMF History & Forecasts, at current prices, as at August 2018.
Value is now scarce in today’s financial markets. Since 2007, despite the Global Financial Crisis, the world has added almost 50% (US$78 trillion) to the global debt tally. Much of that debt supports today’s asset markets, either directly (leveraged property investments) or indirectly (US share buy-backs supported by borrowing). We would argue that one of the few pockets of relative value left is emerging market equities.
The current 30% discount on emerging market equities (on both trailing price/earnings ratio [PE] and price/book) compared to developed market equities offers good value in a relative sense. In an absolute sense the c. 13.4x trailing PE as at end of the third quarter 2018 has historically been a good entry point in valuation terms, generating double-digit returns on average over a three-year period (although c. 20% of the time you could also have seen negative returns even from that low entry point). Emerging markets have traded at higher valuations than this roughly 70% of the time in the past 25 years.
We fervently wish for today’s central bankers to return to anonymity, so that real fundamental investors can once again determine where value lies in capital markets. This will likely lead to much more dispersion of stock returns, in a much more volatile environment.
We believe such an environment will increase the opportunities for stock pickers such as ourselves, albeit within a riskier environment. But higher risk should mean higher return, assuming we execute our investment disciplines faithfully and professionally. We might argue in short, when the going gets tough, the tough get going.
Perhaps with trepidation we welcome 2019. After the bloodied nose received through 2018, we are perhaps allowed to show more caution than a year ago. While we remain constructive on European equities, we look to reflect on the past year to give clues to what the new year may bring.
Figure 1: European equity market
Source: Bloomberg, 31.10.18. For further information on indices, please see the Important Information section.
From a corporate viewpoint, 2018 went as planned: earnings rose as expected, balance sheets continued to strengthen and signs of M&A activity increased. However, European markets drew down. So, what happened? Is the market signaling imminent danger, or are investors being given a chance to buy at better prices? Falling prices simply mean a transfer of value from sellers to buyers especially at a time when balance sheets are strengthening.
Of course, a key driver for stock markets is what happens to global growth. Throughout 2018, we witnessed challenges to the upward growth trend:
Actions to narrow the trade deficit between the two largest economies in the world, the US and China.
Brexit uncertainty and seemingly chaotic negotiations.
The new Italian government’s spending plans.
In the US, politics is a key driver, including (still two years out) the US presidential election in 2020, and the Republican’s loss of the House of Representatives, causing political gridlock in the meantime.
Much has been written on each of these subjects, but our central case currently is that of positive but slower growth.
Going into 2019 we continue to focus on strong structural themes that are global in nature.
We are often asked how truly technologically advanced Europe is given it does not have the global technology giants the other markets have. Indeed, this may be a time to reflect on how corporates are adapting the worlds we live in: how the European universe of stocks is changing to meet new challenges and more importantly to reward investors for their patience.
On technology, one only must step onto the high street to observe not just the emerging cashless society, but also contactless technology adoption meaning a device on your wrist is all you need to pay your way through the day. Indeed, the fast-growing payment solutions sector is firmly anchored in Europe through the likes of Adyen and Wirecard, which are leading the way into further innovative ways to pay for everyday necessities. In the financials sector we are witnessing the maturation of fintech onto the stock market. With no legacy infrastructure nor balance sheets, these companies can grow strongly, cherry-picking profitable niche areas such as small-to-medium enterprise lending. This is an underserved market by incumbents, because the opportunity is too small for the c. €1 trillion size of their balance sheets.
Europe, specifically the Czech Republic, is home to the largest consumer security software company, Avast, with over 435m users. Its ‘freemium’ model cannot easily be replicated by competition. With less than 5% of the users paying, it earns decent margins to fund innovation into new products as well as drive ‘premiumisation’, giving good growth visibility.
We still like the energy sector, though we acknowledge greater oil price volatility at current higher prices. The world is decarbonising, but our role is to engage not avoid, enabling the targets set by the Paris Agreement to be met. The strong cashflows generated by oil and gas need to be reallocated better. We also understand natural gas has a place in a low-carbon environment and will remain so until large scale energy storage is achieved.
We still have exposure to financials, whether through banks or insurance, where these mature sectors rely on economic recovery for growth as market share gains can only be small. For banks, we are seeing returns rise and note improving revenue performance as the economic recovery unfolds. We also note that many banks are back to 2012 lows despite better financial performance. The sector has not had a proper stock market recovery.
