14 July 2014

Equities draw interest despite valuation concerns 

The article outlines how banks are reconsidering investing in emerging markets as equity valuations have become attractive again after more sceptical market sentiment earlier this year

With global equity markets at record highs, investors are having to hunt far and wide to find value, but wealth managers believe the asset class remains attractive

As the global equity rally enters its sixth year, with the S&P500 reaching new record highs in June having hit the bottom in March 2009, investors are worried about how long the growth will last and whether equities will remain attractive.

Valuations have increased significantly from very low levels, driven by gradual normalisation in the global economy and supported by exceptionally accommodative monetary policy. While there has been a broad-based and substantial upward move in international equity markets, with the US and Europe leading the way, selectivity is key today.

"The easy money in equity markets has been made over the last five years, when there has been a massive recovery of valuations from extremely depressed price levels," says Alan Mudie, who recently joined Société Générale Private Banking as head of investment strategy. "While there is not a great deal of value in major market indices, attractive valuations can still be found with careful market, sector and stock selection," he says.

But as ‘markets climb a wall of worry’, investors may have missed much of the performance, and now may find it difficult to get back in, considering how far prices have risen.

"An improving global economy, with the resulting increase in corporate profitability, will provide some support for equity markets from earnings, which should enable them to continue to rise on average," states Mr Mudie. "We remain with an overweight allocation to equity markets for our clients."

Also, the greater dispersion in returns or the variability of price performance between stocks and sectors indicates the market is beginning to trade off fundamentals, which provides opportunity for stockpickers, in particular in the alternative space, for example for long/short managers.

"One of our themes is ‘go East’ – rotate out of some markets which have generated good returns for us in the US and Europe, and move to the Asia Pacific markets," says Mr Mudie.

Despite the stockmarket run last year, the next phase of both monetary accommodation from the Bank of Japan and reform packages implemented by the Abe administration could be very positive for Japanese equity prices and negative for the yen. The French bank is looking to hedge exposure to the yen but continue to benefit from the second, "imminent" uptick in Japanese stock prices.

Attractive valuations are found by the bank in the more developed markets of the Asia Pacific region, such as Australia, Singapore, Taiwan and South Korea, which are well geared to the improvement in global trade and economies in the West, driven by the US. These markets have also tended to be under-owned by investors and there is anticipation that money will flow back into those regions.

Within the eurozone, Société Générale  recommends a refocus on Germany. The periphery equity markets, such as Spain, Italy or Greece, having enjoyed a period of strong performance driven by financial and banking stocks, are now less interesting and investors should buy the "underappreciated" German market. German equities are trading at 13.9x forward earnings, below the eurozone average of 15x.

But Europe, and peripheral countries in particular, continues to draw interest. "Valuations in Europe are not cheap but, on a relative basis, we believe the region and particularly periphery Europe are interesting," says Iain Armitage, head of investments for Emea at Citi Private Bank.

With a tactical overweight to global equities, the bank is overweight in developed markets, such as Europe or US, over emerging markets (EM). Here selectivity is key, and countries with strong fiscal and external trade deficits, such as Northern Asia, are preferred over economies such as Brazil and India, where structural deficit remains a challenge.

"The message we set up with our clients at the beginning of the year is still intact, which is to overweight equities, which remain attractive today," he says, explaining the bank has a fairly strong and constructive view about the underlying economic situation.

Unloved emerging markets

Concerns about EMs’ growth and China’s possible hard landing have made developing economies one of the most unloved areas of investments. But market sentiment seems to be gradually changing due to attractive valuations, although caution prevails.

Both Societe Generale and KBL European Private Bankers (KBL EPB) in June moved back to a neutral position on emerging markets.

"The risk of hard landing in China has decreased significant since the beginning of the year," says Stefan Van Geyt, group CIO at KBL EPB. "EM valuations have become more interesting too – they are now at fair value –which is why we believe it is time investors dip their toes back in emerging markets."

This is in contrast to what the Luxembourg-based bank had been previously recommending, ie to invest in developed markets only, believing investors were not sufficiently paid for the risk taken in emerging markets.

But EM equities have stabilised since the sell off early this year and offer compelling growth prospects for longer term investors.

Moving back into emerging markets would be a contrarian call and a logical one, from a valuation point of view, acknowledges Johan Jooste, UK CIO at Julius Baer, but challenges around earnings explain the bank’s underweight position in these economies.

 "Our equity exposure is focused on developed countries, which will still have a quarter or two of reasonable run on earnings," he predicts. "The emerging market trade is one where timing is critical and we are still a bit cautious."

The main challenges come from commodities, where supply demand dynamics are not expected to drive prices up. "Quite a lot of emerging markets are sensitive to commodity prices, which have not exactly been stellar, and our view on these is sideways, at best." Also, states Mr Jooste, global demand from developed markets needs to be stronger before it flows into emerging market exports.

The consensus is that EMs will eventually re-orientate towards domestically-generated growth, but these are long-term structural arguments, which will take time to develop.

