The first quarter of 2013 witnessed strong stock market performance, similar to what we saw during the second half of 2012. The star across markets was Japan, up over 21%1 for the quarter in local currency terms. In US dollar terms, world equities were up 8%1, US equities were up a little more than 10% and the MSCI World All Country World Index ex U.S. Index was up 3%. Emerging markets were the laggard, down almost 2% during the quarter.1
What's notable is that the composition of market returns year to date hasn't been typical of expectations for recovering global growth. Instead, we've seen developed markets outperform emerging markets, growth stocks outperform value stocks and defensive sectors outperform cyclicals. For example, consumer staples and health care, two of the most defensive sectors, have outperformed with double-digit returns in every major broad market.
In our view, this suggests that, despite strong overall broad market performance, investors still have a lack of confidence in the economic and earnings growth outlook.
|Strong Performance Overall During First Quarter
International market returns (%) as of March 31, 2013
|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
Past performance cannot guarantee future results. An investment cannot be made in an index.
Senior Porfolio Manager
Earnings, quality and valuation — our view of global markets
Let's look at the world through our earnings/quality/valuation (EQV) lens — the three characteristics our investment framework focuses on particularly closely.
- Earnings: Visibility remains low.
Revenue and earnings revisions remained negative in the first quarter for all major markets except Japan, where a weak yen is supporting export earnings expectations.
Global margin expectations have started to decline modestly since the start of the year.
From an earnings growth perspective, emerging market expectations remain the strongest with an expected 13% growth in equity earnings2 in 2013, while US equities are expected to deliver about 7% earnings growth2. Expectations for Europe are the weakest, at just barely positive earnings growth2, as Europe continues to struggle with recession.
- Quality: Overall, quality remains high, as it was three months ago.
Corporate balance sheets remain strong.
Cash generation and conversion is above average.
Returns on equities are still in the mid-to-high teens, though we'll watch closely going forward because of some trends we're seeing — particularly with margin expectations beginning to decline.
- Valuation: The standard post-global-crisis refrain holds that global equity valuations in the context of mid-single-digit free cash flow yields and 2% to 3% dividend yields are constructive relative to the low returns on cash or fixed income. But consider:
Equity prices across the globe have outpaced any improvement in earnings or real growth expectations as financial reflation by central banks continues to support asset prices and a search for yield in a low-growth, low-yield environment.
It therefore seems reasonable to argue that prices in many areas of the market are now ahead of fundamentals and, as a result, vulnerable to the possibility of a near-term correction.
Senior Porfolio Manager
Europe — lingering recession, lagging indicators
Eurozone equities, up in the low single digits, were the laggard among developed markets during the first quarter, in part because of a weak euro versus US dollar. Europe remains in recession, and leading European economic indicators are rolling over, not recovering, at this point. The European Central Bank (ECB) balance sheet is shrinking, and European credit markets are unfortunately still not functioning as they need to, despite some modest improvement in the interbank markets.
The pace of European household deleveraging is accelerating, with net saving rising. As such, a reasonable argument can be made that austerity policies that have dominated the narrative haven't worked to date. We're not seeing stabilization, even with a recovery in European equities over the past three quarters.
On the positive side, European equity valuations remain among the cheapest in the world. Cyclically adjusted earnings multiples in Europe are on average 30% to 35% below long-term averages versus US equities that look close to fair value on that same basis. Specifically, cyclically adjusted European earnings multiples are just a little above 14 times versus a long-term average of around 20 times. The US is on a cyclically adjusted forward earnings multiple of 22 times, in line with its long-term average.
In addition, ECB President Mario Draghi recently reiterated that policy would remain accommodative for as long as necessary, giving rise to expectations for lower European interest rates and a greater likelihood that the ECB will consider further nonstandard measures to support credit. So it appears that the ECB has joined the party since last summer by demonstrating its willingness to step into this market and go above and beyond to find ways to get credit markets functioning.
Notwithstanding the grocery list of economic negatives in Europe that continues to scare investors, positives include stock valuations that are constructive, and a central bank the equivalent of the US Federal Reserve (the Fed) that's willing to prime the pump. In our opinion, this is a constructive environment for long-term investors to find opportunities in high-quality European stocks.
Japan — structural issues need addressing
As previously noted, Japan was the top performer for the first quarter. The MSCI Japan Index is up 21.5%in local currency terms through March 31, 2013. It has been the best-performing market in the developed world. For US investors, however, that translates to a still-respectable 11.7%— a slightly better performance than the S&P 500 Index at 10.6% — when the impact of the weaker yen, down from 93 to 99 to a US dollar, is factored in.