Changing regulation is driving insurers away from capital-heavy products, annuities and guaranteed return products towards capital-light stock market-driven products. The transfer of risk to the end client, while reducing system risk, is driving more direct exposure to equity and fixed income products. Insurance companies in turn are freeing up much excess capital to be returned to shareholders as well as focus on other capital light strategies such as digital.
In short, we are seeing the evolution of the investable universe in Europe through competition, regulation or stewardship by investors. Longer-term capital owners should take comfort.
We acknowledge that the risks to economic growth have heightened, with outstanding questions remaining. When will the US and China de-escalate on trade issues? Will the UK leave the EU with no trade deal? How will Italy’s new government deal with opposition to its spending plans?
However, cyclical stocks have generally sold off indiscriminately through 2018, despite structural growth drivers and/or adapted business models that reduce cyclicality in some. Along with strong balance sheets, opportunities have presented themselves.
Regarding the risks, we remain pragmatic, looking to avoid stocks where we are not being paid to take the risk, especially with cyclicals where margins have peaked. We have also worked hard to assess further downside. For example, in the event of a no-deal Brexit, we have avoided industrial stocks which depend on the frictionless movement of components. We also note that on agricultural and food products, port have already been identified as key risks, where customs arrangements need to be established to allow unencumbered movement of goods, similar to how it is in Switzerland. What may be reasonable to expect is continued volatility as politicians tend to engage in brinksmanship.
We remain constructive on European equities. We expect slow but positive growth globally, meaning some cyclical sectors have become attractive, having sold off indiscriminately. We also see opportunities in European multinationals with structural growth drivers offering diversification benefits. We believe the risks to our base case are well known and look for exposure where risk and reward is skewed favourably.
Volatility in the Chinese equities market in 2018 has been driven by tightening domestic liquidity as well as escalating trade tensions with the US.
However, the long-term investment case for China remains clear and opportunities are emerging in this environment. If we look beyond short-term headwinds, active investors with a disciplined investment process should be able to find quality Chinese companies with good long-term growth potential and decent management.
Concerns about China abound, including a build-up of debt, negative demographic trends, state-owned enterprise inefficiency and general corporate governance risk. We recognise the challenges in all these areas. Yet, we should not ignore China’s ongoing transformation, which is being driven by government reform and innovation in the economy. This transformation addresses many of the concerns investors have and supports the development of the equity market over the long term.
Government reform efforts are happening on multiple fronts. Supply-side reform has nearly completed its third year, with capacity reduction targets well on track and even exceeding expectations in certain industries such as steel. Environmental control remains stringent, driving significant decreases in air and water pollution. State-owned enterprise reform is helping to align the interests of the state, management teams and public shareholders. Financial reforms continue to foster better risk control in financial institutions and a further opening of the domestic capital market to global investors.
With a large consumer base and growing wealth, China has seen increasing demand for higher quality products and services. Large numbers of Chinese go on shopping sprees abroad, which is driving domestic companies to innovate so that they can capture more market share. Good infrastructure and efficient supply chains provide the backbone for a more innovative China. An abundant and inexpensive talent pool, significant social capital and supportive government policy also play crucial roles.
An example of this is the World Intellectual Property Organisation’s Seven Pillars of Innovation, where China has generally performed in line or even better than the average high-income country, and is well ahead of what might be a more obvious comparator, the average for upper middle-income countries.
Figure 1: The seven pillars of innovation
Scale 0 to 100, higher score means greater capacity.
Source: World Intellectual Property Organisation, HSBC, Dec 2017.
Although more and more investors, both institutional and retail, are considering strategic allocations to China, they remain underweight despite moves to open capital markets and make investing in China easier.
MSCI is looking to quadruple China A-share weighting in its major benchmark indices from 2019, only one year after its initial inclusion, which is faster than the market expected. FTSE Russell will also start phased inclusion from June 2019, which will see China A-shares representing 5.5% of its emerging market index. If fully included, China A-shares should account for more than 16% of the MSCI Emerging Markets Index and more than 20% of the Russell Emerging Markets Index. China’s onshore and offshore markets together will account for over 40% and 50% of the two indices, respectively.
Given China’s strategic importance, attractive long-term growth potential, increasing index inclusion and diversification benefits, we think global investors’ allocation to the world’s second-largest equity market will grow over time. Increasing foreign investors’ participation should help reduce market volatility and improve pricing discovery in the A-share market.
We believe the market drawdown provides entry opportunities for fundamental investors and will reward them in the long term.
