Central banks seem to be stuck in a feedback loop of politics, economics, and market vulnerabilities, with politicians joining the critics of low interest rates. In Europe in particular, the ECB’s dovish actions will continue to influence other central banks throughout Europe and negative interest rates will continue to proliferate the continent. President Draghi postponed any decision-making on further quantitative easing to December, when updated macroeconomic forecasts and the conclusions of relevant committees working on QE implementation will be available.
Against this backdrop, central banks are likely to tread carefully when contemplating how quickly to hike (Federal Reserve), how soon to taper (European Central bank), or even what steps to take to increase monetary stimulus (Bank of Japan). Even though China’s policy-induced growth surge does not look sustainable, Europe’s problems appear even more severe. Portugal may keep its investment grade status over the course of this year, but its banks remain impaired and its debt dynamics very challenging. Italy, with the world’s third-largest sovereign debt market, is in a similar position. Europe’s fragilities are amplified by political risks: Greece has just begun a difficult program review, Italy is approaching its crucial referendum and Spain still has no government.
All factors considered we think European interest rates stay on hold and the FED continues to raise interest rates in December. This is an interesting fact but does not drive our investment process per se, but only influences our decision making process if low interest rates lead to opportunities for us in the equity market
Has quantitative easing helped certain sectors more than other?
The table below illustrates that the technology, energy and utilities sector have been the best performers this year in the US. We have zero exposure to the last two and one could argue that a low interest rate environment has helped the utility sector this year. We remain concerned about long term fundamentals for most utility companies due to regulatory pressures. On the flip side we still see lots of opportunities for certain sectors within technology to keep growing whilst using strong free cash flow to reinvest back into their businesses or return cash to shareholders. Names which performed well for us this year include Alphabet, PayPal, Samsung, Microsoft and Oracle.
Figure 1. S&P 500 Sectors
Source: Merion as at 24/10/16
Has low bond yield resulted in high equity valuations in certain regions of the global equity market?
Global bond yields continue to be extraordinarily low – see table below
Figure 2. Global bond market 10 year yields
The reason equity valuations in “bond-like” equity proxies are high is perhaps because bond investors are flocking into these names and pushing valuations higher even when earnings growth is weak – see the tables below. It should come as no surprise that over the last two years we have sold names like Louis Vuitton, ABI Inbev and British America Tobacco as valuations reached unsustainable levels.
Figure 3. Staples growth
Source: Goldman Sachs and JP Morgan
Looking at growth prospects of consumer staples our short term more negative view has been reinforced by evidence from the third quarter reporting season, as multinational staples companies grapple with slower emerging markets, more competition and developed market disinflation causing EPS growth to fall to a 20-year low (see chart above). Over the last two years we have substantially reduced our consumer staples exposure in favour of mostly an increased health care position.
For companies like Nestle where slower growth rates are widely expected we do believe this increases the likelihood of strategic action by the new incoming CEO and illustrates that well run businesses with strong moats can make meaningful changes to their business model if the micro environment is difficult.
On the flip side for businesses like Coca Cola (which we sold six months ago) the fundamentals remain tough with sales globally and in Europe in particular very challenged. We are watching this business with a keen interest to see how their new strategic plans work out over the next three years as they disinvest from their bottling operations.
The table below show that dollar sales growth has withered for Coca Cola lately:
Figure 4. Coca Cola quarterly dollar sales growth
Source: Goldman Sachs
Source: Goldman Sachs
If we are selling certain consumer staples stocks are there other high quality names on our radar screen in Europe?
Essilor is the leading player in a market that should generate decent defensive growth over the longer term. The Company designs, manufactures and markets a range of lenses to improve and protect eyesight. It also develops and markets equipment for prescription laboratories, and instruments and services for eye care professionals. It operates through three segments: Lenses and Optical Instruments, Equipment, and Sunglasses & Readers. While this growth is defensive, it is also relatively modest. Essilor has boosted its organic growth through M&A as it continues to consolidate a fragmented market.
Looking at the valuation below one could argue that a 3.83% free cash flow yield is attractive vs. local French bond yields at barely 50bp. However as equity investors it would be foolish to measure equity risk against a potential bond bubble in sovereign European debt. We therefore prefer to remain on the side lines for many European high quality names like Essilor even when the growth prospects appear rosy long term.
Figure 6. Earnings yeild (& local bond yield)
Source: Goldman Sachs
Are there value traps to due ECB tapering efforts and other monetary easing efforts?
European banks looks extraordinary cheap on a relative basis and following a period of severe under performance due to money printing activities globally. These monetary efforts have compressed interest rate margins for the banks and caused earnings to collapse.
We continue to avoid the banking sector until such time as we become more confident that Europe can withstand a higher interest rate environment.
Figure 7. MSCI Eurozone price relative to MSCI World
Source: JP Morgan
Figure 8. MSCI Eurozone 12m Fwd P/E relative to UK
Source: JP Morgan
Figure 9. Eurozone Banks P/Book relative
Source: JP Morgan
Where are we investing in today’s low inflation environment?
Medical care CPI inflation has accelerated sharply this year. The increase is broad based across medical goods and services. We think the rise in medical CPI is being driven by structural shifts in the health care sector. We are exposed to healthcare at a sector level through both drug companies and medical equipment companies and are looking for opportunities to re invest in names like Stryker on any pullbacks. Our list of top positions also reflects our “healthy” health exposure to an industry we perceive as a solid growth sector long term.
Figure 10. Prescription drugs are driving medical goods inflation
What has driven equity returns over the last 2 years?
Figure 11. Rolling 2-year in $US
Source: Bloomberg, SPW
Many investors favoured Europe and the UK over the last two years but we have been consistently under weight both these regions (on a combined weight). The Nasdaq performed well and through companies like Alphabet and Microsoft, two names we continue to favour, we remain invested in that part of the market due to secular growth dynamics even as these names reach new all time highs.
Over the last six months emerging markets have performed well after 18 months of severe underperformance before that but we have sold positions like NetEase and Samsung after very strong moves of 40% or more in US$ terms on average having built up these positions when valuations were low.
Top positions for the global equity strategies managed by SPW UK
Our core positions continue to favour companies with pricing power, strong balance sheets and decent growth prospect whilst trading at attractive valuations. Positions are diversified amongst sectors we continue to believe will have good growth prospects long term irrespective of the macro environment. Examples are included below: