As we said at the end of the first quarter, 2013 presents a better stock-picker's market than the risk-on/risk-off market — denoting investors' tolerance for more/less risk — of the past few years. But the backdrop for picking stocks is rife with question marks.
- The earnings picture remains mixed, which is a slight change from "less visible," the descriptor we used last quarter. Clarity depends on two critical questions — whether profit margins peaked last year and whether growth will accelerate during the remainder of the year.
- From a quality perspective, three factors are at play. First, if margins are stable, returns are likely to be stable; if margins have peaked, we'd expect net margins to drag down return on equity (ROE) unless global gross domestic product (GDP) accelerates. Second, merger & acquisition (M&A) activity, at record lows, is increasing, which may ameliorate growth prospects. Third, the potential for strong buyback activity to continue in the US and to rise in other markets may support shareholder returns.
- Concerning valuations, they remain constructive - particularly in Europe and emerging markets.
Here are several regional observations for investors to consider during the second half of 2013:
- Europe: European valuations are notably compelling versus US valuations.
- Broad Emerging Markets: In emerging markets, a material sell-off in 2013 accelerated at the end of the second quarter, leaving them looking particularly oversold. An improvement in global growth during the second half of the year may make emerging markets attractive for select investors.
- China and Brazil: Market corrections in the troubled economies of both China and Brazil have created opportunities to add to long-term growth opportunities at more reasonable valuations.
- Japan: Investment opportunities in Japan have been limited by political and structural issues that have reverberated in their economies.
During the second quarter, world equities, as measured by the MSCI World Index, were up a more modest 64 basis points this quarter after the strong 8% gain in the first quarter. Japanese equities, as measured by the MSCI Japan Index, closed up a more modest 4%, US equities, as measured by the S&P 500 Index, up a little less than 3% and non-US equities down 3%, as measured by the MSCI World ex U.S. Index. As in the first quarter, emerging markets carried the baton in terms of negative performance — the MSCI Emerging Markets Index closed down almost 8%.
|Global Markets Overall Reflect Moderating Trend
|MSCI World Index
|MSCI Europe Index
|MSCI All Country Asia Pac ex-Japan Index
|MSCI Japan Index
|S&P 500 Index
|MSCI Emerging Markets Index
|MSCI EAFE Index
|MSCI EAFE Growth Index
|MSCI EAFE Value Index
|MSCI World ex-U.S. Small Cap Index
Past performance cannot guarantee future results. An investment cannot be made in an index.
Matt Dennis, CFA
Senior Porfolio Manager
Earnings, quality and valuation — our view of global markets
When we look at the world through our earnings/quality/valuation (EQV) lens — the three characteristics our investment framework focuses on particularly closely — two key question marks become apparent.
The first question: Did profit margins peak last year after roughly four years of strong improvement, with scope for downside from here? It's not a stretch to argue that taxes, wages and interest rates will rise, creating headwinds for margins. In fact, since the start of the year, 2013 and 2014 consensus operating margin assumptions have fallen in every region of the world, bar Japan, with the largest downgrades to margin expectations so far coming in emerging markets.
The second question — the bigger one, I would argue: Are we at a growth inflection point right now? At the start of 2013, general expectation was that growth in terms of gross domestic product (GDP) and earnings would be less than exceptional during the first half, but that it was going to be a second-half year. So the critical question becomes: Are we on the precipice of that acceleration as we move in to the second half, or will those hopes be dashed?
Let's look at EQV more closely.
- Earnings: Picture remains mixed around the world
If the Federal Reserve's (Fed) message of tapering, improving purchasing managers indexes (PMI) we're seeing in Europe, and the strong move upward in bond yields in May and June are indicative of better growth to come, the scope for earnings revisions to improve is reasonable and considerable. But we're on watch right now for several reasons.
- Earnings revisions in the US and Japan are positive year to date, but European and emerging market revisions are negative. However, as always, the data are inconclusive when downward revisions to US and China GDP estimates year to date, combined with weakening PMIs this past month, are factored in. The US certainly appears to be on more solid footing, but China's willingness to allow slower growth to help unwind excesses in their economy clearly remains a near-term threat.
- The workhorse of Latin America, Brazil, is struggling with deteriorating growth, high inflation and a weakening currency, which only serve to stoke inflation concerns in that market.
- Anecdotally, we have an increased tone of concern coming from many multinationals about emerging market growth contributions in the second half.
- Lastly, the ratio of negative-to-positive second-quarter preannouncements for S&P 500 Index companies has shot up to a record high so far, which is inconsistent with an improving growth outlook.
Each incremental data point — whether the most recent European PMIs slightly above actual second quarter earns and revised outlooks or anything from China or the US — is going to be watched closely to help identify the earnings trajectory.