Following a significant pullback in 2018, the Chinese equity market currently trades below its 10-year historical average valuation level from both the forward price-earnings and the price-to-book perspective. The valuation discount versus developed markets has widened despite the more positive growth outlook.
Although we do not attempt to call the bottom without seeing evidence of positive surprises on corporate earnings, an increasing number of opportunities are emerging on the back of the market pullback. As more value emerges, we are finding opportunities in a number of sectors. The evidence suggests that companies with good quality, attractive valuations, improving operating momentum and increasing investor attention tend to outperform over the long term and this remains the framework for our stock selection. Our 4Factor screen currently sees most opportunities in the materials, energy, financial, utility, and communication services sectors.
Clearly, the Chinese equity market faces short- to medium-term, most significantly policy execution and growing trade tensions between China and its trade partners, particularly the US. Over the long term, we believe a consistent investment strategy focusing on identifying high conviction ideas, using a bottom-up approach, is the best way to provide long-term risk-adjusted returns to our investors. We remain broadly fully invested in our portfolio as there are abundant opportunities that can be found in a dynamic market environment such as China.
Our bottom-up stock-picking generates ideas from a broad range of sectors, covering both new and old economy segments. Fundamental analysis, combined with objective screening, will continue to drive new investment ideas for our portfolio.
Was Baron Rothchild correct when he said, “The time to buy is when blood is on the streets”?
2018 has produced all the volatility that 2017 lacked. So, what has changed and how is that likely to affect the investment opportunities looking into 2019? As of time of writing, Asian markets have officially entered bear market territory, having fallen more than 20% since the early 2018 highs. Earnings have been downgraded, as have valuations, which have slumped to levels last seen in previous troughs. However, expectations for earnings growth remain positive.
There have been 19 market corrections in Asia since 2003 and only four of these have been more than 20% declines. Among these, the average price/earnings ratio (P/E) at the trough has been 10.4x forward P/E vs. the recent trough valuation of 10.6x forward P/E. Equally, on a price-to-book (P/B) basis, previous troughs have averaged 1.6x P/B vs. the recent valuation of 1.4x P/B. Only once before has the price-to-book ratio fallen below the level seen recently.
Source: Bloomberg. October 2018.
Following these troughs in valuation, there have only been three instances where the index was lower a year later, the most severe of which was during the global financial crisis. Despite the pessimism experienced at each of these troughs, on average the index was over 20% higher in the subsequent twelve months. In terms of well-understood behavioural biases in markets, we are now at the point of fear, with investor sentiment having turned negative and flows out of the region reaching the levels of capitulation last seen in the 2015-16 market correction.
Are we at a point where you can see potential for 20% returns? Or are we in one of the few instances where the market ended up lower twelve months from now? The 4Factor investment team has long believed that neither high returns nor low valuations on their own make an investment case.
We need a catalyst to drive an improvement in investor sentiment, or higher earnings upgrades. In the near term, China’s slowdown, US dollar strength, higher interest rates and trade concerns are likely to weigh on investor sentiment, while delayed spending decisions from both companies and consumers are leading to earnings downgrades.
Despite limited spending, recent industrial trade fair surveys in China suggest the desire to invest remains strong. Therefore, an improvement in sentiment – either through a thawing of trade concerns or some sort of domestic stimulus – would send the markets higher as investors sitting on the sidelines start to invest.
Figure 1: Where do earnings go from here?
Forecasts are inherently limited and are not a reliable indicator of future results. Source: Factset, Investec Asset Management, 05.09.18.
How should one position portfolios in this scenario? Some of these positions are counterintuitive and contrary to market behaviour in the past ten years. Earnings are no longer growing across the board, which means that building a more balanced portfolio looks reasonable. Equally, with interest rates rising in the US, discount rates for all assets have risen, which in turn has led to a correction in long-term value assumptions, particularly for growth stocks.
Likewise, high-dividend stocks have been defensive over the last ten years as investors have reached for yield. However, rising interest rates may start to undermine their defensive credentials. Add into this that quality remains expensive and you have a more confused picture than at perhaps anytime in the previous decade.
We also have conflicting signals from both sides of the world. The US Federal Reserve continues to tighten as business conditions remain robust and policy is deregulating. In China, policy and financial liquidity remain tight, as the country tries to address its high debt levels, which is causing a slowdown in demand. These are two very different paths. When deciding which stocks are likely to perform, investors will need to decide which will have the bigger effect.