To understand the bigger economic picture in Japan, it's necessary to examine the changes we're seeing — and, just as importantly, those we're not seeing. This is the second term for Prime Minister Shinzo Abe; his first term several years ago was not very successful. But he has now taken a much more aggressive stance toward fiscal and monetary policy than his predecessors have, resulting in:
- The recent installation of a more aggressive Bank of Japan (BOJ) governor, Haruhiko Kuroda. In early April, the BOJ initiated a new quantitative easing (QE) program that essentially doubles the size of its balance sheet over the next two years — a much more aggressive QE program than those of other central banks around the globe.
- A new target of 2% inflation within two years. While most economists don't believe Japan will be able to accomplish this, the target clearly indicates stepped-up effort.
In anticipation of these policies, the yen has weakened — down from 75 yen to a US dollar at the start of 2012 to 99 yen currently. The weaker yen has given export-oriented companies some much-needed breathing room.
To date, the government has made the easy moves — increasing government spending and printing more money. It's worth noting that this isn't the first time the Japanese government has pursued similar initiatives, and they've not been successful with those previous attempts. More importantly, however, the government, as in prior cycles, has yet to address the structural reasons for the economy's weakness. Their remedies so far are akin to taking aspirin for a broken leg — it might reduce the pain a little bit, but you still can't walk.
So let's look at the structural problems plaguing Japan's economy. They include:
- A declining working population shrinks about 1% per annum, and the aging retiree population is growing faster than the workforce. In addition, the aging population puts increasing pressure on government budgets for health care and social security spending and pension obligations.
- The ratio of government debt to gross domestic product has risen from 59% in 1983 to an expected 237% by the end of this year.2 Consequently, the debt service burden is rising.
- The tax system needs reform to generate government revenues.
- Japan lacks natural resources. The Japanese are net importers of food, oil, natural gas and other products.
- Japan's global competitiveness is declining because their productivity isn't keeping pace with the rest of the world. For example, South Korean electronics manufacturer Samsung, has replaced Sony and Panasonic as the global leaders in televisions. Likewise, Japan's global market share of shipbuilding has halved from 40% to 20% over just the past 10 years.2
- Finally, the government is increasing the consumption tax rate from 5% to 10% over the next two years, which will be a significant drag on an already persistently sluggish economy.
Given these structural problems, what sort of changes do we need to see in order to develop a more constructive view of Japan's economy and investment outlook?
- A change in corporate culture. We'd like to see increased focus on profitability, return on equity and return on assets. Also, managements must begin to recognize that they work for shareholders, rather than for employees.
- More efficient corporate capital allocation. Corporations need to reduce bloated balance sheets and increase dividend payout ratios and share buybacks. In addition, companies must stop investing in poor businesses with poor returns.
- Immigration reform. Japan has one of the tightest immigration policies in the world and has done little to alleviate the growing labor shortage. Some projections suggest that the Japanese population could fall from its current level of about 130 million to below 90 million over the next 50 years.
- Tax reform. The government has taken no steps toward increasing revenue.
- Reduction of debt. No plan is in place to cut Japan's ever-increasing debt burden.
Finding Japanese companies that meet our EQV criteria is challenging. Increased earnings expectations are all currency related at this point, and underlying improvements in businesses aren't apparent yet. In addition, return on investment remains quite low by global standards, and valuations for high-quality companies are currently excessive.
Senior Porfolio Manager
Emerging markets — macro headwinds, earnings downgrades
Emerging markets fell by 2% in US dollar terms during the first quarter — significantly underperforming the developed world — largely because of earnings downgrades and macro headwinds, especially an overall growth trend that was slower and weaker than expected.
Across emerging markets during the first quarter, we saw:
- Deceleration in Asia, driven by slower export recovery.
- Slowing down in Latin America, driven by weaker commodity demand and higher consumer gearing.
- A sharp slowdown in Eastern European economies due to economic downturns in the eurozone.
In addition to slower growth, other economic fundamentals deteriorated, especially the higher current account deficits and higher inflation in an increasing number of emerging market economies. These deficits and inflation will constrain policymakers' ability to be flexible and accommodative in monetary and fiscal policies. In some economies where inflation and current account deficits are already at elevated levels — as in Brazil, Indonesia and Turkey — the easing bias we've seen could be removed, thus increasing the risk that interest rates may rise.
On the earnings front, all emerging market regions posted more earnings disappointments during the fourth quarter, driven by slower top-line growth and margin compression. Corporate profit margins continued to fall, driven mainly by rising labor costs. Emerging market regions have seen record wage growth over past several years, attributable in part to a shrinking population of working age. This is more of a structural, secular trend as opposed to a shorter-term cyclical one.
