Macro indicators and the search for yield
Our principal short term concern for equities remains the relatively negative outlook for company earnings. Despite recent improvements in the commodity and emerging market landscapes, valuations remain in high territory, with longer-term earnings forecasts also likely to be revised downward should global growth remain at the current soft levels.
Global equity markets remain remarkably subdued with the number of days since MSCI World recorded a +/-1% move now at 40 days and daily volatility hovering around 10 year lows. Last month was dull in the financial markets, even by the normally sleepy standards of August. The S&P 500 stock index didn’t move up or down by more than 1% in a single day all month. This lack of volatility coupled with depressed interest rates presents a challenge to those tasked with generating returns. However, while today’s rate environment is highly unusual, the volatility is not. Indeed MSCI World has already been through sustained multiyear periods (1992-1997, 2003-2007) with similarly low levels of volatility – periods associated with major equity bull markets and notably strong profits growth.
At times like this, it’s good to have a more active investment approach and remain selective of entry and exit points for individual securities within a narrow overall trading range in the market. Our focus continues to be one of investing in quality companies that offer sustainable longer-term returns. Amid all of the uncertainty and concern for global economic growth, there could be a glimmer of hope for those seeking decent returns – emerging markets appear to be waking from their five-year slumber. However one must be very careful in which areas you invest. The decline of return on capital and return on equity in recent years within emerging markets are well documented and include:
- structural factors including slower productivity growth and a lack of structural regulatory reforms,
- companies raising excessive capital and allocating capital inefficiently,
- a slowdown in top line growth,
- poor cost discipline and
- strong wage/employee compensation growth
Figure 1. Average Return on Capital and Return on Equity
Source: Datastream, BCA Calculation
While it’s still too early to get overly excited, emerging markets do indeed deserve some attention. Over the course of history, they have outperformed their developed peers, enjoying higher economic growth rates, better demographic trends and a more attractive risk premium. The underperformance of emerging markets relative to developed markets over the last few years means that valuations are cheaper and margins have room to improve. As a result, good investment opportunities are presenting themselves, even accounting for the added inherent risk. A recent example is Aberdeen Asset Management which is heavily exposed to emerging markets and was bought opportunistically during the Brexit related mini crises at the end of June. Aberdeen is currently showing a book profit of 7% in AUD within the Clime International fund as we invested in two tranches.We continue to focus on areas in emerging markets where companies can grow due to strong consumer demand without returns on capital being depressed because of new competition. Year-to-date figures show that emerging markets are outperforming those of developed markets on a relative basis. We have enjoyed 20% plus AUD returns this year from names like Yum! Brands and Samsung where their focus continues to be to grow their market share in the Asian consumer market. We have used these rallies to take profits (Yum) or sell our positions completely (Samsung) as we wait for better entry points again.
Quality factors continue to dominate returns over the last 12 months
Investors who focus on buying high quality companies continues to out perform strongly over the last 12 months courtesy of outsized outperformance in Europe and the US. The downside is that valuations in Europe in particular for consumer businesses like Nestle and Unilever remain elevated as investors continue to be attracted to the growing dividend stream. The graph below indicates that high quality stocks continue to trade at a premium to low quality stocks and that the premium has widened over the last few years.
Figure 2. Widening valuation spread – high and low quality stocks
Source: SG Cross Asset Research / Equity Quant
Globally value styles enjoyed a strong resurgence in August and indeed from the June lows in the market. We are pleased that the fund has taken advantage of the pullback during the middle part of the year as names like Moody’s is up by close to 20% from its low point in JuneOn the flip side the recent pullback in a high quality business like Novo Nordisk, a leading drug company listed in Denmark is finally showing up as getting closer to fair value on our radar screens after a 25% pullback year to date.
How do we react to slower growth environment?
With equity markets having traded in an ever tighter range in recent weeks, it did feel that a breakout of some sort was due and markets have slowly grinded higher. The market is very comfortable with the view that interest rates will remain low for a long period of time, and the rates market is still predicting a much shallower normalisation than the Fed. The dollar is weaker this year against most emerging market currencies and about 5% against the AUD since December last year. We maintain a fundamentally bullish view on the Dollar due to our expectations for US rates which are likely to rise eventually, whereas the ECB, BoJ and BoE (along with a number of other central banks) are still looking to ease policy. This policy divergence should be supportive for the Dollar. Also, despite our worries over the structural health of the US economy, we do believe that it is better placed than most. We still think that Europe and Japan have major structural issues that are mostly being ignored by policymakers, and the UK has the Brexit negotiation to resolve. If the dollar was to rally it should put pressure on US multi national companies which should provide us with some opportunity to increase our equity exposure in the fund.
Fund performance in AUD
Clime International Fund
PERFORMANCE TO END OF AUGUST 2016
*** Total return including the reinvestment of income / dividends received
There are a few observations from the table above. We have mentioned in the past that the outlook for equity market returns are subdued unless a market correction presents us with a better opportunity to put more cash to work in the fund. It is noticeable that the equity market returns over the last year has been flat with significant volatility in January, February and June. The frustrating element of this year’s equity environment is that the pull backs have been sharp but quickly reversed within a few weeks. Whilst we did invest aggressively in February and June of this year we were left frustrated that the market did not suffer a more significant broader medium term correction. Perhaps we can blame Central Banks unconventional actions for this market phenomenon?
Over the last year and rolling two years our returns are comparable to that of the market overall but with a significant increase in valuations within sectors that we would like to invest in but is deemed too expensive (mostly household good companies, pharmaceuticals, business service companies and cyclical industrials). In a nutshell our relatively large cash position has not hurt the fund due to superior stock picking.
Our watch list of high quality companies are broad and the long term opportunities plenty to invest at hopefully more compelling valuations. We are looking forward to deploying more cash into the equity markets on your behalf when the opportunity arises.