International equities investors facing more turbulence

While three key global equities markets still face trouble, there has been a major shift in investor behaviour towards this sector. Benjamin Levy reports investors are moving away from wholesale regional investing and sticking to the safe multinationals.

The world of global equities is a dangerous one these days.

There is no country, no region that is entirely safe for investment funds.

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Europe struggles with its intractable debt problems, while politicians and public alike attack proposed and passed austerity measures.

The United States (US) is struggling to convince investors that its recent growth statistics are the start of a sustained period of uplift, instead of a short blip on the radar. Even emerging markets are slowing as China dials down growth and the Euro banks pull out of the region.

In their despair, investors are turning to strong, sound, multinational companies with bankable growth opportunities, and sectors that are resistant to the global malaise.

But that doesn’t mean that they are the only opportunities to be found. A careful approach taking each region in its turn can help investors understand where the opportunities are and yield surprising results.

Turning away from regional investment

If the past few years have taught investors anything, it’s that they can no longer simply divide their funds according to region when trying to build a global equities portfolio. Investors are moving away from wholesale regional investment towards multinationals that have proven themselves able to withstand the global tumult.

“What we’re seeing is investors focus very much on looking for companies that are able to access growth, wherever they are,” says MLC Investment Management head of equities Jonathan Armitage.

The country in which a company is listed may have very little to do with where the company makes its money, he says.

“For global investors, it’s much more about where the company is able to generate its revenues and where it makes its profits,” Armitage says.

Most of the companies in NAB's global fund are multinational businesses, he says.

Investing in multinationals can also bring the diversification necessary to tolerate the widespread economic volatility throughout the global economy, according to Bell Potter director of research Peter Quinton.

“Rather than pick a stock that’s just in emerging markets or a stock that’s just in Australia, if you can find a global stock with attractive valuations, you are buying a diversified exposure,” Quinton says.

Like the active management approach now prevalent in Australian equities, investors must treat each company separately and avoid sector investment.

There are still bad companies to be found, and investors who don’t do their research may buy into a bad company within a good sector and miss out on the sector benefits, according to Wingate chief investment officer Chad Padowitz.

A strong market rally in Europe over the past three to four months has ensured that company valuations are rising sharply. Certain well run companies have become very expensive and valuations may now be too high to benefit.

“Although they look good on all metrics, if you overpay for something you generally lose money, so anything that has no level of concern about it is probably overpriced,” he says.

“You need to find something which is somewhat out of favour that doesn’t have a structural issue,” Padowitz adds.

The popularity of the large multinational companies is a manifestation of the risk-averse behaviour of investors, according to AMP Capital’s senior portfolio manager for international equities, Mary McLaughlin.

Perceived safe companies, with earnings that can be forecast more easily, have had their prices pushed up as investors seek out safe bets in the equities market.

On the flip side, investors have shunned companies that are economically sensitive.

“Where a company’s prospects depend on earnings growth in the developed economies, then the market has shunned those companies in favour of the perceived safe companies,” McLaughlin says.

The safety of the large multinationals is their flexibility to manage business costs. In manufacturing, different labour costs and input costs in several countries give the large companies the ability to absorb the impact of price rises in one country inside the low costs of another.

Different sources of revenue can also give a diversified pattern of earnings that can guard against shocks from any one country.

“That pattern of earnings, because of the diversification, might appear more sustainable, and that’s what investors have been favouring,” McLaughlin says.

AMP Capital approaches global investment through strategy, rather than by regions or sectors, she says.

Falling behind

Investing in larger quality global stocks to the exclusion of all others may prove to be a drag on portfolios when markets improve.

van Eyk sent out a warning earlier this year that fund managers biased towards quality stocks last year could lag the benchmark if European markets continue to rise.

Fund managers with an investment style biased towards larger stocks outperformed in the risk-averse markets of 2011, the researcher said.

“Investors need to make sure their portfolios are not too heavily exposed to quality-based managers if they are concerned about the potential for lagging the benchmark in a recovering market,” senior investment analyst Chris Bigg said.

That shift may already be occurring. Cyclical sectors have outperformed the global equities market in the first quarter of this year – a sign that investors may be moving to a more risk-on approach to equities.

Diversification is the best method of avoiding that lag.

Financial planners are going to have a very difficult time if they try to shoot the lights out with their global investments, according to Padowitz.

However, if they want to keep steadily growing their clients’ wealth over time, not feel the pain too much, and benefit from those quick market rallies, then they need to have exposure to a wider range of shares, he says.

MLC rebalanced its global equities strategy last month, adding growth-focused fund manager Delaware Investments to the mix and removing Capital International.

The changes will impact five different funds within MLC.

“We need to do better than the market in all conditions, and we’re now rebalancing the strategy so it can outperform in rising as well as falling markets,” Armitage said.

Carefully, carefully

A certain degree of caution is wise when deciding how to invest in the different areas of global equities.