- Quality: Solid, but margins and return trajectory bear watching
With No change to constructive backdrop of strong corporate balance sheets and healthy returns on capital in most of the non-financials — but three quick observations on what we look for:
- Returns on capital, including return on equity or cash flow and return on investment, should track margins. If margins around the world, excluding Japan, have peaked, then we may have seen a cyclical peak in returns on equity unless global GDP accelerates from here.
- Strong balance sheets. Cheap capital remains constructive for merger and acquisition (M&A) activity. While M&A activity outside the US remains near lows, it's picking up because of flush balance sheets and the cheap cost of financing — either equity or debt — from corporations, many with limited organic growth outlooks.
- Buy Backs. The buyback story likely continues to support overall shareholder returns, in our view. In 2011 and again 2012, US companies spent in excess of $400 billion to buy back shares, the strongest buybacks we've seen. It will be interesting to see if the more modest pace of non-US buybacks picks up in late 2013 and 2014.
- Valuation: Constructive, particularly in Europe and emerging markets
Notwithstanding some strong moves we've seen in flows year to date, it's reasonable to argue that equities remain underowned versus cash and bonds.
- That's particularly true in Europe. Valuations are compelling versus those in the US — roughly a 35% discount based on cyclically-adjusted earnings and more than a 40% discount on nonfinancial book multiples.1
- The S&P 500 Index cycle-adjusted earnings multiple is getting close to 25x, more than 40% above its long-term average. That compares with 14x for European equities, a 30% to 35% discount to the long-term average.1
- After underperforming in 2011 and 2012, a material sell-off year to date has occurred incrementally in emerging markets, and they are definitely looking oversold. Emerging market equities are trading below their long-term average discounts to developed market equities, and they're the cheapest we've seen since 2005. If global growth improves in the second half of 2013, this is an area of the market that will benefit, in our view.
Europe — energy, materials, financials compelling amid signs of stabilization
While most European countries remain in recession with fairly low growth expectations, economic conditions appear to be stabilizing. Market pundits are focused on the pickup in May and June, and most recently, on data from the broad PMI indexes suggesting a pickup in activity. This stabilizing trend is encouraging, given constructive valuations and the scope for earnings upgrades.
While Germany continues to do well, we're starting to see signs of more stability in some of the more volatile European markets. Spain, for example, may be past the worst of credit compression, but we continue to wait and see. The UK is still muddling along as it deals with very tight fiscal pressures, but it's constructive to see signs of a recovery in housing, a critical factor in recovery, as it is in the US.
Liquidity constraints haven't really affected European core (Germany, France, the Netherlands, Finland, etc.) year to date as they did in previous years -- with the exception of Turkey, a notable casualty in terms of volatility. Though abating, the risk remains, given some weakness in the dollar here recently.
Even though we're more constructive in some financial areas, Europe has still not effectively addressed its banking sector issues. Authorities have roughly $500 billion in earmarked funds to address capital issues in the banking sector, but estimates to truly address them effectively reach as high as $2.7 trillion. That suggests that the European Central Bank (ECB) remains the lender of last resort. Should volatility return, the ECB may be forced to keep the zombie banks — those too unhealthy to lend to firms — walking.
On the earnings front, we continue to see downgrades, but PMIs are picking up. Over the past year, European margin expectations have fallen more than 100 basis points. The trajectory suggests that any positive indication on growth could spur stabilization. Valuations are supportive should the growth outlook improve, and large shocks from liquidity or defaults, for example, don't occur.
Where are we seeing opportunities in Europe?
- Energy exploration & production and energy services, offers interesting value opportunities.
- Investors with strong stomachs might consider exploring opportunities in materials after the earlier significant market selloff. We would be leery, however, of potential value traps, given weakness in expected longer-term trends in mining and mining capital expenditures.
- Financials are garnering more of our research hours. Should economic growth improve and interest rates rise, the scope for higher margins and better earnings growth in banks makes them decidedly interesting, given their current low valuation. But selectivity will be key until banking reforms progress.
Mark Jason, CFA
Asia and Latin America — market corrections create opportunities
For most of Asia and Latin America, the second quarter was characterized by fear of a strong US dollar and higher US yields, as well as a weaker global economy.
A major area of concern is China's GDP growth forecast, which has been falling. The market's looking for 2013 GDP growth of about 7.6% — although that seems strong, it's come down from above 8% in April.1 The significant market revisions have resulted from new leaders' moves to decelerate credit growth to correct what they see as the previous administration's missteps, such as permitting China's shadow banking system to flourish. In addition, the government's focus on tackling corruption is reducing consumption — Premier Li Keqiang very recently ordered 1400 companies to cut excess production. So the reforms, although positive for the long term, pose a near-term negative for growth.
