Tony Cousins MA (Hons), CFA
CEO & CIO, Pyrford International
BMO Global Asset Management
Ben D. Jones
Managing Director – Intermediary Distribution
BMO Global Asset Management
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International investing themes for 2017 and beyond
Investors allocate to international equity for a number of reasons – diversification, growth potential, low correlation to U.S. markets. But investing in these markets recently hasn’t been a cakewalk. Investors and their advisors must consider the global themes and economic uncertainties that could impact long-term returns.
To uncover what is behind these themes, we speak with Tony Cousins, Chief Executive and Chief Investment Officer of Pyrford International. Tony has been investing in international markets for more than 20 years and recently authored a paper on the major themes for 2017 and beyond. We’ll talk about the case for equities, the case for value, and the opportunities in Asian countries. We’ll also discuss international events such as Brexit and European populist movements that will shape 2017.
In this episode:
- What will happen when interest rates normalize
- The effect of European populism movements
- Where to find value in your international allocation
- The productivity growth in Asia
Like what you hear?
Tony Cousins – Investment is about having enough money in the future to pay your liabilities, which is an absolute concept, and the key to delivering a good absolute real rate of return in the long-term is to avoid big drawdowns in markets. There’s no rocket science here. If you lose 30% and then make 30%, you are still down nine from where you started. We have always felt that capital preservation at times of high risk is exceptionally important, and clearly an active approach gives you far more flexibility to deliver that capital preservation.
Ben Jones – Welcome to Better conversations. Better outcomes. presented by BMO Global Asset Management. I’m Ben Jones.
Matt Smith – And I’m Matt Smith. In each episode, we’ll explore topics relevant to today’s trusted advisors, interviewing experts and investigating the world of wealth advising from every angle. We’ll also provide actionable ideas designed to improve outcomes for advisors and their clients.
Ben Jones – To learn more, visit us at bmogam.com/betterconversations. Thanks for joining us.
Disclosure – The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates, or subsidiaries.
Ben Jones – As an advisor, you know that robust, diversified portfolios should include international investments, allowing your investors to harness the potential gains of the international equity markets and diversify return streams in the case that a downturn occurs in domestic markets.
Matt Smith – Our guest today is Tony Cousins, the Chief Executive and Chief Investment Officer of Pyrford International. Tony authored a paper concerning international investment themes in 2017 and beyond. We’re going to discuss this paper today to uncover what’s behind these themes and some information you should consider when thinking about investing in international markets this year. We’ll talk about the case for equities, the case for value and the opportunities in Asian countries minus Japan, which is referred to as Asia, X Japan in this interview. We’ll also discuss international events, such as Brexit and European populism movements that will shape 2017.
Ben Jones – You may be thinking, I know, I know, I need to invest in the international equity markets. But with all the uncertainty in world economies, I’ll just invest in an indexed fund and call it a day. Tony explains why you may want to think twice about that approach and heed some of his key points from the discussion today.
Tony Cousins – I think an advisor should care about these points because there are very significant opportunities to lose money by investing in the wrong thing. If you index, you buy an awful lot of poor quality heavily overpriced assets that are represented in those indices, financials are the biggest weighting in the international index. There are enormous lists within the financial sector, particularly within Europe. We are about active managers. One of our greatest risk controls is a willingness to own zero in anything. Just because something is a big part of an index, it doesn’t mean that you need to own it. An active approach allows you to avoid those areas which are likely to deliver the most unattractive returns.
Matt Smith – An active an educated advisor is in the best position to help his or her clients make better decisions. With that in mind, let’s explore some of the international investing themes for 2017, starting with equities and their valuation. I sat down with Tony recently in Chicago.
Matt Smith – You make this point that your ultimate return is heavily influenced by the price you pay for equities. Can you talk about that?
Tony Cousins – Sure, yeah. This being — while equities over the very, very long-term have clearly been the best performing asset class, there have been some periods when they have delivered absolutely dreadful returns. Our view is that it is purely driven by the valuation that they offered at the time. There is endless evidence to show that owning inexpensive, cheap assets is a very sound long-term strategy, which delivers return. There’s just as much evidence to show that owning expensive assets is a lousy strategy. The valuation, the starting point at which you buy is incredibly important in our eyes and certainly in our process.
Matt Smith – In your words, how do you look at determining valuation of an equity?
