Chad Padowitz reviews the regions and sectors investors should target – and avoid – in 2014.
In many respects the performance of global equities in 2013 was spectacular. Strong returns were experienced in most markets and sectors. Short of very poor stock or sector selection, any allocation to the asset class was well rewarded.
To best determine whether this can be repeated, let’s look at the causes of the returns and how they might influence markets this year.
Firstly, approximately two thirds of the S&P 500 returns – and more in many other markets – were due to valuation expansion.
Therefore, all the support from improving economies and better corporate earnings only accounted for one third of returns.
The balance was simply investors’ willingness to pay more for a level of earnings than they did before. The result is a reasonably (at best) valued market with signs of hubris in certain sectors. This creates an obvious performance hurdle this year.
Before discussing the sustainability of these tailwinds, it’s worth mentioning the reasons behind them. In the years leading up to 2013 many concerns hung over the market, including:
- Whether the Euro would break up;
- Southern Europe solvency;
- Whether the US would emerge from its housing-led recession; and
- China growth concerns.
Over the past few years these risks have all receded, which has allowed investors to effectively reduce the risk premium for equities and allow a higher valuation.
Not to be left out of the party, the various central banks all but ensured that equities, in an attempt to increase risk-taking, was the only attractive asset class. Cash and bond yields for safe debt are all but non-existent.
To appreciate the dynamics of reduced risk leading to higher returns, it is useful to look at the best and worst performing markets last year and their respective GDP growth rates.
Global equity market returns
What is noticeable is the non-existent correlation between the best and worst performing markets, highlighting the low level of materiality between GDP growth and earnings.
As aforementioned, investors were enticed back into the global equity market because of risk reduction. (Refer to figure 1)
In addition to reasonably high valuations, the level of corporate earnings as a percentage of the economy is at a multi-year high.
This is a function of many things, including the weak bargaining power of labour, decreases in relative cost of capital equipment, and low interest rates – making financing equipment cheaper.
When looked at in combination, global equities are trading at reasonably full valuation on higher than normal profitability.
We do not anticipate a significant reversal of these forces in the near term, although over time valuations and profit margins do mean revert.
Over the short term the bigger issue is the likely lack of further support. Therefore, in the absence of valuation expansion and margin improvement, the determinant variable is revenue growth. In the long term, sales growth drives share prices, and we expect this to be key in 2014.
Looking around the world for sources of demand that will allow sales growth is a reasonable place to start. (Refer to figure 2 and 3)
United States
In economic terms the US is in pole position. Having borne a large amount of pain in the GFC, many sectors and consumers have deleveraged.
The financial system is in very good health, housing is improving and the advent of shale gas is helping to spur a renaissance in manufacturing.
These factors have allowed a steady improvement in employment and growing demand for consumer discretionary goods.
The US is also fortunate to have no particular threat to its economy on the horizon. Bond yields are behaving, the fiscal situation is improving and the more extreme parts of the Tea Party have lost some level of support.
While not everything is perfect, it is fair to say the US should enjoy a reasonable level of growth this year.
Europe
The situation in Europe is less rosy. The political appetite appears more focused on maintaining stability rather than real reform or deleveraging.
As a whole, debt to GDP in Europe is currently approximately 230 percent compared to 200 percent in 2007. There has been no deleveraging.
Further, the ‘at risk’ corporate loans in much of Southern Europe are greater than 50 percent. The historical release valve of specific European countries depreciating their currencies is no longer an option given the adoption of the Euro.
While recent equity performance has been impressive in Europe, the majority has been revaluation rather than any strong sales growth. We do not expect much upward momentum in demand from Europe as a whole in the near future.
Japan
Japan has enjoyed a rare bout of optimism with ‘Abenomics’ fuelling growth and inflationary expectations, helping drive the yen down and equity markets up. Being unloved for so long meant there was always a potential rebound, just waiting for a catalyst.
Looking ahead, the next leg up requires fundamental reform within the economy as high debt and declining population is not a recipe for growth.
Due to very powerful domestic interests the ability for real reform is regarded as low and, without a crisis and its associated equity market implications, we don’t expect much traction. As such we regard the risks in Japan as not being compensated with potential return.
China
China is the most difficult to assess over the short term, given the multiple issues happening concurrently. The largest overarching trend is the attempt to transform the economy from investment-led to a more balanced profile where consumer spending is far greater.
At around 35 percent, Chinese consumer spending as a proportion of the economy is far lower than any country of its level of size and sophistication.
All other countries are more than 50 percent, with the US and western countries generally more than 60 percent.
Too much of China’s economy is in building and investment, creating volatility and leading to excess capacity and lower returns.
A number of factors justify caution on accepting China’s consistent high growth of prior years at face value.
These include the challenge of creating a more balanced economy while also contending with a reducing workforce, which has been steadily declining since 2012 due to the one child policy; shadow banking issues affecting potentially several trillion dollars; and the incremental loss of competitiveness to the US and Japan.
Investment opportunities
A combination of political issues and rising rates has hampered progress across most emerging markets, with these more likely to be a source of negative surprise in 2014 than the other way round.
Taking the above into consideration, we expect a reasonable but low level of demand growth across the global economy which should hamper significant upward momentum in corporate revenues.
When combined with valuation and margin headwinds, the 12-month outlook for global equities is for relatively low returns with some potential for a negative return if margins and valuations contract.
However, we do not believe significant downside risks exist as there are few attractive opportunities for savings.
The lack of yield in both cash and most fixed income markets should ensure a high level of support for global equity markets, given any sustained weakness.
Previously, investors in global equity markets gave up yield – with rates of 5 percent plus common on cash and sovereign debt – in return for the potential of capital growth.
Thanks to unprecedented central bank accommodation, the current situation allows many quality global equity investments to provide a yield greater than the risk-free rate. Selling out of equities to cash, therefore, has a negative yield impact.
This is an important consideration for investors at or near retirement age, as well as insurance companies and foundations responsible for managing (and growing) very large pools of savings.
Against a backdrop of unexciting growth and lacklustre general equity market returns, finding investment ideas is more challenging.
At Wingate we currently have two areas of particular interest – companies that generate efficiencies through scale, such as US healthcare, and companies that provide production to a supply-constrained market, such as select large oil companies.
Healthcare
The affordable US National Health Care Act, ‘Obamacare’, has made a very complex industry even more so. Healthcare is the largest sector in the US economy and accounts for more than 15 percent of GDP (and rising).
Certain companies that enjoy scale advantages and have a value proposition focused on lowering costs to consumers are strong beneficiaries.
Specific companies of interest are United Health, the largest health insurer in the US; Express Scripts, the largest purchaser of pharmaceuticals; and LabCorp, a large independent laboratory provider.
Oil
The oil sector provides opportunities, as it is an industry that constantly needs to replace production. On average, existing wells have a declining production profile of approximately 7 percent per year due to lower geological pressure.
This supply challenge requires high oil prices to incentivise new production, meaning oil has stayed north of $100 a barrel even with consistent substitution and overall weak economic growth.
Companies that enjoy large low-decline reserves in geographically safe places are potentially attractive investments.
As oil companies are at their core capital allocators (much like any other company), strong and aligned management is crucial. Companies we like include Canadian Natural Resources, Occidental Petroleum and Devon Energy.
While there is unlikely to be a broad-based upward support to global equity markets in 2014 and significant challenges exist, there is reasonable support in the event of weakness and many compelling stock-specific opportunities are available.
Chad Padowitz is chief investment officer at Wingate Asset Management.
