We believe the low interest rate environment of the last decade has greatly distorted investor behaviour. By suppressing the yield on the safest asset classes, central banks all over the world engineered a situation that forced investors to ‘reach for yield’ in ever-riskier products. Slowly, but surely, this yield suppression is coming to an end and in fact reversing.
Central banks must shrink their balance sheets, not only because permanently stimulating monetary policy can have unintended consequences (such as inflation), but also because they need to rebuild their ammunition for when the next recession hits. No central bank wants to enter a recession with interest rates at zero and a constrained balance sheet.
Figure 1: Let the great unwind begin – Combined balance sheets of US Fed, ECB, BoE, SNB, BoJ
Source: Bloomberg, 31.10.18, including US Federal Reserve, European Central Bank, Bank of England, Swiss National Bank and Bank of Japan in US dollars.
We fear the market may lose confidence in central bankers and their bag of tricks over the next cycle. In this environment, those assets which have been most supported by easy money over the last decade become the most vulnerable and those which have been most out of favour become more attractive. In this transition stage there is a good chance that asset volatility could increase significantly.
The long-awaited market wobble in October has posed clear challenges to mixed-asset investors. Equities have in general performed well, but many have reached uncomfortable valuations particularly as earnings momentum seems to be waning, cash remains unattractive and bonds (of all flavours) continue to offer more risk than reward. Alternative assets, meanwhile, may simply just offer investors an alternative way to lose money.
We stick with the principle that what has gone up most in these markets is most vulnerable to sell-offs and what is most unloved may offer the best form of protection. So in general we would look to:
Consequently, we remain defensively positioned in both bonds and equities in our Investec Cautious Managed fund. We continue to use precious metals - both bullion and shares – to protect the portfolio against the tail risks of a return to quantitative easing (and derivatives of) or higherthan- expected inflation.
Our UK Special Situations fund is constructed using a bottom-up investment process. We initially study a long list of out-of-favour equities and from these we select those which we believe have the best chances of recovery.
One bright spot in this scenario might be commercial banking. Banks earn their revenues on interest rates, so the higher the interest rates, the higher the earnings for the bank. Of course, they have to pay some of that to depositors but, historically, there has been an increasing spread between what they earn and what they pay out as interest rates go up. Some might worry that higher interest rates could mean more bad debt for banks. However, banks have been de-risked since the financial crisis. They also now have a lot more capital on their balance sheets, which provides a much greater cushion in any future downturn.
We do not specifically invest in themes, but often find that companies from the same industry do fall out of favour at the same time. Sometimes out-of-favour companies share characteristics outside their own business area. For example, given the lack of clarity over Brexit, investors are reluctant to invest in the UK listed stocks that are the most exposed to the domestic economy.
We have no insight as to the outcome of the Brexit negotiations, but typically when investor sentiment is this extreme, pricing anomalies occur. We try to look through short-term issues and assess if we are being invited to pay a low price for the profits the companies can generate through the cycle.
The Brexit paralysis has provided us with a chance to build holdings in companies such as retirement homebuilder McCarthy & Stone, builders’ merchants SIG and Travis Perkins, retailers such as Marks & Spencer and Kingfisher (owner of Screwfix and B&Q), as well as banks such as Royal Bank of Scotland and Barclays. We believe these companies have the capability to generate higher profits than they currently do.
It is no secret that the low interest rate environment of the last decade created a scarcity of investment returns. By suppressing the yield on the safest asset classes, central banks all over the world engineered a situation where investors were forced to ‘reach for yield’ in ever-riskier products. Slowly, but surely, this yield suppression is coming to an end and in fact reversing.
Central banks need to shrink their balance sheets, not only because permanently stimulating monetary policy can have unintended consequences, but also because they need to rebuild their ammunition for when the next recession hits. No central bank wants to enter a recession with interest rates at zero and a constrained balance sheet.
Over the course of 2019 we will be able to see where this money has been flowing and which asset prices have become most distorted. To some degree we are already seeing the first symptoms of this withdrawal of easy money, most notably in the rise of bond yields worldwide and in the weakening of emerging market currencies and equity markets. The equity market swings in October 2018 could also be ascribed to this phenomenon.
We are also likely to see dispersion increase within markets, as those companies that have financed themselves imprudently, or whose valuations have been pushed to unrealistic heights, see their stock prices decline. The US looks particularly vulnerable to this, as Figure 1 illustrates.
The left-hand chart shows the historical distribution of valuations in the US, European and Japanese equity markets, while the right-hand-chart shows today’s distribution. It appears that while European and Japanese equity markets are no more expensive than average, the US is on a lower earnings yield compared to its history and other markets.
Figure 1: Reported Earnings Yield distribution in MSCI indices
Historical distribution, 20 years to 8 October 2018
Distribution as at 8 October 2018
Source: Société Generale Cross Asset Research, Equity Quant, 8.10.18.
Our current opportunity set is in line with this assessment. We see many more opportunities in emerging markets, Europe (including the UK) and Japan than we do in the US. UK and emerging market equities appear particularly attractive, owing to their recent weakness.
On a sector level, we continue to find value in financials, which should do well if interest rates continue to rise, as well as in industrial companies which we see as trading below their long-term intrinsic value. After having little-to-no exposure to healthcare and consumer staples for some time, we are finding several such companies trading at apparently attractive valuations. Both of those sectors, however, still contain many companies whose perception as ‘safe’ or as ‘bond proxies’ could prove to be flawed.
