Beyond our borders

As domestic bias in Australia wanes, investors are increasingly looking abroad to add not just diversity but also better returns to their portfolios.

And the figures show why. As chart one shows, both sector averages and indices for global equities outstripped their domestic counterparts in the last five years.

But with a global stage dominated by earnings downgrades, domestic upheaval across European and South American states, and arguably the most unpredictable White House in history, it can be hard for investors Down Under (or indeed, anywhere) to make sense of everything that’s happening abroad.

So, what happened in global equities last year and where should investors be looking going forward?

A look in the rear vision mirror

Looking back on 2018, two key stories in the global equities universe were China and the US.

In China, economic growth slowed as the Government deleveraged the system, which Nikki Thomas, a portfolio manager at Alphinity Investment Management, put down to the Asian giant starting to address its balance sheet issues.

Then there was the added strain of tariffs imposed by US President Donald Trump, which also flowed through to the US’ story for 2018.

Despite threats of trade war from what Thomas labels the US’ “accidental President” however, the US market had a strong year. Tax cuts saw the market rallyup until September, with December’s drop unexpected by most.

Looking more broadly, it was a year defined by growth globally before a surprisingly damp end.

“2018 began well with synchronised growth across a number of key economies and a cyclical uptick in global growth but ended in a flurry of volatility and disappointing returns,” Hyperion’s CIO, Mark Arnold, says.

Amongst many reasons for the downturn, geopolitical instability (think of Brexit) and the spectre of a trade war between the US and China stand out to Arnold, as well as slowing growth in Europe and Asia.

What does 2019 hold?

Earnings look to be formative to the global equities landscape for 2019, with pretty much every sector and region experiencing earning downgrades in the last six to eight months. This may continue or even worsen before it improves.

“Many sectors of the market will find it difficult to maintain even their current levels of earnings,” Arnold says, with his deputy CIO, Jason Orthman, pointing to ‘old-world’ businesses as those that will struggle, as a changing world sees oil and thermal coal, for example, overtaken by renewables.

We may also see rerating occur, with Principal Global Equities CIO, Mustafa Sagun, believing that any resolution in the US and China ‘trade war’, the US government shutdown and Federal Reserve policies are all catalysts for rerating.

So what does this mean for businesses and growth?

“[In] 2019, we believe that global growth will very likely continue to slow, but not to the point that all expansion will be at an end,” Arnold says. “Business conditions will definitely be more challenging, and ... a number of headwinds will likely create the low inflation, economic growth and interest rates that are likely to be our global economic reality for at least the next decade.”

And what are these headwinds? According to Arnold, they’re rising levels of consumer debt, the middle class hollowing out, technological innovation’s impact on job prospects and wages, an ageing population, and environmental factors.

While this may sound a bit doom and gloom, investors shouldn’t be holding their breaths about recessions as there’s very little data to support one happening in 2019.

Thomas warns however, that “the market has this funny ability to create its own recession” if it’s discussed enough and debt and equity markets create tightening.

There are also silver linings to be found in the de-ratings environment.

“After significant de-ratings with no consideration of earnings growth profiles, there are opportunities to take advantage of at the stock level, particularly within emerging markets (EMs), particularly China and South Korea,” Sagun says.

Looking east and west

Unsurprisingly, the US is a key market to watch in 2019: “It’s such a big opportunity set, I think you have to be looking there,” Thomas says.

The market is nervous that the Fed will step on the US’ fiscal stimulus-driven growth from last year though, she says, trying to control inflation. Some communication from the Fed could be useful in calming those fears.

Regardless of the Fed’s actions, Thomas believes that US growth is “almost guaranteed to slow” in 2019 as markets create tightening, sentiment changes, and fiscal stimulus fades compared to 2018.

And the “accidental President”?

“Interestingly, in 2018 Trump was very positive for US economic growth as he was pro-growth domestically, although I’d argue he wasn’t good for growth in the rest of the world,” Thomas says. The problem, rather, is whether, given the US debt position, there is any room left to sustain it into this year.

It’s worth considering that the US only joined the earnings downgrade party in 2018’s last quarter so more downgrades are expected before they turn.

Indeed, Sagun warns against the “less favourable” earnings/valuation backdrop within US large caps, with earnings set to reduce off the back of tax abatements. He cautions that despite their cheapness, financials will likely remain under pressure as rates stay at historically low levels, squeezing net interest margins.

The next most important country to look at, Thomas says, is China.

“Investors should at least be watching what is happening there, even though actually finding investible ideas is hard,” she says.

Sagun suggests industrials, consumer and materials based upon valuations, infrastructure spend, and upside to physical commodity prices given weakness in 2018 and issues stemming from iron ore supply problems may prove investible opportunities.

Investors should also remember that China is suffering from its deleveraging, plus there’s a real risk of Trump escalating tariffs in March.

“The risks we see with China and the US include a lack of trade resolution between the countries, as well as stimulus measures failing to provide as a backstop to slowing China growth,” Sagun says. “A dovish Fed moves back to a more hawkish approach, leading to a strong USD, but a negative for EMs and multinationals.”

Thomas is optimistic however, that China’s attempts to stimulate growth will flow through: China will “throw fiscal and monetary stimulus at it” until something works, and she thinks that something will in time.

And where else is there opportunity?

While Europe isn’t offering much currently, Brexit looks set to resolve this year, and Thomas says that that could see investors again having enough certainty to price risk there.

Of course, the best time to buy is before others are willing to face that risk. Now, UK stocks are cheap on a yield basis, as well as being at a 30 and 10 per cent discount to the world and Europe respectively when measured against P/E and P/BV.

“Our belief is any form a resolution could lead to a rerating of UK domestic stocks,” Sagun says. “For investors, these valuation levels mean the opportunity for discounted UK stocks is now.”

For Asia, EMs will be risky due to their high exposure to the USD.

With the right people on the ground however, and the necessary levels of knowledge of the idiosyncrasies of those markets, there could be something there. As written in Money Management’s Investment Centre this week, this could be somewhere for investors with long-term horizons to look.

In terms of sectors to watch, the consumer discretionary sector is one to be wary of, Thomas says, with earnings coming under pressure.

For technology in general, Sagun warns that while its growth profile remains strong, risk is to the downside: “Investors should be cautious as high valuations eave for limited rerating potential as well as any quarterly missteps”.

In terms of individual businesses to look at, Arnold says, unsurprisingly, those that will succeed have strong fundamentals.

“By this we mean modern businesses with strong value propositions, those with large and growing addressable markets, and can grow revenues and profits organically rather than on the back of cheap debt,” he said.

Luxury goods brands are such businesses, Orthman says, favouring those with sufficient brand equity to maintain prices, and benefitting from the growing number of high net worth individuals in countries such as China and India.

Global equities aren’t going anywhere

As Aussies grow more comfortable with global investing, interest in equities abroad looks set to sustain.

“Australia’s market is very small by world standards – so it goes without saying that there are more opportunities abroad than at home – and that’s the benefit,” Arnold says. “Offshore markets offer both a larger universe of stocks and greater diversity of industries to choose from – and equally importantly, the economies in which they operate often have higher growth potential than the Australia’s.

Furthermore, although Thomas acknowledges she took a “pretty bearish tone” in her thoughts on 2019’s global market, she says “there’s always opportunity for change”.

The world is developing rapidly, not just in terms of technology but also in how society works. There’s simply much more chance to invest in that development by looking at what’s on offer beyond our border.