Showdown With the Global Slowdown: Long-Term Investors Find Opportunities
International markets second-quarter review and outlook
International stock markets continued to be challenged during the second quarter, as investors absorbed a constant stream of negative economic news. In the eurozone, debate over debt levels and austerity measures continued, while elections in Greece and France added to the uncertainty. In the Asia-Pacific region, markets struggled to rally in the face of the weak global macro environment. The US market performed relatively well compared with international markets, but it still declined as political stalemate continued to frustrate the market. Meanwhile, weakness in emerging markets also reflected the global slowdown. However, we believe the flip side of the negative news is some compelling international opportunities for long-term investors who are willing to look beyond the near-term slowdown and negative headlines.
International Market Performance (%) as of June 30, 2012
|MSCI EAFE Index
|MSCI World Index
|MSCI All Country World ex-US 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-US Small Cap Index
|Russell 2000 Index
The greatest uncertainty surrounded the "E" in EQV because earnings generally ratcheted down during the quarter.
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 second quarter.
- Earnings: The greatest uncertainty currently surrounds the "E" because earnings estimates and growth rates generally ratcheted down during the quarter. Growth rates were clearly in retreat, with trailing growth rates turning negative in some markets as margins contracted from high levels. Near term, earnings will remain a question mark, in our opinion, as long as expectations for gross domestic product (GDP) growth rates are being revised downward.
- Quality: From a quality perspective, corporate balance sheets remain healthy, having had several years to delever. But returns — whether return on equity (ROE), return on invested capital (ROIC) or other measures — are under pressure as earnings estimates revised down.
- Valuation: Three months ago, we viewed valuations to be "constructive but not overly compelling." However, they have now become more interesting, given the market softness through the second quarter and into the current quarter. Shiller price/earnings ratios (P/Es) are now in single-digit levels in many markets and, particularly in Europe, are looking relatively compelling. We also see more constructive valuations in many emerging markets, where positive long-term demographics and growth fundamentals remain in place but appear to be disregarded in many instances.
Now let's take a look at how regions fared on a macro level during the second quarter.
Europe continued to be a focal point for most investors, with no meaningful changes to their list of concerns during the quarter. These included:
- Southern European debt levels which continued to rattle investors.
- Northern Europe's persistent demands for austerity continued, particularly from the Germans, who hold the checkbook.
- Credit markets continued to show dysfunction and banks struggled to do business. In Europe, banks represent roughly 80% of corporate lending versus only 30% in the US.1
- Regulatory confusion and the fragile macroeconomic environment in Europe and beyond, undermined global confidence.
In Greece and France, elections in early May resulted in political shifts to the left and endorsement of more populist policies. In our opinion, the policy shifts upended market hopes for quick solutions and increased the probability of continued uncertainty and market volatility.
While it's easy for investors to get caught up in all of the negative headlines, valuations in Europe are pricing in much of the negative news.
- Europe is today trading at a 40% discount to the US, based on Shiller P/E's of 12.6x and 20.8x respectively.1
- That's a very large discount that, in fact, puts Europe at a 40-year low on a relative basis to the US.1
- The US is clearly facing many challenges of its own, but arguably US valuations may not yet be discounting those issues as much as European valuations already do.
In our opinion, this may be a generational opportunity for patient investors with appropriate, long-term time horizons to revisit European equities.
We believe Japan's economy should improve from last year, when it was plagued by a major earthquake, the tsunami and nuclear disaster, record yen strength, weak export markets and flooding in Thailand, which is a manufacturing hub for Japan. Although Japan has been quiet in 2012 in terms of natural disasters, its economy remained weak during the second quarter. Japanese exporters are also still trying to cope with the challenges of yen strength and a relatively weak global macro economy.
Valuations have come down due to the weakness in the Japanese economy but, even with valuations at a low point, we continue to believe better opportunities can be found elsewhere.
In the Asia-Pacific ex-Japan region, including China, negative numbers started to create more opportunities during the second quarter.
Although central banks in the region have already responded to the weakening economy, thus far the stimulus has had very few positive effects. In fact, macro and corporate numbers were weaker than expected, leaving markets struggling to rally in the face of a weak global macro environment.
While we do expect improvement in the economy, the timing remains unclear in the short term. Over the long term, the demographics in the Asia ex-Japan region remain a powerful factor that should keep the region growing for many years to come. The good news is that the price of quality companies has been coming down, in line with the nearterm risks, and we believe the long-term growth story for the region remains intact.