Tony Cousins – Okay, well, we have one full definition of value. That is dividend yield, plus sustainable long-term growth in earnings and dividends per share thereafter. We’re big students of history at Pyrford. We know what is achievable. The sum of growth plus dividend yield has to be adequate for the riskiness of investing in equities. Long-term history of returns has shown that dividends are very, very important. They account for about half the returns you’ve got from equities. In these days of financial innovation, dividend yield may appear like quite an old-fashioned measure of valuation. Firstly, as I said, it has accounted for a large part of total return. Secondly, it’s a measure which cannot be distorted. You can hold a dividend in your hand and you can count it and no accountant can try and make it look like something else. That is one of the key drawbacks to our view of certain other valuation measures that rely on the accuracy and validity of the accounting used to construct them.
Ben Jones – Next, Tony and Matt talk about international events, particularly the ones in Europe, that will shape the global markets in 2017 and the years to come.
Matt Smith – When we normalize — and when I say normalize, interest rates going back to historic norms — is there a risk that economies normalize at different rates in different geographies? Does that create either risks or opportunities by different geographies?
Tony Cousins – Yeah, I think it will lead to quite desperate effects. One of the countries, I guess, we’d be most concerned about is my own one, the UK. We got into trouble, like many other places, by having a debt-fueled housing boom. The government, which needed to get re-elected last year, decided to try and get the economy moving by having another debt-fueled housing boom. What this has created is a very leveraged household sector. Many people don’t appreciate that the mortgage market in the UK is an entirely floating rate system. It’s not like the US where you can fix for a long period of time. In the UK, vast majority of mortgages are at floating rate. This leads that economy, in particular, highly vulnerable because people have been able to go out and borrow money from Barclays Bank or any other UK bank at around 1% for a significant amount of time. That 1% is linked to the base rate equivalent to the fed funds rate. What this means, though, is that interest rates only need to increase by 50 basis points and the mortgage interest payments go up by 50%. I think normalization of the yield curve is going to have different effects in different countries. Clearly, those that have debt which is high which is geared very much to short-term rates are the most vulnerable.
Matt Smith – Since we’re talking about the UK, let’s also talk about another unprecedented event that has happened and is still an unknown. I’m interested in your opinion as to the effect that Brexit will have on the UK economy and its effect on the European economy.
Tony Cousins – Well, the initial effect of the Brexit vote has been positive. Many countries in the world would like to bring about currency depreciation, yet if they do, they incur the wrath of other countries. In the UK, we’ve managed to achieve 15% or slightly more decline in Sterling on the trade-weighted basis, which has provided a significant impetus to the economy. We can blame that on the Brexit vote and we got away with it without really incurring the wrath of our trading partners and neighbors. In terms of what Brexit will bring, nobody really knows. There is a phenomenal amount of political posturing going on. I guess that’s what we should expect. This is what politicians do. This is an incredibly complex task of negotiating the trade deals that we — and the trading relationship that we are to have in the UK with the rest of Europe. I believe that this process is going to take at least the two years, which is earmarked for once Article 50 is triggered. I think what we can expect are far calmer heads getting down from the nitty gritty to try and come up with a mutually acceptable solution. In the paper, I talk, as an example, about the car industry and the German car industry in particular. For VW, BMW and Mercedes, the UK is an extremely important market. For cars that are exported in Germany, it only lies third behind the US and China. A company like Volkswagen has just had to announce the loss of 30,000 jobs because of the emissions scandal in the US, what it can ill-afford now is having its cars made less attractive in its third largest export market. I think what we can expect is some fierce industrial lobbying against two politicians to come up with a sensible solution here. The devil is going to be in the detail, but trade does generate growth, so we are, at Pyrford, very against protectionist strategies. We think that just creates losers all the way around. We do believe that there — when these calmer heads get around the table, we are going to be able to negotiate something which is sensible and won’t just succumb to these posturing by politicians.
Matt Smith – This theme of populism, Brexit clearly was a populist vote. You could say that the Trump election in the United States was our version of populism. But there’s other areas of Europe that this theme of populism is continuing. Can you talk about your thoughts on the rise of populism in Europe?