“There are three key different forces at play throughout the world: you can roughly divide them into emerging markets and Asia, the other one being the US, and the third being Europe as a bloc.

"All three regions are facing vastly different dynamics,” says Tyndall head of implemented management Ken Ostergaard.

Understanding those dynamics is key to knowing what to do. At the beginning of this year, Fidelity Worldwide Investments positioned its portfolios as defensively as they were in 2008, citing bad policies being implemented in the European Union.

Instead of trying to deflate wages and asset prices on the periphery of the euro zone, policy makers should be looking to inflate the core Euro countries.

A weaker Euro exchange rate could also boost exports, according to asset allocation director Trevor Greetham.

Policy makers are instead insisting on ever deeper austerity cuts, threatening banks with injections of public capital and hinting that countries who don’t play by the rules should leave the Euro.

Bad policies there are making the problems even worse, Greetham added.

While there has been a strong rebound for all global equity markets since then, investors are starting to see a divergence in performance between the three big regions.

In the past four or five weeks, Europe has started lagging compared to the United States.

Economic data coming out of Europe has continued to show a deterioration in economic performance. Total unemployment has risen in Spain and Italy, while youth unemployment in particular – the most damaging kind for the economy – has reached sky-high levels.

Ostergaard is blunt about the outlook for Europe.

“We see Europe as quite a problem area,” he says.

Stagnant growth is bad enough that several countries within Europe, including the United Kingdom, have now slipped back into recession. Continuing debt issues, unemployment, and riots over severe austerity measures have ensured that the region will face problems for years to come.

While it is likely that the recession in parts of Europe is likely to be relatively mild, all the risks are on the downside.

Those risks will persist until sovereign debt issues are under control, and that is likely to take at least a couple of years, according to industry experts.

“There is little cause for optimism for growth in Europe. We can’t really see where that would come from – especially given all the obstacles that European bankers and governments are facing,” Ostergaard says.

Any regional company that has exposure to the weaker peripheral European economies would be struggling, according to Padowitz.

The recent reporting season has exposed weak sales, regardless of what they’re selling, he says.

But that doesn’t mean that all companies are out, either.

“We have seen some of our managers buy stocks in Europe, but they tend to be around very specific stories, where they believe that the current valuation discounts an extremely prolonged recession,” Armitage says.

With the Australian dollar so high, global equities is a good opportunity for an investor who can take a three to five-year view of investments and can add risk within their portfolio, he says.

Planners have not been responding to rising markets and improved economic data out of the US by pouring client money into global equities.

While the total allocation of client money to equities has remained fairly stagnant over the past two years, the amount of planner funds sitting inside global shares has decreased.

When international fixed interest allocations are split off, planners have only 11 per cent of client funds invested in global shares. In 2010, when fixed interest allocations are removed, planners had 15 per cent in global equities, according to Investment Trends senior investment analyst Recep Peker.

Fixed interest allocations have risen slightly over the past two years.

The amount of new client money going into international assets – including fixed income – has also dropped slightly from 28 per cent to 26 per cent over the past two years, Peker said.

While the Adviser Product Needs Report said planners estimated that advisers would have more money in global equities by the end of 2012, that is subject to economic performance data and the consequences of the recent political elections in Greece and France. Share markets have already been buffeted by the election outcomes in those two countries.

Self-managed super fund (SMSF) investors aren’t much more confident either.

In a recent Westpac SMSF report, 17 per cent of respondents said they were waiting for better economic numbers to come out of Europe before they reinvested their cash holdings.

Fifteen per cent are looking for better numbers out of the US. Only one quarter are exiting cash as opportunities have permitted.

“The message from SMSF trustees is that the timing will depend on events in the global economy, particularly Europe,” said Westpac director of economics Matthew Hassan.

The United States

The US is the only shining light in global equities at the moment.

The end of the first quarter reporting season in the US has shown most companies beating their earnings and revenues expectations quite easily, while a downwards trend to unemployment and a stabilising housing market have combined to produce some optimism among fund managers here.

The accommodating monetary policy of the US Treasury is also having an impact on economic growth and share prices.

“We are starting to get a bit more optimistic about the US, simply because the US economy has had a good dose of Quantitative Easing 1 and Quantitative Easing 2, and various other measures,” Ostergaard says.

That optimism has come down in part to starting off from low expectations from investors, according to some.

The fact that share market prospects have improved simply because the housing market and other factors appear to have stabilised is a demonstration of those low expectations.

“The way the share market bucked the global trend for equities is underpinned by its starting point, where everyone was very concerned about a potential double-dip recession,” McLaughlin says.

The sustained weakness of the US dollar is also starting to boost the competitiveness of local industries like manufacturing.

The sector has been in the doldrums for years in the US, but small pockets have started picking up, McLaughlin says.