In China, we saw slowing growth during the second quarter, partly from the lingering effects of last year's attempts to slow inflation. Chinese authorities are doing what they can to stimulate the economy and make credit more available, and, in some instances, valuations are now pricing in the near-term uncertainty rather than the long-term attractions. High valuations have often been a historic barrier to our buying stocks in China, but the market correction is starting to present more reasonable and attractive opportunities.
Macro numbers in China continued to look weaker — the second-quarter GDP, for example, was 7.6%, versus 8.1% in the first quarter1 — so the deceleration is evident. But with expectations already lowered, we believe potential exists for numbers to improve because central banks have already reacted to the weak global macro environment, and banks and governments may increase stimulus.
In 2012, Chinese GDP is now expected to grow about 1.5% slower than the 9.2% rate seen last year, Despite being healthy by global standards, that number has been revised downward from 8.5% only six months ago.2
Overall, we remain constructive for the Asia ex-Japan region and believe long-term prospects remain good.
Brazil and Mexico, the dominant Latin American economies, saw diverging trends during the second quarter. In Brazil, which had been the region's strongest economy until this year, the economy is trending a lot weaker than expected. Only nine months ago, we were looking for GDP numbers of about 3.8% in 2012, but consensus today is more like 1.9%, and that number is falling1, despite the central bank lowering interest rates. In our opinion, even the 1.9% growth rate may be hard to hit because GDP growth would have to rise 4% during the second half of 2012.
Over the longer term, we expect Brazil to grow at stronger levels, given the same demographic trends that we've seen in other developing regions of the world. But despite the very good underlying long-term demographics, the Brazilian economy may endure more short-term weakness, in our opinion, with declining commodity prices being one of the headwinds.
In Mexico, the economic story is much more favorable. Although the Mexican economy has been displaced by China as the US production hub over the past decade, there is evidence that this now appears to be stabilizing. Recently that production gap versus China has started to reverse. As wages and manufacturing costs in China have risen, Mexico has gained back some of that competitiveness. In addition, the new president's PRI party holds the majority in the Mexican congress, making the prospect of policy measures to stimulate growth and investment more likely.
The continuing global slowdown was reflected in the economies of emerging markets during the second quarter. We still don't believe in decoupling, so to the extent that the US, Europe and Japan suffer, emerging markets are going to suffer too, in our opinion.
Many emerging market governments and central banks, enabled by lower commodity prices, continued to ease monetary policy. Earnings growth rates on a trailing 12-month basis have turned negative for both the MSCI World Index and MSCI Emerging Markets Index. Expectations for the next 12-month forward earnings for the MSCI Emerging Markets Index are still predicting 13% earnings growth, but these estimates continue to be ratcheted down. While downward revisions did slow in the first quarter, they reaccelerated again in the second quarter.
On the positive side, emerging market equities are now selling at below-average levels when measured against various valuation metrics. Once again, we believe this is offering attractive investment opportunities for investors with a long-term investment horizon.
Overall, we continue to believe the long-term story for emerging markets remains intact — that is, a transition from export orientation to increased internal, domestic consumption.
Implications for investors
With the US stock market performing relatively well compared with international markets, investors may be prone to the potential classic mistake of rearviewmirror investing — in other words, investing in the markets that have performed most strongly in the recent past. But, in our opinion, they should highly consider international markets, which offer a large opportunity set — about 55% of the world's market cap2 — including many attractively valued, high-quality companies.
To state the obvious, the potential for higher long-term returns is greater when stocks are inexpensive and investors are worried rather than when they're happy and stocks are expensive. In our opinion, the steady stream of negative news that has sent people running for the exits from international markets has actually created many compelling opportunities for long-term investors.
Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, relative lack of information, relatively low market liquidity, and the potential lack of strict financial and accounting controls and standards. Investing in developing countries can add additional risk, such as high rates of inflation or sharply devalued currencies against the US dollar. Transaction costs are often higher, and there may be delays in settlement procedures.
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.
Securities issued by foreign companies and governments located in developing countries may be affected more negatively by inflation, devaluation of their currencies, higher transaction costs, delays in settlement, adverse political developments, the introduction of capital controls, withholding taxes, nationalization of private assets, expropriation, social unrest, war or lack of timely information than those in developed countries.
Small capitalization companies often have less predictable earnings, more limited product lines, markets, distribution channels or financial resources and the management of such companies may be dependent upon one or a few key people. The market movements of equity securities of small capitalization companies may be more abrupt and volatile than the market movements of equity securities of larger, more established companies or the stock market in general and are generally less liquid than equity securities of larger companies.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise; conversely, bond prices generally rise as interest rates fall. Specific bonds differ in their sensitivity to changes in interest rates depending on their individual characteristics, Including duration.