Step-back, Take Stock
Typically, investors are focused on the near term. That is understandable, given rapid shifts in sentiment about growth, politics and investment flows that can have meaningful impacts on portfolio performance. It pays, however, to occasionally step back and survey matters with a longer-term perspective. Among others, taking stock of trends in the world economy and asset prices can shed light on sustainable valuations and plausible long-term returns, which are essential for proper portfolio construction and strategic investment decision-making.
Fundamentally, the world economy has been characterised for nearly a decade by subdued growth, low inflation and extraordinarily low interest rates. While a number of factors have contributed to that outcome, demographics, modest productivity growth (despite extraordinary innovation) and subdued inflation expectations suggest more of the same over the medium term. At the same time, the arrival of full employment in the US, the UK, northern Europe and Japan points to the need for monetary policy to become less accommodative, a process which could unleash potentially disruptive adjustments across capital markets. Equity markets appear well supported by sustainably high levels of corporate earnings, with a potential transfer of leadership from the US to Europe, Japan and emerging markets.
Equity: Macro Rules as Anxiety Fades
As anxiety about electoral mishaps in the core countries recedes, investors in European equities should focus on the strong macro-economic backdrop and the significant recovery potential for European returns on equity from historically low levels. PMI data in France has continued to post multi-year highs so far in 2017 and it remains firmly in expansion territory elsewhere in the eurozone. Other measures of corporate and consumer confidence are similarly encouraging. Earnings revisions have turned positive for the first time in several years and the number of European corporates seeing upgrades has now surpassed the US. This makes for an increasingly compelling opportunity considering that both the relative performance of European equities against the US as well as the valuation premium remain close to multi-decade lows. While absolute valuations in Europe are less obviously accommodative than in the recent past they are still far from stretched with the forward price-earnings ratio only slightly above the median of the last 30 years. We have exposure to domestic European cyclicals that are well positioned in their respective markets but remains focused on companies offering compound value creation through structural growth, which will also benefit from the stronger economic environment.
Equity: Positioning for Virtuous Flows
Following the election of President Trump, a new world order emerged – investors were forced to grapple with the prospects of stronger inflation, which potentially would mark the end of a multi-year backdrop of deflation, secular stagnation and negative real rate distortions. With developed economies recovering at differing paces, emerging market (EM) assets have been caught in a cross fire of divergent G3 monetary policies. But looking at previous Fed rate hike cycles, EM stocks have typically rebounded once the first rise was completed. Earnings growth is also anticipated to be more buoyant in 2017 after a plethora of subdued years.
EM equities are the final investment-grade laggard that appeals to value, growth and yield investors. This, plus their valuation arguments, will start a virtuous cycle of investment flows to the region’s equity markets, and hence trigger an enviable prospective risk / return profile. This will come from being less volatile, having greater earnings per share and free cashflows than their developed peers, as well as being underowned.
Fixed Income: Emerging Market Debt – Stronger For Longer
Mark Twain once observed that ‘history never repeats itself, but often rhymes’. Historically, a key driver for emerging market (EM) asset performance – both equities and fixed income – has been the growth differential between EM and developed markets: as the growth differential widens, EMs typically outperform strongly until the economic cycle is complete. This element of history has actually repeated itself again and again. Looking ahead, however, the potentially interesting part of the EM story is that which could turn this repetition into a rhyme. Following an extended period of painful readjustment, EM economies are less vulnerable today than they have been for years because trade balances have adjusted significantly. Capital flows, which had weighed on currencies, have finally returned and foreign currency reserves have stabilised, providing a crutch to cheap valuations. In addition, economists appear to be underestimating the impact of a positive credit impulse on growth and, therefore, the potential for EM outperformance. This cyclical upturn is likely to rhyme with its predecessors, with the key differentiators being its potential to prove stronger and last longer.
Alternatives: Evolution not Revolution
When GAM launched its alternative risk premia strategy more than five years ago, the decisive challenge was to generate attractive returns with little correlation to other asset classes. This is something we have already managed to achieve, so the future is more about refinement rather than reinventing the wheel. Investors are becoming increasingly sophisticated, with many appreciating that much of what they used to think of as alpha is in fact hidden, or alternative, beta, which can be accessed at a much lower cost with complete transparency and daily liquidity. As investors advance to the next level of sophistication, they are going to demand even more from their providers in the form of sustained performance edge and proven expertise. The future always presents new challenges and, with 12 years of pioneering experience under the belt, GAM’s ARP team is more than ready to embrace them.
Equity: Japan – It Is Time That Perception Changed
Ernst Glanzmann / Reiko Mito
We often hear commentators referring to Japan as a country that has lost decades to an economic stagnation. But, for many residents of Japan and diligent investors, it has never really felt like a recession at all. The streets were neither filled with derelict shops nor occupied by beggars. In fact, we have been through a really exciting period for Japanese stocks. Various levels of corporate recovery have been visible at different stages, but the market has largely remained in the doldrums. Indeed, rather than stagnating as many infer, Japanese corporates are, on average, generating growth in earnings per share of around 7-8% per annum over a three-year cycle. Overseas observers tend to focus on Japanese GDP, which is improving but remains weak, and this is beguiling. Lots of companies are experiencing growth and improvements in corporate governance will benefit investors in terms of returns on equity. What’s more this has yet to be factored in to share prices – valuations remain attractive. In the future, we will continue to focus on strong companies while trying to avoid the value traps. And, rather than being constrained by a benchmark index, we look to take only the best out of the market. Our hope is that investors will cease to be paralysed by fear and come to appreciate the potential for Japanese companies to considerably enhance shareholder value over the medium term.
Alternatives: Where The Past Meets The Future – An Inflection Point
The global financial crisis (GFC) was seen by some as having the potential to mark the end of capitalism as we know it. Within financial markets there is plenty of evidence to suggest this has indeed been the case. For some time, security prices have been unable to find their own equilibrium and central banks, through their manipulation of the yield curve and by forcing interest rates to be held in a state of disequilibria, have created distortions across asset classes. We believe that we are approaching an inflection point where the past meets the future. There is only so long that continued improvements in the fundamentals can occur before even the most dovish of central bankers needs to respond. Over the past two years we have been noting these improvements but ever more negative interest rates, in the Euro area and elsewhere, have been pushing markets away from equilibrium. In a number of cases, valuations have become extremely stretched. We believe that the pieces are falling into place for a more notable shift away from the post GFC policies, allowing fundamentals to reassert as the primary driver of asset-price movements. In many cases, markets are still priced for a continuation of ultra-accommodative monetary policy and this appears to have created some very attractive and asymmetric trading opportunities.