Investment is about having enough money in the future to meet your liabilities. It is an absolute rather than a relative concept. It has nothing to do with benchmark index weightings or tracking error. Investments need to generate an adequate absolute real rate of return to achieve this.
The mainstream asset class that has been most successful in generating such an adequate absolute real rate of return over the very long term has been equities.
However, during this long period of outperformance by equities, there have been many shorter periods where holding stocks has produced dreadful returns for investors. The key to generating long-term returns has been the valuation that investors have had to pay to buy equities. There is endless evidence to show that buying cheap equities is a sound long term strategy whereas owning expensive stocks is a lousy approach. The below chart showing total returns for different quintiles of dividend yields makes this point elegantly.
In response to the financial crisis, interest rates in major economies were slashed to almost nothing in an attempt to stimulate recovery. When this did not work the leading central banks of the world embarked on a great experiment to print money (they called it quantitative easing to make it sound respectable) to provide additional stimulus. And boy, have they printed money!
Ordinarily such massive monetary stimulus would have generated the mother of economic booms but these are not ordinary times. The world is in a debt hole and the expected credit creation has not ensued. It has been tantamount to Keynes “pushing on a string”. The recovery in the US economy has been the weakest since World War II by a country mile. In Japan and Europe growth and inflation have been highly anemic at best and non-existent at worst. The printed money has not made its way into the real economy through credit creation but has become trapped in the financial system, seeping out to create huge inflation in financial assets. Asset price inflation is not synonymous with economic success. If it was, Argentina and Zimbabwe would be the most successful economies on the planet and they are not.
Equity, bond and real estate yields have been driven to very low (in some cases absurdly low) levels. Stocks are now discounting a level of earnings and dividend growth that have never been delivered in the past and certainly will not be delivered in the years ahead.
When markets are this overpriced they are vulnerable. It is interesting to speculate what might cause this bubble to burst and there are certainly a number of major risks to consider: normalization of yield curves, emerging market debt, crumbling of European cohesion, the threat of protectionism etc. It may or may not be one of these issues that tips the balance but in the end it doesn’t really matter. When markets are as expensive as this, they always reprice and sometimes very quickly.
Now this all seems a bit downbeat. It is true that there are a number of intractable economic problems in the world but we do not need to wait for these to be solved. Things do not need to look good – they only need to look cheap. The three best buying opportunities of the last 50 years have been 1974, 1981 and 2009 and at all of these times the economic news was universally bleak. What made them tremendous buying opportunities is that equities offered excellent value.
The price you have to pay for something matters. Current overpricing will be corrected. Sticking to the areas of the market which offer the best quality and value will preserve capital and will ensure you have more money available to commit to higher risk assets when value re-emerges, as it surely will.
Examining key international economies gives us insight as to where there are current opportunities for value and risks to be avoided.
Real wages in the UK still stand significantly below where they were in 2008. When people have not seen a real pay raise for 8 years and their standard of living has gone nowhere, they will look for a scapegoat. Enter the EU. The decision of the British electorate to leave the EU was a protest vote. So, what of the aftermath of this shock decision? First of all there has been an immense amount of political posturing. No one should be surprised by this. This is what politicians do. They posture in an attempt to curry favor with the constituencies that will determine whether they retain power. In the end this will subside and “calmer heads” will take over the hugely complex task of negotiating Britain’s exit from the EU in a manner that is least economically damaging to either party.
Here we need to remember that UK has a very large trade deficit with the EU — we buy far more from them than they buy from us. The “calmer heads” will include a large number of German industrialists who will be desperately eager to ensure that access to the large and lucrative UK market is not restricted. Lets’s take the German car industry as an example. For VW, BMW and Mercedes, the UK accounts for 10.1%, 10.3% and 9.3% of revenue respectively. The figures for operating profit are 14.1%, 9.0% and 7.5% respectively (Source: HSBC). UK is the third largest market in the world (after US and China) for cars exported from Germany. Post its emissions scandal in US, VW has had to lay off 30,000 workers to deal with the sharp resultant drop in sales. These are real jobs that are being lost. We can be sure that executives in Wolfsburg will be putting huge pressure on the German government to ensure that there is not a similar effect on trade with UK as a result of Brexit.