Tony Cousins – Europe in 2017 or we take sort of the recent Italian referendum is never — is unlikely to see such a concentration of electoral activity. We’re going to have a general election in Holland, one in France and also one in Germany. The Italian election isn’t scheduled until early 2018. But they have a temporary, as a technocrat government in there which could fail at any time. We certainly wouldn’t rule out Italy having a general election, as well, in 2017. Now, in all these countries, you have seen the rise of an unorthodox, at best, and sometimes extreme, at worst, political views. In France, polls are showing that Marine Le Pen, who leads the national front, a very right-wing party, will win the first round of the French general election. It’s likely, but by no means certain, that she won’t actually get elected in the second round, although the candidate she’s likely to face, Monsieur Fillon, could drive some of these disaffected working class voters towards her. It isn’t something that you could rule out. In Italy, running neck in neck with incumbent Democrats, is the Five-Star Movement, led by an ex-stand up comedian, a guy called Beppe Grillo. They are extremely Euro-skeptic in their approach. In Holland, the leaders in the polls are the Freedom Party led by Geert Wilders. They openly advocate that Holland follows the British out of the EU. Some of these folk are not particularly savory. Mr. Wilders has recently been convicted of a hate crime with some of the things he said about Muslims and his popularity actually rose in the aftermath of this conviction. This is pretty disquieting stuff. Even in Germany, the alternative for Deutschland has been making heavy strides in recent provincial elections. This started out as a party which was anti-Euro founded by a bunch of German academics. It has since been hijacked into an anti-immigration party and has moved quite considerably to the right. I think it’s because of this that Angela Merkel, who was by no means certain to stand again at an election has decided that she must stand because there is no other strong leader in Germany to keep this new political force at bay. These political forces, the AFD, the National Front, the Freedom Party, the Five-Star Movement are preaching a very populist brand of policies, highly Euro-skeptic. They’re just playing to the highly disaffected people within the population. What Europe doesn’t lack is youth unemployment. Youth unemployment is at quite staggering levels. These folk do not have a job, but they certainly have a vote. All the polls are indicating that they are turning more and more to these highly unorthodox views. The markets have so far managed to brush this off, but this does create a tremendous uncertainty and is something that we’ll be quite concerned about.
Matt Smith – Other than the uncertainty, and in some cases, as you pointed out, the unsavory nature of some of the candidates or some of the things that they’re espousing — but other than the uncertainty, what impact would the success of some of these candidacies have on the capital markets or economies?
Tony Cousins – I think they’re indicative of the breakdown of the European cohesion, certainly for peripheral southern Europe the euro has been a disaster. It generated many countries a huge credit boom followed by a huge credit bust and has left many of their economies highly uncompetitive. The result has been very, very disappointing. Growth, which has been made worse by austerity measures and this has led to very significant rises in public debt, and also in unemployment. I think it’s quite understandable that the populations in these countries, or a significant part of the population in these countries, are not going to vote for more of the same. The part of the economy, I think, that we would be most concerned of in this environment, is the European banking sector. We haven’t held a European bank for any client in any portfolio for seven years. This is a very sickly sector indeed. I think the most rational reaction to the Brexit vote was that European banking stock prices got crushed again because this sector doesn’t need less Europe. What this sector needs it more Europe. It needs the rich countries, Germany in particular, to try and help them out of the bad debt, lack of capital issues that they are suffering from. Surely, this has to happen. I think one lesson from the financial crisis is you simply cannot let banks go. They’re too big. They’re too important a part of the economy. They need to be propped up and, indeed, cleaned up and rescued. That is going to require a lot of public money. So far, there is really no will to do this and the greater the threat to European cohesion, I think the more remote the prospect of that happening is.
Matt Smith – Let’s say I’m an advisor in the United States and I’m managing my clients’ portfolios. I know the importance of having a geographically diverse portfolio, so I want to allocate a portion of this to international. You just talked about we’ve got some uncertainty and challenges in the UK, certainly have uncertainty and different challenges in continental Europe, and Japan, despite the expansion of the money supply, still has a struggling economy. I realize this is a leading question, but where else can we look for opportunities in the international portion of our portfolio?
Tony Cousins – Well, I think some places are more overvalued than others. There were certainly lots and lots of problems out there in the world. But you don’t have to wait for everything to look good before you invest. You just need to wait for it to look cheap. The three best buy opportunities over the last 50 years have been 1974, 1981 and 2009 when the economic news is universally bleak. The difference was, was that there was good value there. I think the job of the professional asset manager is to seek out where we can find, in the markets, that value. It’s also very, very important, in what might be quite turbulent times, to stick to a very high quality business models. The key metrics we look at when we’re building portfolios are high and consistently high return on equity capital, low levels of the balance sheet gearing, and good, sound dividend yields. It’s this strict combination of value and quality which will protect investors’ money in such turbulent times. We think that this is also the magical combination for long-term investors. If you can buy a portfolio that’s way more profitable, more profitable without having to use a lot of debt and you can buy it cheaper than all else being equal, that’s going to work. That is what we strictly focus on. I’m pleased to say you can still find some companies that fit the bill and that’s our job. These may not be household names. They may not be very glamorous companies, but they are companies that provide a decent, respectable dividend yield and have a business model, which enables them to grind out positive — not spectacular, but positive earnings and dividend growth year in, year out. That’s our job to go and find them. We also look for areas of the world that have a following tailwind of benign economic growth. Those are harder to find, but clearly, Asia excluding Japan offers a — certainly a more attractive outlook on that basis.