Finally, we think balance sheets are likely to prove particularly important going forward. We intend to be particularly cautious around businesses that have financed themselves inappropriately during the easy times.
Where we are unearthing value opportunities
Alessandro Dicorrado: Is this the moment of truth?
As part of The Big Picture Podcast channel, Alessandro Dicorrado sees 2019 as being the moment of truth where we will see which asset classes have been the most distorted over the last decade.Listen to the podcast Subscribe to our podcast channel
After the optimism and strong returns of 2017, volatility has stalked equity markets in 2018 as risks emerge. While the US economy appears to be strong, talk of synchronised global growth has waned and the investment outlook for 2019 is less certain.
As the US Federal Reserve began to steadily hike rates on a path towards monetary policy ‘normalisation’, the market has started 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 macroeconomic 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 focusing on structural, rather than cyclical, growth will be key. The fortunes of external factors, such as commodity prices, interest rates, or the economy, cannot be relied upon to sustain growth.
We strive to uncover quality business models that are exposed to attractive categories, and structural growth drivers. Some of the themes embedded in our portfolio include:
Meanwhile, we are aware of the potential threats that exist to the dominant market positions of certain quality companies. For example, we pay close attention to disruption in the consumer staples sector. While the impact of the ‘infinite shelf’, made available by e-commerce, is lowering barriers to entry and supporting smaller brands and private label penetration, this impact is not felt equally across all categories. Therefore, the impact will not be felt evenly across companies. In many cases it will likely provide opportunities as well as risks, requiring careful stock selection.
Quality companies can reinvest cashflows for future growth. In sectors such as IT, healthcare and consumer discretionary are capital-light, cash-generative businesses that typically spend the most on research and development (R&D). This investment in R&D allows companies to innovate, which in turn entrenches competitive positioning and ensures the sustainability of growing cashflows.
In aggregate, Global Franchise companies vastly outspend the market as a whole, investing nearly four times more – as a percentage of sales – on R&D.
Figure 1: Aggregate R&D spend by sector
Source: FactSet, based on constituents of MSCI ACWI, as at 31.08.18.
Despite this heavy investment, these companies still generate far superior margins and returns on capital than the broader market.
Figure 2: Superior margins and returns on capital
Source: FactSet, Investec Asset Management, as at 30.09.18.
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 companies, with long-term structural, rather than shortterm cyclical growth drivers, should be well placed to perform in 2019. We will continue to focus on finding these attractively valued quality companies, with demonstrably enduring competitive advantages that are able to grow their cashflows into 2019 and beyond.
Events in 2018 have reminded investors not to be complacent. There is no longer talk of the synchronised global growth that characterised 2017. Instead, with monetary conditions tightening, threats emerging from tariffs and trade wars, a stronger US dollar impacting several emerging market economies, rising political uncertainty and populism, alongside debt concerns across governments, households and corporates, the global growth outlook has become increasingly uncertain.
In the UK, the consumer environment continues to be weak. While at the time of writing it remains nearly impossible to predict the Brexit outcome, most scenarios still point to continued political infighting, sterling volatility and weak business investment resulting from the ongoing uncertainty. The spikes in volatility we have seen in equity markets in both the first quarter, and more recently, the fourth quarter of 2018, are a timely reminder of investor nervousness and the potential challenges that lie ahead in 2019.
This uncertain macroeconomic and political backdrop, particularly the withdrawal of liquidity, means that investors can no longer rely on a further expansion of valuation multiples, supported by accommodative monetary policy, to drive returns in 2019. The UK market is trading at its largest valuation discount relative to global equities since 1990, but in absolute terms, valuations are still higher than longer-term averages. Caution is required.
Figure 1: Valuations remain rich
|COUNTRY/REGION||P/E* 18E||DY** 18E|
Source: Morgan Stanley Research, using MSCI country and region classifications, as at 02.10.18.
*Price earnings ratio. ** Dividend yield.
The recent challenges of certain cyclical industrial and consumer stocks have also shown that investors should be careful of overstretching for yield in cyclical companies that appear cash generative, with attractive valuations and yields, but where the cash earnings are close to cyclical peaks and not sustainable.
Market sentiment has started to reflect this caution. As we look forward to 2019, we see a continued shift back in favour of more resilient quality stocks with sustainable business and financial models, reliable cashflow and dividend growth drivers, strong balance sheets, and lower sensitivity to the economic and market cycle.
We believe larger multinational companies with globally diversified revenue streams will be best placed to deal with the domestic political and economic challenges and risks to sterling. Smaller companies, despite their relative nimbleness and flexibility, will not be immune to more difficult market conditions, and liquidity will be important.
However, opportunities still exist in smaller companies with proven business models whose valuations already price in the risks of a UK recession, as well as smaller companies that have demonstrated quality characteristics through previous cycles, or have niche products, services or business models that provide an element of protection from general market volatility.
Last year we wrote about the fine balancing act for the market and economy in our outlook for 2018. As we look forward to 2019, we expect the environment to be even more challenging and uncertain. However, opportunities still exist at the stock level across the market cap range for companies able to generate cash and reinvest that cash at rates of return well in excess of their cost of capital, supporting future growth in cashflows and dividends. We continue to believe in the merits of an active quality approach, driven by stock selection and implemented through diversified portfolios, whether growth, income or small-cap orientated.
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.
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.
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.