Finding value in volatility
After a volatile 2018, the year ahead looks just as choppy for equities as geopolitical events plague share markets across the globe.
The last 12 months saw global equities knocked around by a multitude of events, including China’s economic slowdown, the US trade war with China and Brexit.
RARE Infrastructure chief executive Nick Langley agrees that 2018 was a volatile year for investors, with substantial equity market falls in February and October making it clear we are now in a late cycle stage of the global economy.
Based on his company’s analysis of the global markets, he believes there are two factors that could determine how long the late cycle will last: the trade tensions between China and the US, and the rise of populist politics.
“We believe this may result in a greater likelihood of a downturn earlier due to a rise in government spending and less room for corporates to grow their earnings over time,” Mr Langley says, talking specifically about the rise of populism.
“This could lead to an earlier and potentially even deeper downturn.”
The challenge for financial advisers and their clients this year will be navigating the choppy waters of foreign markets while continuing to feed their clients’ insatiable appetite for equities.
Australians’ ownership of international shares bought directly through overseas exchanges returned to its pre-GFC peak in 2017, which according to the ASX Investor Study may partly reflect an improved appetite for, and better access to, overseas listed investments.
The report notes that over the same period, the proportion of funds under management allocated to global equities increased 7.7 percentage points to 39.2 per cent in 2017.
Saxo Bank chief investment officer Steen Jakobsen says Australia is very much an equity-based investor in the universe.
“That has been shown to be a good strategy for the last credit cycle,” he says.
“Now you are shown to be swimming naked, because you have two assets: equity and real estate. Both of them are very highly leveraged to global growth and the economic environment.”
Geopolitical events have had a seismic impact on financial markets and equities are arguably becoming increasingly sensitive to external events. Put simply, the market tends to overreact to news.
Hexavest co-CIO Vincent Delisle anticipates that 2019 will see a different picture emerge, with macro visibility bottoming in the first half of the year.
“Investor optimism regarding future growth has dimmed considerably in the latter part of 2018, and sentiment entering 2019 is much more cautious,” Mr Delisle says.
“Hence, from a risk-reward standpoint, the opportunity to increase risk assets and cyclical sectors could present itself this year and thus provide investors with an opportunity to eventually redeploy cash and reduce exposure to defensive sectors.”
Despite the obvious risks, many fund managers remain optimistic and are actively identifying opportunities.
Market anxiety about the risks of a recession is also likely to add further to volatility and there is certainly the potential here for investors with a shorter time horizon to be spooked, says Kim Catechis, head of global emerging markets at Martin Currie Investment Management.
“However, we believe these risks create opportunities for long-term investors such as ourselves. Specifically, to initiate holdings in companies that we see as being exposed to long-term secular growth drivers, at attractive valuations,” he says.
Will Hamilton, CEO of Hamilton Wealth Management, quoted a Capital Economics paper that reported 2018 was the first time in 25 years that all 10 major asset classes delivered negative returns. As a result, he believes there is value to be had in global equities over the next 12 months.
“As we enter 2019, we are biasing towards equities, especially after the recent sell off. This was and still is the least overvalued asset class – and remains cheap relative to mainstream fixed income,” he says.
The Trump effect
Fund managers have voiced their concerns over the US economy since President Donald Trump took office in January 2017. Two years on and the American economy is firing on all cylinders, with unemployment down and the share market way up – perhaps too high for some.
RARE’s Mr Langley sees a slight divergence between the S&P 500 and the real economy, while Chris Wheldon, portfolio manager of the Magellan High Conviction Fund, thinks there is potential for greater uncertainty regarding Mr Trump’s presidency in his behaviour and actions in the year ahead.
“The Democrats now control Congress and the Republicans still hold power in the Senate, but that changing dynamic may mean the Trump administration is subject to more scrutiny and pursuit of wrongdoing,” Mr Wheldon says.
“That may cause increasingly irate behaviour and increasing uncertainty and that may impact market sentiment.”
The Federal Reserve raised interest rates throughout 2018, lowering projections for interest rates (from three rate hikes to two) and economic growth in 2019. The market reacted badly. A day after the Fed raised rates in December, the S&P 500 plummeted to a 15-month low.
Mr Catechis of Martin Currie Investment says tightening labour markets, rising wages and reasonably strong economic activity will continue to lead the Fed to increase rates.
“Higher rates will not be good news for some expensive equities, especially stocks of companies which have gorged on cheap liquidity for the last decade, as among other things they mean higher borrowing costs,” he says.
RARE is optimistic in its predictions. Mr Langley says profits may increase in the US, although not at the same rates as they have in the past.
The trade war
The stand-off between China and the US is one of the major global themes keeping portfolio managers up at night.
Mr Wheldon of the Magellan High Conviction Fund says much of the impact will depend on what happens next, with various rounds of negotiations and announcements affecting markets and sentiment over the course of 2018.
“It seems there will be another round of discussions between Chinese and US officials scheduled for early 2019, so we will see if there are any ground is being made in areas where there is currently disagreement,” he says.
“I think our longer-term concern is that China is unlikely to back down on much ground in areas related to technology development and technology supremacy. If that is the case, it’s hard for us to see the US backing down on a number of its claims as well.”
