Market performance continued to be very strong during the fourth quarter of 2012, as risk-on trading — when investors move to higher-risk assets from cash and Treasuries — drove stock markets higher around the globe. Foreign markets outperformed US markets, with especially strong performance from China and Europe, up 12% and 7% respectively during the fourth quarter.1 However, this very strong market performance wasn't necessarily supported by strong economic activity. In general, we actually saw relatively weak activity, as well as continued downgrades to corporate earnings expectations.
As our team said at the start of 2012, there was some risk that higher-quality stocks might start to underperform after enjoying significant outperformance during the risk-off environment in 2011. A snapback was inevitable at some point, and that's exactly what we saw in the second half of 2012: Higher-beta, lower-quality stocks tended to work well over the year.
In 2013, we believe quality stocks could continue to lag in a strong risk-on environment, where markets continue to rise sharply. But because part of this snapback has already occurred, we may see renewed market rotation with quality stocks starting to return to favor again.
Despite the robust stock returns in 2012, it's important to remember that headwinds remain. These include the continued deleveraging by Western consumers and institutions — in our view, this will likely dampen future growth prospects relative to the past. In addition, the European crisis is not over and remains likely to cause future volatility.
|Attractive Performance but Potential Volatility Remains
International market returns (%) as of Dec. 31, 2012
|MSCI EAFE Index
|MSCI World Index
|MSCI All Country World ex-U.S. Index
|MSCI Europe Index
|MSCI Japan Index
|MSCI All Country Asia Pac ex-Japan Index
|MSCI Emerging Markets Index
|S&P 500 Index
|MSCI EAFE Growth Index
|MSCI EAFE Value Index
|MSCI World ex-U.S. Small Cap Index
|Russell 2000 Index
Senior Porfolio Manager
Earnings, quality and valuation — our view of global markets
Our investment framework closely analyzes three key characteristics — earnings/
quality/valuation (EQV). Here's a snapshot of each of these characteristics as of the
- Earnings: Negative earnings revisions continue in all geographic areas, including the US. It's possible, however, that this trend may stabilize and start to reverse. Expected earnings growth in 2013 is about 10% for Europe and the US but with much stronger growth in Asia and emerging markets — between 14% and 20%.2
- Quality: Overall, quality remains high. This is illustrated by return on equity (ROE) that is solidly in the high teens and balance sheets that continue to be strong.
- Valuation: Markets and valuations have moved up somewhat. The price/earnings (P/E) ratio range, closer to 10 at the beginning of 2012, is now closer to 11 to 12.5 times,2 depending on the particular market. These still appear mostly attractive for long-term investors, but quality stocks are often priced at a relative premium.
Now we'll look at how regions fared on a macro level during the fourth quarter.
Europe — remains sluggish, but much negative news is priced in
The Euro Stoxx 50 Index was up 5.5% during the fourth quarter. In addition, the valuation gap between the MSCI Europe Index and the S&P 500 Index has narrowed from previous levels — the MSCI Europe Index is now trading on a 2013 P/E ratio of 11.9 times compared with 13.4 times for the S&P 500 Index. It's fair to say that the rise in the MSCI Europe Index since the third quarter has been driven by multiple expansion (i.e. higher valuations) rather than by higher earnings.2 In addition, dividend yields in Europe — as measured by the MSCI Europe Index — remain strong at 3.8% versus 2.3% for the S&P 500.
Despite little in the way of major company news flow, European markets have remained strong in early 2013. Besides improving growth in China, three additional factors helped boost investor sentiment:
- The Basel Committee on Banking Supervision relaxed liquidity standards for banks, essentially letting them count lower-quality assets — such as corporate bonds — toward the high-quality liquid assets regulators are demanding. The committee also delayed compliance from 2015 to 2019. This news helped convince short-term investors to don their risk-on hats and drive a rally in financials and cyclical stocks.
- Eurozone finance ministers gave Greece an additional two-year lifeline, which coincided with the country's passage of another round of severe austerity measures. This is viewed as evidence that the risk of "grexit", and its related uncertainties, has receded.
- Government bond yields have continued to fall into 2013. In Italy, Spain, Portugal and Ireland, 10-year yields have continued to decline over the period, which has helped to increase market confidence.
What do we need to watch for in the next few weeks? There's speculation that banks will start repaying the €1 trillion the European Central Bank (ECB) lent under its Long-Term Refinancing Operation (LTRO) plan to avert a credit crunch — implying that banks require less help. However, any sign the ECB is straying from its longer-term commitment to prop up weaker banks will ultimately be viewed negatively by the markets, as banks' borrowing costs would increase.
On the economic front, some recent European data have shown continued weakness, primarily in the southern region. Unemployment and real gross domestic product (GDP) maintain a negative spiral, but this is not unexpected at this stage. Here are three recent data points of interest for investors:
- Preliminary figures show that GDP in Germany — still regarded as one of the healthier economies in the region —declined by 0.5% for the fourth quarter2.
- The euro has appreciated by another 3.5% versus the US dollar since the end of the third quarter.2 While that signals confidence, it could also pressure exports if the currency remains high.
- Demand for new cars in Europe fell to a 17-year low in 2012, attributable to austerity measures, lack of job growth and tougher credit standards.