The rise of populism in Europe
Einstein’s definition of madness was “doing the same thing over and over again and expecting a different result”. On this basis, an awful lot of European politicians are clearly insane. They appear to believe that serving up the same old policies to their voters will ensure that they will be returned to power regardless of whether they have worked. The euro and austerity have been catastrophic for many countries in Europe (especially Greece, Italy and Portugal). Greece has been mired in depression for several years while Italy’s economic output is the same as it was 15 years ago. Youth unemployment is running at staggering levels. These young people do not have a job but they do still have a vote and they are clearly reaching the conclusion that “more of the same” simply isn’t going to work for them. In circumstances like these, voters reject the old establishment order that has failed them and turn to populist leaders who offer them something different. That is exactly what is happening in Europe.
Starting with the recent constitutional referendum in Italy which has cost Prime Minister Renzi his job, over the next 12 months European voters will have an almost unprecedented opportunity to give their verdict on their leaders. In 2017 general elections will take place in Netherlands, France and Germany and probably in Italy too. Portugal already has a neo-Communist government and Spain has a rickety minority government that could collapse at any time. All over Europe populist political forces are on the rise. In France, Marine le Pen of the far right National Front looks likely to win the first round of the Presidential election. In Italy, polls show a tie between the ruling Democrats and the Five Star Movement led by ex-standup-comedian Beppe Grillo. Even in Germany, the AFD, a right-wing anti-euro and anti- immigration party, has gained huge ground and recently relegated Angela Merkel to third place in her home state of Mecklenburg. In Netherlands, Geert Wilder’s Freedom Party (which advocates that Holland follow the British out of the EU) is well ahead in the polls.
The biggest casualty of this is likely to be European banking. This is a very sickly sector which was never cleaned up following the financial crisis and now labors under a huge burden of non-performing loans; negative nominal interest rates have crushed profitability and in many cases, stated tier one capital ratios are a great work of fiction. The most rational reaction to the Brexit vote was the crushing of European bank stock prices. Brexit represented a key fault line in European cohesion and there may be more such shocks to come. European banks need more Europe, not less.
The attractions of Asia
So far we’ve not been very optimistic so let’s finish on an upbeat note. Clearly the brightest spot in the international firmament remains Asia ex-Japan. These equity markets offer the best value in the developed world. They have not been absurdly inflated by money printing. These countries have not printed money because they haven’t needed to. They have intact the traditional economics 101 drivers of growth: labour force and productivity growth. Demographics are the most attractive on the planet outside the largely uninvestable Middle East and Africa. These demographics put Europe and Japan in the shade.
These people also save money, unlike workers in the west. Savings drive investment and investment drives productivity.
The result is that the economies of Asia ex-Japan were able to withstand the effects of the financial crisis far more resiliently and have continued to generate attractive levels of growth in the subsequent years.
Superior long term economic growth provides the tailwind of revenue growth which benefits the companies which operate in these economies.
Asia continues to be under-represented in world economies and particularly global equity markets. Asia ex-Japan accounts for 58% of global population but only 27% of world output and less than 10% of global equities. It will catch up.
Equities play a key role in diversified portfolios that have long-term investment horizons and seek capital appreciation. Across the globe equities have in the past delivered compelling long-term returns. Returns vary by region therefore it is important to consider a geographically diverse allocation to equities. Particularly for investors whose portfolios have a strong home-country bias, an international equity allocation can provide that geographic diversity.
The price paid for an equity ultimately has an impact on the long-term return that equity will deliver to the investor. Dividend yield and the prospects of sustainable future earnings define the value of an equity. Regionally, the current environment and future demographic trends will have an influence over a company’s ability to generate earnings and pay dividends. Based on these factors, some regions of the world provide more compelling investment opportunities than others. We believe that currently one of those compelling regions in which to invest is Asia ex-Japan.
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Download "Finding quality overseas", a conversation guide for advisors to use with their clients when discussing how the BMO Pyrford International Stock Fund compares to a broad market index.