“What we are starting to see are positive signs for economic growth – albeit, moderate economic growth,” she says.

Those reasonably consistent positive economic signs are what drove the market rally in the first quarter of this year.

While retail investors have been putting more funds into the US in the first quarter, their sentiment levels remain poor. In other words, they are still edgy, and ready to pull their money out quickly if needed.

A significant amount of investors have been putting money into bond funds, Armitage says.

US government fiscal policy is still a big question for investors.

A host of tax cuts will automatically expire at the end of the year, as well as spending proposals, and until – or unless – the Government acts to prolong them, uncertainty will continue to plague the share market.

GDP growth is likely to be affected if those tax cuts expire, Quinton says.

Investors are likely to find no solace in the long-term predictions of fund managers here.

Except for certain emerging markets, global equities are expected to return somewhat below long-term averages in the next five to 10 years. The sector usually returned 10 to 12 per cent before the global financial crisis.

Short-term predictions are no more comforting.

“We’re optimistic on global equities over the medium term, and over a very short time period I tend to think of that as somewhat unknowable,” McLaughlin says.

“We’re reasonably positive on the back of rising earnings, and for other areas, one hopes that as investors’ fears dissipate, we’ll get to see fundamentals driving the market.”

Diversification and volatility

Despite these sombre predictions, fund managers are urging wary investors not to forget the diversification benefits of global equities.

“In a global portfolio, there are many more opportunities than in a single country market,” Armitage says.

Much of Australia’s 300 or so stocks are skewed to mining companies and materials, while there are 5,000 to 6,000 companies to look at in a global equities portfolio.

There is also a much more even exposure to different sectors in global equities, McLaughlin says.

The opportunities to find good healthcare companies, or strong information and technology companies, are also stronger than in Australia.

Global equities have been outperforming the market here since last year. Domestic equities were down 14 per cent in 2010, while the MSCI ex-Australia world index was up 0.7 per cent.

The Australian market has almost been too optimistic about its economic growth prospects.

Although McLaughlin admits that domestic shares have been up 6 per cent in the first quarter of 2012, over the past year the equity market has been dragged down by resources as a result of shifting expectations of economic growth tied to China.

Investors who are worried about market risk can adopt several strategies to reduce it.

Tyndall uses a multimanager structure to get the best risk-adjusted returns on their global portfolios, and is planning to roll out a similar solution to Australia.

They also use exchange-traded funds in certain volatile sectors like US financials to smooth their total returns.

“Our portfolio has a relatively high degree of consistency in terms of performing well in most market conditions,” Ostergaard says.

McLaughlin believes that sometimes investors have to simply tolerate the volatility being dished out by the market in exchange for the opportunities offered.

One of those is the foreign currency exposure, which has helped dampen equity market volatility at home.

“We keep trying to come back to a longer term perspective, differentiating between noise and information on what is acceptable volatility,” McLaughlin says.

Good financial advisers can help clients stay the course on global equities, rather than being whipsawed by unsettling volatility, she adds.

The Asian tiger

Things aren’t as smooth as they seem in Asia either. 

While most companies that are doing well have part or all of their growth sources in the emerging markets, those economies have been highly dependent on euro money for financing their growth. Now that the Eurozone is suffering, that money has begun to disappear.

“They’re not just lending less to the emerging economies, they’re demanding payment of some of the loans that were already made to the emerging economies, because they want to take their money back home,” Quinton says.

European governments are also pressuring those banks to lend to domestic sources instead, to restart growth at home, he adds.

However, other fund managers believe the disappointing results in Asia can be blamed mostly on China rather than European banks.

Most of the performance in Asian shares hinges on what Chinese demand will be like through the next few years, McLaughlin says.

Excess optimism about Chinese growth has led to disappointing results in Asian equities over the past 18 months. Any kind of faltering there has scared investors in the region.

Seres Asset Management chief investment officer Evan Erianson warned at the end of last year that the combination of slowing demand in the developed world and ongoing credit tightening in China was dragging on the export engines that power the economies of Japan, Korea, Taiwan and Thailand.

Average yearly export growth has fallen from 30 to 35 per cent in 2010 to roughly 15 per cent in September 2011, Erianson said.

While Armitage admits that issues like inflation are a concern for emerging markets across India, China and Brazil, the region is still very attractive at their current growth rates.

Investors can also dodge high valuations in emerging markets by investing in companies outside the region who have most or a large proportion of their revenue in those countries, Armitage says.

Tyndall’s global equities portfolio is overweight by 10 per cent to Asia, but underweight in the US. That is part of a deliberate strategy of using their underexposure to finance their growth bend in emerging markets.

Over time, emerging markets as a group will outperform developed markets including the US, Ostergaard says.

European concerns, slower growth and debt issues, and a slowing Chinese economy have already been priced into the emerging markets sector, while more fiscal discipline has been implemented in high inflation countries, Ostergaard adds. 

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