‘Normalisation’ of the global economy will impact EMs more than developed markets, says Kieron Launder, Cazenove Capital Management’s head of investment strategy, and on that thesis the firm has been overweight developed markets for some time.

‘Normal’ means global sustainable growth. But this is going to be lower than the exceptional levels reached pre-crisis, when expansion was driven by debt and leveraging in the West. Export-oriented emerging companies, which greatly benefited from this, will be hit.

 However, he says, the most attractive opportunities are usually found in unloved areas and EMs are certainly unloved. In value investing, which characterises investments in emerging markets today, it is crucial to look for "micro catalysts or macro turning points", which may be specific to a company or country.

These may be the election of prime minister Modi in India, or signs of stability or determination in China to attain 7.5 per cent growth. Recent stability in EM currencies can also be seen as a turning point, states Mr Launder.

With the US equity market returning 200 per cent including dividends over the past five years, getting dollar-based investors to a level close to the index weight in EMs takes some work, explains Leo Grohowski, CIO at BNY Mellon Wealth Management. "Most investors are well underweight the index level in EM equities, as they have not felt the need to look elsewhere, and usually that is exactly the time you want to start looking elsewhere," he says.

The American bank favours US stocks, in particular large caps where valuations are still "reasonable"; it has become "more constructive" on Europe, but it maintains a neutral weight to EM equities. With EM equities trading at a P/E multiple that is at a 30 to 40 per cent discount to developed markets, today will turn out to be a very good entry point, he says. "But we are only neutral weight because we do recognise that it could take a few quarters for some of the concerns about China to smooth out or some of those outflows to dissipate."

However there are opportunities to take advantage of those dislocations for investors who have intermediate to long-term time horizons. But even for those who profess to be long-term oriented, it is hard not to be short-term in their actions, as investors are equipped with short-term information and have access to portfolio daily values. "Behavioural finance helps us to understand why emotion is so hard to divorce from the discipline required to be a long-term investor," says Mr Grohowski.

Bringing a contrarian view, London-based multi-family office Stanhope has a strong underweight in the US equity market, due to valuation concerns, and is overweight everywhere else as a result, including EMs.

"China looks cheap," explains Jonathan Bell, CIO at the firm. "The Chinese market has fallen by almost 60 per cent since the end of 2007, whilst earnings have doubled and the P/E has fallen from almost 50 to a prospective of 6.3, looking two years out. The current price to book is also reasonable."

Russia would look cheap but is higher risk, and overall other EMs are generally attractive, states Mr Bell.

Emerging market investment manager specialist, Ashmore, warns of the dangers of investment bandwagons.

"There has been a true negative sentiment towards emerging markets to the point of selling them down so much relative to the earnings expectations and that’s why they are cheap and there is value," explains Julie Dickson, equities portfolio manager at the firm, emphasising that EMs cannot seen as a homogenous group. "I think it is very important not to be influenced by this herd behaviour and not to paint emerging markets with just one brush."

Across EMs, companies have been very profitable and are growing their businesses despite headline news, for example in the Middle East. "There is an enormous amount of concern around Iraq and other places in the region. However other countries such as the UAE, Qatar and even Saudi Arabia have been so far resilient in the phase of this conflict, with companies within those markets able to generate earnings growth,"she says. "But it’s very important to be selective."

Another over-reaction was the selloff of Russian equities in March. The market priced in the risk of a "cataclysmic outlook", anticipating Russia and Ukraine and even the US could go to war, which was extremely unlikely, maintains Ms Dickson.

When picking stocks it is important to understand whether the risk implied in the valuation is actually realistic, she states. Markets in Russia have recovered very sharply, as the new government in Ukraine was officially recognised and is opening channels of communication. 

"China also gets beaten up a lot and unjustifiably so," believes Ms Dickson. China has been on a path of reform for the last three to five years, its growth is expected to remain in the 7 to 7.5 per cent region, earnings are also very stable and the country is going to benefit from the recovery of the global economy.

"So far China has delivered, but every time there is bad news, the market gets hit really hard. At the moment the country is in a nice sweet spot, and there are a lot of opportunities out there."

Other "groundless bandwagons", according to Ashmore, relate to the negative sentiment on the Fragile Five – Brazil, India, Indonesia, South Africa and Turkey – identified by Morgan Stanley as particularly vulnerable, in particular to Fed tapering, due in part to large current account deficits. That highlights the "tendency to confuse cyclical imbalanced such as inflation or current account deficits with intractable structural problems".

On the other side, a positive sentiment towards Abenomics is based on the false belief that "Japan can fix all its structural problems with a dose of fiscal and monetary stimulus," according to the investment firm.

Herd mentality in investing is a "double-edged sword". On the one hand it creates opportunities, on the other it creates headwinds. Good companies sometimes get sold off for no reason other than the fact they happen to be in unloved markets, whereas expensive companies are in demand because their markets happen to be in favour.

Investors have to take a long-term view and look at the valuation of fundamentals. "You have to take a long-term view, but you have to be patient, and hold your nerve through these market movements, and if you have a strong value discipline then you are able to generate value over the long-term," says Ms Dickson.

- Professional Wealth Management