Economies affected by the strong U.S. dollar, such as Australia and Brazil, are seeing decelerating growth factors, while their currencies weaken. The Australian dollar has weakened 12% in second quarter alone.1 But unlike in Australia, where the central bank is still easing, many emerging markets are taking more a hawkish stance in response to currency weakness, contributing to tighter financial conditions globally. We've already seen these reactions in Brazil, India, Indonesia and Turkey.
Brazil's currency has become problematic because the weakening Brazilian real is adding to inflation, currently close to 7%. The government's response has been to raise rates. They have already increased rates 125 basis points, and the market believes there's more to come — in the face of stagnating GDP growth.1
Despite these concerns, we've increased our weighting in both China and Brazil because market corrections are giving us opportunities to add to long-term growth opportunities at more reasonable valuations.
Japan — blue-sky valuations, lower expected returns limit investment prospects
Japan remains our largest underweight. Why? Because Prime Minister Shinzo Abe's success is being priced in, and breaking free from two decades lost to stagnation is a difficult challenge to overcome. Achieving real economic growth requires changes that are hard to implement.
Since our last call, Prime Minister Abe's party, already the majority in the lower house of parliament, won a majority in the upper house in a recent election. While the victory should allow him to push through some reforms, his position within his coalition requires him to make political concessions. As a result, we believe genuine structural and political reform in areas such as labor, taxes or social security will be difficult to accomplish.
Continued monetary stimulus has caused Japan's currency to depreciate 14% through the end of first half of 2013. Most of the depreciation occurred in first quarter; the currency has been more stable in the second quarter. In addition, compared with the first quarter, the Nikkei 225 Stock Average, the leading index of Japanese stocks, has moved much less dramatically in second quarter, appreciating only 4% to 5% in US dollar terms.1
We've talked before about Japan's anemic shareholder returns, and Japanese companies are still focusing on more balance sheet size, and less on profitability. Valuations are already reflecting optimistic, blue-sky numbers. Compared with the rest of the world, Japan has lower expected returns while valuations are similar. For example, return on equity for the Japanese market is 9.5% versus close to double that for the MSCI All World Country Index, while price/earnings ratios are roughly equivalent at 14x.2
Because our EQV discipline drives us toward high-quality companies at reasonable valuations, Japanese equities aren't affording us many opportunities to increase our exposure. Consequently, we continue to remain underweight in Japan.
Borge Endresen, CFA
Senior Porfolio Manager
Emerging markets — challenged fundamentals create long-term opportunities
No doubt about it — there are headwinds. But there's good news among the widely reported bad news.
First, the bad news. Profit growth in emerging markets remains poor for several reasons:
- Natural resources, a large part of emerging market economies, have stalled out.
- Financials, a large part of emerging market indexes, are in a slower part of the cycle.
- Labor wants a larger share of the spoils after a decade of growth.
- Interest rates are going up when they arguably should be going down to stimulate growth.
In addition, earnings expectations have continued to be downgraded essentially for the past two years, and the downgrades accelerated through the second quarter. For July the downgrades were close to 7%.3 Current expectations are for 8% earnings growth in 2013, moving into double digits in 2014.3 Consensus is that these earnings downgrades will continue for a little while more, although we expect positive growth.
Additionally, as a consequence of lower earnings — and poor investments, in some instances,— return on equity (ROE) has deteriorated. Emerging market ROE is currently about 13%. While that compares favorably with the MSCI World Index ROE at 11.7%, the downward-sloping trend is not helpful.1
Finally on the bad news front, the headlines are clearly not helping. Recent events in Egypt, Russia, Turkey and Brazil remind investors of internal conflicts in many emerging market societies and incite fear that these events may spill from the social sphere into the economic sphere.
But there's good news among the widely reported bad news.
Most important, valuations on an earnings basis are currently one standard deviation below average historic levels since 1992.3 This is equally true for forward estimates — which, as we all know, are prone to forecast error and eternal optimism — and for trailing earnings, which are the cold, hard facts. Trailing earnings are currently one standard deviation below historic averages going back 21 years.3
This is also true if you look at price-to-book ratios. Emerging markets are currently about 20% cheaper than the five-year average and about 30% cheaper versus 10-year average. For perspective, the US is about 20% expensive versus five-year average on same metric.1 It's important to reiterate that risk is a function of price an investor pays, not newspaper headlines — and the current price is more attractive than it has been in a long time.
Also in the good news category, according to the recently completed Merrill Lynch Global Fund Manager Survey, positioning toward emerging market equities is at the lowest levels since 2001.