The abundance of media coverage on the trade war between the US and China undermines the global business climate, according to Montreal-based global equities specialist Hexavest.
The group has alluded to trade between the two countries representing less than 1 per cent of global GDP, as shown by International Monetary Fund data.
“The decision by the Trump administration to postpone the application of a 25 per cent tariff for three months affects only a tiny piece of the global economic puzzle,” says Hexavest chief economist and portfolio manager Jean-Pierre Couture.
“The end of the business cycle, which is far more important for corporate earnings and financial markets, has been shaping the global macroeconomic backdrop in recent months.”
Mr Couture says investors must look beyond the media and the sigh of relief that came at the end of the G20 summit, as postponing the US tariffs will not be enough to remedy the situation.
“For the time being, we maintain a defensive positioning because we think many investors will be surprised when the slowdown is borne out by economic data and earnings announcements at the start of 2019,” he says.
Hexavest noted in the third quarter, the stagnation of the eurozone economy, abrupt slowing of investment in the US, weak credit growth in China and much dimmer prospects for some technology companies confirmed this strong trend.
The US-China trade war has also had a contagion effect, impacting small economies that have provided decent returns for Australian investors.
Amit Lodha, a portfolio manager at the Fidelity Global Equities Fund, notes the trade tensions and rhetoric around US-China relations have disproportionately impacted emerging markets. However, he thinks the trade the war could have potential upside.
“Trade uncertainty lasting for longer could become a drag for investment, and would be very negative for investors,” Mr Lodha says. “But I also believe that this would force Chinese authorities to push even more aggressively towards a stimulus scenario to counter the effects of a slowdown in its economy.”
The Organisation for Economic Co-operation and Development’s (OECD) composite leading indicator, which provides early signals of global economic activity, suggests that the Chinese economic slowdown will continue from 2018.
As policy makers began to roll out measures aimed at injecting stimulus into China’s economy late last year, the People’s Bank of China said it would supply lower-cost liquidity for up to three years to banks willing to lend more to smaller companies.
Saxo Bank’s Mr Jakobsen says China is significantly below the growth number it has been reporting and what the world has been expecting.
“There was a massive political questioning in China about whether they would continue with opening up and reforms. That has now been confirmed,” he says.
“That left 2018 as a year of holes, of waiting and seeing and it will take all the way to Q2, Q3, to have a real impact on Australia.”
With some fund managers now considering US stocks to be too pricey, Europe has provided an ample opportunity to pick up some fair value equities. But, like all corners of the globe in 2019, the European Union has its own woes.
“Within Europe, the market has punished Italian equities and government bonds for the country’s debt laden budget, and we could expect more volatility as negotiations with the European Commission continue,” says Fidelity’s Mr Lodha.
Mr Catechis of Martin Currie says uncertainty around the final ‘divorce’ deal in Brexit and Italian sovereign risk will be a preoccupation for markets. Mr Langley of RARE adds that political uncertainty and growth concerns in the region mean that utilities and other infrastructure names across the continent have been oversold and look attractively valued.
“We expect European growth to be firmer this year, coming in at trend rates or above, which will provide a boost to infrastructure valuations,” he says.
“While in the UK, a significant sell-off of the utilities sector on fears of a Labour government and a nationalisation program have dissipated. Some of this has already been reflected in resurgent share prices of UK names, but there is more to come here, and we remain overweight for now.”
Like Japan, Europe is slowly planning its exit from negative rates, but the pace of normalisation is expected to remain slow in these two regions.
Other geopolitical factors to look out for include rising crude oil prices, which are primarily driven by supply distortions in Iran and Venezuela and are also weighing on oil-importing economies, which calls for additional caution, according to Mr Lodha.
“All of these issues are interdependent, as the path of the oil price in some cases drives the path for bond yields and emerging market currencies,” he says.
“What is making things more complex is that price signals are increasingly spurious, as they are driven by algorithms and ETF trading.”
The long game
Fund managers generally agree that short-term market uncertainty this year will be a great opportunity for long-term investors, allowing multiple entry points to gain exposure to companies that are tapping into powerful long-term trends.
“From our standpoint as international equity specialists, we continue to see a huge amount of opportunity for investors looking beyond their domestic markets,” Martin Currie’s Mr Catechis says.
“For instance, optically, emerging market equities are around their long-term price-to-earnings average. However, we believe the asset class still represents good value in terms of an international equity allocation.”
Return on equity is fairly synchronised with developed markets, as represented by the MSCI World Index, although price-to-book and price-to-equity values remain low relative to history and developed markets.
For Fidelity’s Mr Lodha, the US and Japan continue to provide interesting bottom-up investment opportunities.
“The US growth outlook remains strong, due to robust macroeconomic data, tax cuts and fiscal spending stimulus, while overseas cash repatriation is encouraging buyback activity,” he says.
Meanwhile, Fidelity’s Alex Duffy considers the financial sector as being one of the most interesting areas of the market, given the balance sheet of dominant, retail-facing banking models. The portfolio manager believes these businesses are well-positioned to serve the pent-up demand for finance and consumption across emerging markets.
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