At GAM Investments’ Weekly Investment Meeting held on 03 April 2019 the speakers were Michael Biggs, who provided a macro overview, Niall Gallagher, who outlined some of his areas of focus within the European equity arena, and Tim Love, who explained why he continues to feel optimistic about the outlook for Emerging Market equities.
Global growth slowed sharply at the end of 2018 and into the early part of this year. This weakness was particularly evident in purchasing managers’ indices (PMIs) and industrial production. We think the weakness is very much trade-related and at least partly driven by China; the same weakness is also evident in the euro area.
Our view is that US growth, which was strong last year largely due to fiscal stimulus, is likely to slow from here, while at the same time growth in China and Europe recovers. That would be a good environment for risky assets – adequate growth combined with a weaker or sideways US dollar and low yields.
In China, lending surged in January then normalised somewhat in February. Policymakers have eased interest rates, which we believe should help the credit impulse make further gains. In the past it has only been a matter of time before this has fed into economic activity, and we have already seen a strengthening in China’s PMI. An associated rebound in industrial profits is still required to confirm a recovery, but we expect an improvement in the coming months. If this does not happen it will be difficult to sustain the growth rebound.
Last year new borrowing in the euro area slowed and the credit impulse turned negative. However there were also a number of one-off factors, such as emissions regulations for the autos sector and Rhine river water levels, which caused growth to slow by more than we expected. We expect euro area growth to rebound when these shocks unwind.
Evidence of a euro area recovery has been mixed. Industrial production and retail sales growth were strong in January, despite weakness in Germany. German car production rebounded in February and manufacturing sales have been stronger than production. We need to see PMIs rebound and the real activity strength to be maintained to be sure of a rebound in euro area growth.
A stable US economy and stronger growth in China should support risky assets, but some US dollar weakness could trigger a significant rally. For this, though, it is likely that we need to see a strengthening in euro area growth.
It has been a positive start to the year for European equities. Global equity markets rebounded in the first quarter of 2019 following a very challenging fourth quarter of 2018. We believe that European economic data sets were negatively affected by a number of standalone events towards the end of 2018, including the new vehicle emissions testing regime (WLTP) and weather issues surrounding the Rhine river water levels which particularly dented German industrial production data. While economic sentiment remains jittery, with geopolitical concerns over Brexit and trade wars, we are not seeing this uncertainty reflected in companies’ underlying results. US-China trade tensions remain at the fore and a quick resolution would be beneficial to global activity, we believe. A resolution to the trade dispute is also important given that China and emerging markets are increasingly more important to the earnings of European companies - over 50% of the revenues of European companies are now derived from outside of developed Europe, with over one third coming from emerging markets. Going into 2019, we remain positive on the outlook for European equities. We feel that European stock valuations, dividend yield and corporate earnings look attractive. Stock selectivity this year is likely to prove key in extracting the benefits from this asset class.
Turning to our current themes, we feel that the retail sector has undergone major structural changes owing to the rise of internet shopping. A good example of this trend is Zalando, a pure play online retailer. We believe it is making the necessary changes in order to future proof its business model by becoming a platform that can enable retailers to access their own stranded inventory to service the platform’s 26 million strong customer base in a manner of their choosing.
The rise of the Asian premium consumer who has developed a taste for luxury products remains another key investment theme. We believe that companies such as LVMH are able to successfully tap into this growing trend and we think the company’s strong performance recently is testament to its reinvigoration of innovation.
We remain positive on the structural growth trends prevalent in Italian wealth management and we feel that FinecoBank is well placed to take market share in this space. From a technology perspective, we are of the view that this is one of the most sophisticated banks in Europe (the CEO is a software engineer).
We are seeing a recovery in Ireland’s construction markets. An example of a company benefitting from this trend is materials company Grafton group. We believe that the management have emerged stronger out of the structural challenges facing the industry and the company has become very competitive in this space.
We do not think EU policymakers realise the true consequences of tepid banking sector profitability. As a result, we do not feel that EU banks represent good value; ultimately, we believe that a change in the interest rate paradigm is required to enhance banks’ performance.
Emerging Markets Equity
In our view, the reason why emerging markets (EM) equities remain under-owned relates to the higher levels of volatility seen across the EM universe (around 16% per annum). The MSCI EM index remains substantially below the peak levels witnessed in 2007, so, on a relative basis, the asset class has effectively been in the wilderness for 12 years, notwithstanding the very robust performance witnessed in 2017. The first quarter of 2019 has proved less challenging than the calendar year of 2018, with solid gains recorded, but we believe this is the first leg of the recovery and that there is more to come.
Therefore, in our view, we are in fascinating territory for EMs. We remain focused on fundamentals, valuations and the risk / return logic for buying this asset class. Our overall approach is style agnostic – we seek to buy quality stocks at cheap valuations in the context of a disciplined risk management framework. We think it is essential to capture the upside (as well as aiming to deliver some downside insulation) and, in order to achieve this, we need to be prepositioned for rebounds from troughs.
We often refer to the EM equity complex as being the last remaining ‘investment grade laggard’. Eight of the top 10 EMs are investment grade – the two exceptions being South Africa and Brazil – and this compares with just four out of 10 in the early-to-mid 2000s. Since EM equities have substantially underperformed the equivalent sovereign bond markets, we expect to see some liquidity inflows from crossover investors and those seeking positive carry trades. EM stocks are well positioned in terms of the structure and robustness of balance sheets and appear to offer compelling appeal to value, growth and ‘search for yield’ investors. On a price-to-book basis, the universe trades at a very cheap 1.3x (compared to 3.0x at the 2007 peak), while P/E multiples are also undemanding compared to any of the growth-based ‘disruptors’ (such as the FAANGs in the US). They also offer a healthy dividend yield of 3.5%, which is currently growing at a rate of around 15% per annum.
In terms of positioning, we are currently seeing a tilt towards cyclicality, but this reflects the fact that our pricing models are steering towards sectors such as financials, industrials and real estate in our continuing quest to capture uncrowded alpha. Our aim is to put risk capital to work with conviction. We have just completed our asset allocation and model recommendation for Q2 2019 in which we believe the key drivers will be a more dovish Federal Reserve (good for local currencies, some of which have sold off massively), China stimulus and trade war reconciliation. At the country level, we believe Turkey has become very oversold but we prefer to put risk on the table where the outcomes are less binary. For example, we believe there is a 60% chance that Brazil will embark on a reform passage by autumn of this year and, as we have experienced before, it generally makes sense to align positioning with progress on regulatory reform. Similarly, Russia is the subject of the fear of further sanctions and valuations are sufficiently compelling for us to buy into the recent sell-off. Conversely, we are underweight Taiwan, South Africa and, to a lesser extent, India. All of the country-level positions reflect the reconciliation of the top-down and bottom-up recommendations of our models.
Finally, in terms of frontier markets, we continue to favour the VARPS (Vietnam, Argentina, Romania, Pakistan and Saudi Arabia), which are typically uncorrelated to the broader EM universe and offer investment growth at reasonable entry valuations. They are all candidates for further MSCI EM versus frontier market upgrades and provide reasonable liquidity with positive credit momentum in the main.
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Source: GAM unless otherwise stated.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. Reference to a security is not a recommendation to buy or sell that security.