As a prelude to discussing consensus positioning, I want to emphasize that emerging market contribution to global real GDP currently stands at about 30%1 — equal to the contribution of the US economy. It accounts for a larger portion of global imports, about 40%, and is therefore vital to global trade. As a result, it's difficult to reconcile a scenario of improving global growth — the expectation in the Merrill Lynch Fund manager survey previously cited — with a deteriorating emerging market growth outlook. Now, as in previous years, I don't believe in decoupling. So, in my view, consensus is likely wrong either about the global growth outlook or emerging market growth.
Is underperformance versus US markets over? No one knows, but probably not, in my opinion, given the fundamental challenges described earlier and the extreme short-term focus of market participants. The good news is that this speculation is fully aligned with consensus. More importantly, I think the period of underperformance is very far advanced, and none of us will catch the bottom perfectly.
To conclude, the attraction of emerging markets for long-term investors is not only intact, but also more attractive than it has been for many years because valuations and expectations are lower than they have been for a long time. Our EQV process is well-suited to take advantage of this long-term attraction.
Outlook for investors
The second quarter essentially saw concerns we expressed during our first-quarter call play out in the markets — overall stretched valuations in light of strong first-quarter performance in equity markets, a need for some consolidation given still-weak earning dynamics and the scope for higher volatility. We remain cautious about near-term market and economic fundamentals, given the continued lack of evidence to support the case for meaningful improvements in corporate profitability and economic growth.
In addition, investor sentiment has become more uncertain and cautious because of a growing list of concerns, including the possibility of these events occurring concurrently:
- The Fed starts "tapering" — or reducing the level of economic stimulus that has been the primary driver of strong equity returns — at a time.
- China's economic growth rate moderates faster than expected under a new government leadership, which appears to be happening.
- Economic slowdown and ensuing civil unrest in some emerging/frontier markets, including Brazil, Turkey, South Africa and Egypt.
Overall, our ongoing belief is that markets may be ahead of economic fundamentals and earnings, and therefore they remain vulnerable.
As always, regardless of the macroeconomic environment, we remain focused on identifying attractive companies that fit our EQV process. We emphasizes high-quality growth companies that exhibit the following characteristics: strong organic revenue growth, pricing power, strong balance sheet and cash generation, and reasonable valuations.
The price-to-book (P/B) ratio is a financial ratio used to compare a company's book value to its current market price.
Political and economic conditions and changes in regulatory, tax or economic policy in Japan or China could significantly affect the market in that country and surrounding or related countries.
Sovereign debt securities are subject to the additional risk that — under some political, diplomatic, social or economic circumstances — some developing countries that issue lower quality debt securities may be unable or unwilling to make principal or interest payments as they come due.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded. The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified funds.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
Diversification does not guarantee a profit or eliminate the risk of loss.
There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.
FOR US USE ONLY
Note: Not all products, materials or services available at all firms or to all investors. Advisors, please contact your home office or financial advisor.
All data provided by Invesco unless otherwise noted. Lipper is the source for index and market return data as of June 30, 2013.
The opinions expressed are those of the author, are based on current market conditions as of July 25, 2013 and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This information should not be relied upon as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks.
Please obtain and review all financial material carefully before investing. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor.
Past performance cannot guarantee comparable future results.
The MSCI EAFE® Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. The MSCI EAFE® Growth Index is an unmanaged index considered representative of growth stocks of Europe, Australasia and the Far East. The MSCI EAFE® Value Index is an unmanaged index considered representative of value stocks of Europe, Australasia and the Far East. The MSCI All Country Asia Pacific Ex-Japan Index is an unmanaged index considered representative of Pacific region stock markets, excluding Japan. The MSCI Europe Index is an unmanaged index considered representative of stocks of developed European countries. The MSCI World ex US Index is an index considered representative of developed and emerging market stock markets, excluding the US. The MSCI Japan Index is an unmanaged index considered representative of stocks of Japan. The MSCI Emerging Markets IndexSM is an unmanaged index considered representative of stocks of developing countries. The MSCI WorldSM Index is unmanaged index considered representative of developed countries. The MSCI World Ex-U.S. Small Cap Index is an unmanaged index considered representative of small-cap stocks of global developed markets, excluding those of the U.S. The Nikkei 225 Stock Average Index is an unmanaged index representative of a price-weighted average of 225 top-rated Japanese companies listed in the first section of the Tokyo Stock Exchange. The S&P 500® Index is an unmanaged index considered representative of the U.S. stock market. The Russell 2000® Index is an unmanaged index considered representative of small-cap stocks. An investment cannot be made directly in an index. Index returns do not reflect fees or sales charges.
Invesco Advisers, Inc. and Invesco Distributors, Inc. are wholly owned, indirect subsidiaries of Invesco Ltd.