Equities: The world is the limit

Sending client money offshore has once again proved to be a successful strategy for advisers, with investors in global equities being well rewarded over the past year.

Although returns were nothing like recent stellar results, predictions for the immediate future still look pretty good — particularly if the Australian currency declines further and developed markets continue their slow return to growth.

The 14.7 per cent one-year return from the MSCI World Index to December 2014 was a "solid to more than good performance", according to Bronwen Moncrieff, head of research at Zenith Investment Partners.

"Compared to 2013's 47 per cent, the return is disappointing, but if you look at the long-term expectations for the asset class, it is double that."

According to BetaShares chief economist David Bassanese, the good times continued into the early months of 2105.

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"Global equities have had a pretty strong performance, with the MSCI up 15 per cent in Australian dollar terms to the end of February."

This sees unhedged investors sitting on a one-year return of 24 per cent, while those taking the hedged route are enjoying a return of close to 18 per cent.

"The key theme for the year will be developed markets to outperform emerging markets, with the exception of China. Higher US interest rates will make emerging markets vulnerable and so investors need to be wary of them." - David Bassanese 

These returns highlight the important role currency continues to play for investors in global equities.

As Brian Parker, head of National Australia Bank (NAB) Asset Management's portfolio specialists group explains: "It has been a great year for global equities, especially for Australian dollar investors, as they received extra return courtesy of the falling Australian dollar."

Developed markets remain in favour

Looking ahead, Moncrieff believes valuations indicate global equities still remain attractive, with the one-year forward price/earnings (P/E) ratio sitting at 16.5 per cent, while the long-term average is 16.4 per cent.

"We say global equities are fair value at the moment, as if you look at the one-year forward price/earnings, they are spot on."

The picture is fairly similar for emerging markets, she says.

"The ratio for emerging markets is slightly lower than the long-term average at 12.3 per cent, versus 14.1 per cent for the long-term average, so it is roughly in the fair value band."

Despite their valuation, emerging markets are not popular with many experts.

"The key theme for the year will be developed markets to outperform emerging markets, with the exception of China. Higher US interest rates will make emerging markets vulnerable and so investors need to be wary of them," Bassanese notes.

The performance of emerging markets over the past year supports this view, as investors who picked developed markets over their emerging market cousins, backed the winner.

Emerging markets experienced a wide dispersion in returns, with the best performers being India (48 per cent) and China (30 per cent plus), while other markets languished.

"China A-shares were one of the best performers. Due to the slowing property market, retail investors in China have started to shift their money out of local property and into the share market," Perpetual's global equities portfolio manager, Garry Laurance, said.

"Other emerging markets have not been as strong. Brazil and Russia have been very weak."

Given weakness in the Russian market is largely due to international sanctions over the ongoing Ukrainian situation and Brazil is now experiencing hyperinflation due to fiscal and monetary tightening, this underperformance is expected to continue.

Bassanese even sounds a note of caution about the strong performance of the Chinese market.

"It is important to note this has been driven by monetary stimulus, not earnings. It was about investor dollars rushing out of property and into the share market."

Parker agrees the Chinese market is hard to predict. "Taking a view on where China will be in 12 months or two years is a mug's game."

Regions vary in appeal

Drilling down into the global equity space, opinions about the likely best performers are mixed.

"Europe will do best as it is still experiencing easing, while Japan will underperform and will be weaker as its economy does not appear to be performing, despite the share market euphoria," notes Bassanese.

Currencies will again play a role, he said.

"Europe will also benefit from a weaker Euro, especially Germany."

Laurance agrees Europe offers some interesting possibilities.

"We have several positions in European exporters like Volks Wagon and Rolls Royce, as they are benefitting from the lower Euro and slightly stronger demand."

From a valuation perspective, he sees more appeal in Asia and Europe, together with specific US sectors like financials.

Japan remains a wild card, with the view varying among managers, Moncrieff notes. "It is hard to predict the year ahead as some managers are underweight and some overweight Japan."

Laurance is one of the doubters.

"We like Asia ex-Japan and see attractive valuations in Hong Kong and China in a number of sectors including services and the consumer space."

The view on the US is that the outlook is generally still good, although the market is unlikely to repeat its recent strong performances.

"The US will do well and experience reasonable returns as interest rates are still low," Bassanese notes.

Parker says a positive view of the US is supported by the numbers.

"It is hard to call the US good value now, as P/E ratios are around 20. [It] is not cheap, but we are not on a precipice like 2007. It is just hard to find genuine bargains at these prices."

Selecting the sectors

At the sector level, views are also mixed about the potential performers.

"In sector terms, there has been a very good performance from financials and interest rate sensitive stocks, so it is now likely to see a move to cyclicals. Technology in the US has run hard, as has industrials, but now performance will move to the cyclicals," Bassanese predicts.

Parker agrees with this general assessment.

"At the sector level we are underweight financials and utilities and modestly overweight consumer discretionary and technology sectors. Bond markets still look very vulnerable, so equities that are bond-sensitive look less attractive."

Despite the narrowing range of options, MLC's managers are still finding attractive opportunities, he said.

"Our managers are underweight in the US and overweight in Greater Europe, as they like things like Switzerland and some of the healthcare companies there."

In contrast, Perpetual has taken several large positions in the US financials sector, which it sees as under-valued. "This includes US banks like Wells Fargo, which will benefit from the strengthening US economy and future interest rate increases," Laurance explains.

Caution: danger ahead?

Despite the differing views, the recommendation to advisers constructing client portfolios is clear.

"The outlook is for global markets to do better than the Australian share market, but longer term, diversification is also important. The global equity market rally is maturing, so the best returns are behind us, but there are still returns on offer," Bassanese notes.

"On a two to three year view, global equity markets still look OK and central banks can afford to be accommodative, so most clients should have some exposure even though there are still risks."

The re-appearance of a range of geopolitical, debt and growth worries is making many experts wary.

"For me, we are at the stage where you need to be cautious as there is a lot more volatility around and markets are very on/off this year," Moncrieff notes.

"We are more bearish than bullish due to the ongoing situation in Europe and problems in Greece. There is a lot of debt out there, growth in China is slowing and the flow through of that can be expected to continue for years to come."

Laurance also points to dangers from the build-up of debt.

"Investors should avoid any sectors and companies with over-geared balance sheets."

This view is reflected in Perpetual's current holdings.

"We are avoiding over-geared commodity companies such as some of the oil and gas operators with lots of debt. We are also avoiding companies with extended valuations in defensive stocks such as consumer staples, healthcare and utilities, many of which have stretched valuations," he said.

Despite the concerns, the main takeaway for advisers is the likely weaker performance from Australian equities means many client portfolios need to include an allocation to global markets.

"The key message about global equities is you have to be there. Many Australian investors are still under-exposed," Parker says.

Bassanese agrees: "The outlook for Australia is sluggish compared to major markets, so international markets look attractive. Local investors need international exposure as our market is very overweight financials and resources, and underweight sectors like technology and healthcare."

Slower growth and rebalancing in the Chinese economy also has negative implications for many Australian companies.

"China is another reason to be cautious about having too much Australian market exposure," Parker said.

"The China slowdown has been well flagged and they are managing it well so far, but there is still risk there and if there was an adverse shock, we are very vulnerable."

For advisers moving client assets into global markets, the currency question remains fairly easy.

"Even though the Australian dollar has fallen some way, we still prefer global equities investors to be unhedged," he said.

"If there is another shock in the world economy or China has serious problems, then the Australian dollar is very vulnerable. So if you are unhedged, it gives you protection. Unhedged is a better place as you gain from the falling dollar."