The good news for Asia is that unlike the previous bear market in 2015-16, corporate balance sheets are healthier, free cashflow has been strong, and margins have been improving. This allows more flexibility to absorb any weakness in demand. Ultimately, the outcome of whether or not markets will be significantly higher in twelve months’ time depends on whether the conflicting economic signals trigger some sort of recessionary scenario.
Longer term, the potential for Asia remains strong. We are still seeing increased investment into research and development, and domestic demand continues to increase as a percentage of GDP. Equally, Asia remains committed to policy reform to address high debt levels and curb excess supply. Despite near-term concerns, these longer-term trends should provide greater stability and higher quality growth.
In this environment, we find it far more convincing to make investment decisions based on bottom-up fundamentals. We continue to believe that it is best to look for high-quality, attractively valued stocks, with improving operating performance and increasing investor attention.
The intense electoral calendar has taken a toll on investor sentiment. Uncertainty, doubts on sustainability, volatility, and fear of a populist comeback have all weighed on Latin American equities. This will not be the case for 2019. The elections in Colombia, Mexico and Brazil should deliver more certainty regarding policy direction. Outcomes look much better than the worst scenarios that investors were pricing in in 2018.
Both elections in Mexico and Brazil delivered a clear vote in favour of anti-establishment candidates at the expense of traditional parties. In Mexico, the main losers are the traditional parties of Partido Revolucionario Institucional (PRI) and Partido Acción Nacional (PAN) which had previously been in power.
Likewise in Brazil, the traditional parties were all soundly defeated including the Workers’ Party, Partido dos Trabalhadores, (PT), the Partido do Movimento Democrático Brasileiro (PMDB) and Partido da Social Democracia Brasileir (PSDB). In both countries, the new administrations imply governability risks, but we do not foresee space for institutional risk.
Regarding the expected increase in US Federal Reserve rates, both Mexico and Brazil look quite well positioned as current accounts are financed by foreign direct investments. We are optimistic that we might have left the bottom behind regarding the domestic investment cycles.
The global environment remains challenging, although we would highlight that Mexico has benefitted from the new trade agreement: The United States-Mexico-Canada Agreement (USMCA), which will replace Nafta. Meanwhile, Brazil has been a US/China tariff war winner. The result has not been that bad despite the risk aversion fears emerging markets faced in general.
Elsewhere, the Andean countries are marching back toward potential growth, with inflation safely within target ranges. With the elections out of the way, we might finally see the market focusing on Latin American corporate health.
Earnings upside potential is still compelling, with consensus growth expectations of +36% in US dollar terms for 2018, higher than estimates for global emerging markets as a whole (+13%). For 2019, earnings are expected to grow another 15% in dollar terms. In addition, momentum on earnings estimates seems to have begun improving, with a 3.3% increase in September, pushed mainly by upward revisions in Brazil, which we believe should rise even further over the next few months.
Figure 1: Earnings growth should remain robust…
EPS YoY Growth - Latin America Small Caps vs. MSCI Latin America
Source: Bloomberg and Santander estimates, 31.08.18.
For further information on indices, please see the Important Information section.
In terms of valuations, Latin American equities look attractive versus other regions, for small, mid, and large caps. Also, Latin American equities are trading at a smaller premium versus its own historic average compared to any other region versus their historic averages. We are expecting earnings-per-share growth compound annual growth rate (CAGR) 2017-19 for Latin American small caps of 30%. Return on equity continues to rise at 11.0%, and is still below the historic average of 13.6%.
Figure 2: Latin American Return on Equity (%) The worst might be behind us
Source: MSCI, 31.10.18. For further information on indices, please see the Important Information section.
We would highlight the healthy state of balance sheets in Latin America. On the operational front, companies are working hard to improve profitability. These efforts include:
We have positioned our strategy with a focus on companies with sustainable growth and return on invested capital (ROIC) above weighted average cost of capital (WACC).1 Investment themes include:
We see opportunities in companies levered to domestic growth and secular themes. An emerging and growing middle class, expanding services, infrastructure potential, and new technology support multi-year secular changes in habits that are here to stay. We continue to look for the large caps of tomorrow.
We see three main types of investment risk in Latin America for 2019:
We are optimistic for the medium term in Latin America. If core market-friendly policies are put in place and productivity is unlocked, chances are high that the region’s economic growth will approach its potential and might be close to navigating calmer waters, with more visibility. Latin American corporates are in good shape to capture this new stage. The road ahead might be bumpy, but we are moving in the right direction.
1 The rate that a company is expected to pay on average to all its security holders to finance its assets.
This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.
All rights reserved. Issued by Investec Asset Management, issued November 2018.