The decline in commodity prices has a much larger impact on corporate earnings of emerging markets because the commodities sector accounts for a far larger share of the their economic output and corporate earnings than developed markets. Consequently, the recent weakness in commodity demand has hurt earnings of the emerging market companies more than earnings of companies in developed markets.
The consensus forecast for 2013 for emerging market earnings is 13% growth. The overall market valuation looks attractive with a P/E multiple 11 times — this is below its long-term average — and is at a 20% discount to developed markets.
Several significant events affected emerging markets during the first quarter, particularly in China and Japan. The new Chinese government — which has pledged to continue economic reforms and rebalancing the economy — is apparently tolerating slower growth than the previous governments. One indicator of this is tighter policies in the property market, including a 20% capital gains tax and higher down payments on second home purchases. The government has also imposed new restrictions on wealth management products to help control bank lending. Overall, stable growth and continued market reform seem to be key priorities of the new government.
The Chinese government has acted promptly to publicize an outbreak of bird flu H7N9 virus. They also took appropriate and timely action to reduce the spread of the virus, including approval of a new vaccine. As a result, it seems unlikely at this point that the outbreak will become a pandemic, and we believe it will have very little impact on the economy.
Japan's QE program will have both negative and positive impacts on emerging market economies. On the negative side, the cheaper yen will hurt the competitiveness of Asian companies, especially in Japan, South Korea, Taiwan and China, and we could see earnings pressure for the affected companies in those economies. The other negative effect is liquidity flow, which could translate into higher inflation for those economies outside Japan.
On the positive side, reflation from Japan's fiscal and monetary policies could boost Japanese economic growth, which should be positive for emerging markets by increasing exports to Japan. At this point, it's difficult to gauge the long-term impact because it remains to be seen whether the increase in monetary base in Japan will lead to a sustainable recovery in the Japanese economy. We have some doubt it will.
Emerging markets have lagged developed markets for some time now. In our view, earnings data are likely to be the most important catalyst before emerging markets start to outperform again relative to the US and developed markets. We don't see consistent signs that the earnings trend is stabilizing. In some economies, such as China's, this down cycle appears to be bottoming out as corporations benefit from lower commodity prices. Other economies still face challenges as China's growth slows, which could pose downside risks to earnings, especially in those that rely on commodity exports.
Senior Porfolio Manager
Implications for investors
The outlook for 2013 presents a better stock-picker's market than we've seen recently, as opposed to the simple risk-on/risk-off market — shorthand for investors' tolerance for more/less risk — with the high correlations of the past few years. This stems in large part from the ECB — and most recently Japan — joining the reflation party alongside the Fed, thereby collectively mitigating the worst of investors' tail-risk concerns.
On the negative front, we believe the two predominant risks are:
- First, foreign-exchange volatility and the potential impact on dollar-based investor returns, given a steady theme of competitive currency devaluation policies being sought to support growth in many markets around the world.
- Second, the risk that global margins may have peaked, in our view. This certainly seems a reasonable thesis as we look at the US equity market, and even the markets in Europe, and question whether they're peaking, given the weak economic outlook there.
On a positive front, while we're cautious near term — given the strong performance in the past three quarters — positive dynamics include:
- First, even if it's more about reflation than cash flows, the reality is that asset reflation is proving to be a powerful force in markets.
- Second, merger and acquisition activity levels remain near long-term lows. Combined with strong corporate balance sheets, a need for growth and CEOs and CFOs who tend to get paid on growth metrics, deals seems likely, though calling the timing is difficult.
- Third, equity valuations remain undemanding compared with cash and bonds, even if we're concerned near term versus fundamentals.
- Finally, institutional investors remain underweight in equities.
All of this suggests that even if we do get a near-term correction — which the consensus and a lot of the market pundits are calling for and would be healthy, in our view — there is scope for a "buy-the-dip" mentality to put a potential floor under the downside, all else being equal.
We remain, as always, focused on good franchises that have strong balance sheets, superior cash flow generation and pricing power in this low top-line growth environment.
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 April 12, 2013.
The opinions expressed are those of the author, are based on current market conditions as of April 12, 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 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 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.
The dividend payout ratio is the percentage of earnings paid to shareholders in dividends. The price-earnings ratio (P/E ratio) is a valuation ratio of a company's current share price compared to its per-share earnings. Correlation is a statistical measure of how two securities move in relation to each other. The price-earnings multiple is a valuation ratio of a company's current share price compared to its per-share earnings. The cyclically-adjusted price-earnings multiple is based on average inflation-adjusted earnings from the previous 10 years.