The bottom line is that the European economy remains sluggish but much negative news already appears discounted in the valuation. Despite the recent valuation re-rating, the region still trades at a healthy discount to the US market. In addition, many quality European companies in the strategy have adapted well by relying more on growth via expansion outside of the region.
Japan — politics and positive market reaction
Politics drove the market in Japan with the dramatic lead-up to and election of new Prime Minister Shinzo Abe, who has announced a target of 2% inflation and 3% GDP growth through fiscal stimulus. This news obviously excited the market, causing an immediate depreciation of the yen, which helps the competitiveness of Japanese exporters. The Nikkei 225 Stock Average responded positively, returning more than 20% since mid-November,3 but that translates to only about 10% in US dollar terms because of the currency depreciation of the yen.
Despite this positive news, we remain underweight in Japan because Japanese companies tend to have relatively weak fundamentals and a weak return profile, with estimated return on equity pegged at less than 8% for 2013.
Asia Pacific ex-Japan — bull market in Asian equities
Global turmoil aside, Asia had a bull market in equities last year, with strong performance coming in the second half of 2012. While investor rotation toward riskier assets helped drive Asian markets, some, like Japan and China, were driven by politics.
Despite concerns that China's economy was slowing down last year, it now appears to be recovering with new leadership. Evidence of stabilization and stronger growth also helped fuel a rally during the second half of 2012. Monthly indicators reflect recovery — industrial production was up 10% in November, while retail sales increased by 14%.2 Although we remain positive for China's growth prospects, investment opportunities are somewhat limited given the higher valuations of quality stocks with strong franchises.
Other Asian markets also had strong performance in the fourth quarter, with very few exceptions.
Latin America— Brazil struggling, Mexico expensive
The Brazilian government, struggling with weak economic growth, enacted several changes to help consumers and businesses. However, these measures penalized other businesses such as banks and utilities resulting in lower spreads/fees and reduced tariffs on electricity, respectively. Even though the Brazilian market picked up during the second half of 2012, Brazil still underperformed for the year, delivering negative returns in US dollar terms.
In contrast, Mexico had strong performance throughout 2012, driven by the election of President Enrique Peña Nieto, whose reform agenda is perceived to have helped lower Mexico's country risk. But because valuations in Mexico are now more expensive, we're finding it more challenging to identify attractive new opportunities in this market.
Senior Portfolio Manager
Emerging markets — current sentiment positive
The year 2012 was another reminder that GDP growth doesn't equal equity performance. For example, Egypt was one of the best-performing emerging markets during the year, despite political and social disruption.
Growth in emerging markets was generally worse than expected at the beginning of 2012. Earnings expectations for emerging markets continued to be ratcheted down throughout the year, largely because Europe and China foundered as export destinations. As a result, earnings growth for emerging markets was actually negative for the year. These negative earnings estimate revisions continued during the fourth quarter, although at a slower pace. Over the past month, earnings estimates for MSCI Emerging Markets Index have fallen a further about 2%.2
Near-term, buy-side sentiment remains very positive, which could worry a more contrarian investor. As we have said in the past, however, the long-term outlook for emerging markets continues to be good for investors with the appropriate long-term time horizons.
Implications for investors
While the US is a major player on the global economic stage, it has only 5% of the world's population, produces roughly 22% of global GDP and claims about 47% of the world's market capitalization.2 That means an investor with a portfolio of exclusively domestic holdings may be missing out on exposure to the world’s population and GDP market cap. International investing, then, can literally make a world of difference for investors.
Here are three compelling reasons, in our view:
- International and emerging market equities are generally selling at an attractive discount to US equities and offering higher dividend yields. It's important to note that investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
- Although diversification does not guarantee a profit or eliminate the risk of loss, investing internationally may help investors diversify. Because different markets tend to move with different cycles over time, adding international and emerging market exposure can potentially improve the overall risk/return profile of a portfolio.
- International small caps continue to offer a huge, under-researched opportunity set for active stock pickers such as this team. Mergers and acquisitions – fueled by cash-rich balance sheets and cheap financing – increase in a low-growth environment, providing additional support for high-quality small-cap and mid-cap companies. Please consider that stocks of small-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
For long-term investors, international markets may offer many attractively valued, high-quality companies.
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.
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All data provided by Invesco unless otherwise noted. Lipper is the source for index and market return data as of Jan. 18, 2013.
The opinions expressed are those of the author, are based on current market conditions as of Jan. 18, 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.
Price-earnings (P/E) ratio, the most common measure of how expensive a stock is, is equal to a stock's market capitalization divided by its after-tax earnings over a 12-month period.
Beta (cash adjusted) is a measure of relative risk and the slope of regression.
Return on equity (ROE) is net income divided by net worth.
A cyclical stock is an equity security whose price is affected by ups and downs in the overall economy.
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 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 MSCI All Country World Ex-U.S. Index is an unmanaged index considered representative of stocks of global markets, excluding the U.S. The Euro Stoxx 50 Index is an unmanaged index representative of supersector leaders in the eurozone. 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. The Russell 2000 Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co. An investment cannot be made directly in an index. Index returns do not reflect fees or sales charges.
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