Matt Smith – A quick note. When Tony said balance sheet gearing, he was using a financial term that means debt to equity. Or said another way, low levels of financial leverage. Now, you’ve heard about the themes in Europe and the UK, so let’s move on to the opportunities that present themselves in Asia, X Japan.
Matt Smith – What are the economies that are in your definition of Asia, X Japan?
Tony Cousins – Those would be Australia, Singapore, Hong Kong, Malaysia and Taiwan. There are other economies in the region that are attractive. However, the valuations available in those stock markets may be too inflated. Or, in the case of somewhere like Korea, the debt levels are simply too high.
Matt Smith – When you put a list of world economies side by side showing the percent their GDP makes, it represents the global GDP. You put, next to that, a comparison of how those economies are represented in world index. For instance, the MSCI World Index. There’s a clear disparity when it comes to Asia, X Japan where it is the most underrepresented area in terms of that disparity between GDP and world index. I’m really interested in hearing your thoughts on that. Does that define part of the opportunity?
Tony Cousins – Yes, something that does define part of the opportunity. In Asia, X Japan, accounts 58.1% of the world’s population. They produce 27.4% of the world’s GDP. Yet, their representation in global stock markets is only 9.4%. Perhaps we should compare this somewhere like the US. The US accounts only 4.4% of the population. Highly productive economy generating 24% of world GDP. But it accounts for nearly 53% of world stock market capitalization. Asia is very underrepresented, but to get more representation, it needs to continue the growth that it has delivered in recent years. We think it remains a very well place to do that. Trend economic growth can only come from two sources. It comes from labor force growth plus productivity. Labor force growth is highly predictable because, short of bubonic plague wiping people out, it will be driven by how many people were born 16 years ago and how many people are dropping out of the labor force for retirement. On this basis, Asia, X Japan is the most attractive area in our investable universe. There are more attractive areas in the world, places like the Middle East or Africa. But for quality reasons, those are, to a large extent, uninvestable. In the investable world, we can look at Asia, X Japan. Here, I’m including Australia. We can see, by far, the most attractive demographics in the world. Very positive growing numbers of working-age population, which contrasts very, very starkly with Europe and Japan where the demographics are dreadful. The other thing which drives these economies is productivity growth. In a world where productivity growth has been very disappointing in aggregate, the shining lights have been the economies of Asia excluding Japan. China, Indonesia, Thailand, Taiwan, Malaysia, Australia have all driven productivities very significantly faster.
Matt Smith – Why is that? Are they industrializing, computerizing, catching up to other economies? Why are their productivity rates so much different than other developed countries?
Tony Cousins – I think there’s two key reasons for this. One, they are coming from a much lower base. They are putting in investments whether it’s infrastructure or capital equipment where nothing existed before. I guess this is like Eisenhower building the interstate road system in the US in the 1950s. Didn’t exist before. Putting something new, which can really enhance productivity, is very, very meaningful. That’s precisely what these countries have been doing. I think the other benefit that they have is a very high personal savings ratios. In some countries like China, they’re running north of 30%. Savings equals investment, and it’s investment which drives productivity. I think this story has further to go. In the developed world, a lot of this stuff has already been done. To see change in productivity really isn’t there for the taking. Also, many of these countries are seeing sharp declines in their personal savings ratios, so the investment funds tend not to be available.
Matt Smith – If, going forward, the ratios between representation in the world index and share of GDP, if become more equal, where does Asia, X Japan — where do they take share from?
Tony Cousins – I think they particularly take share from Japan and from Europe. I don’t want to be too bearish here, but I think we have in Europe and Japan, two areas which are in long-term decline, largely driven by the demographics. These places need radical change. Europe in particular is wedded to a level of job security and a generosity of welfare benefits that it simply cannot afford. These things simply do not exist in Asia, excluding Japan. These are far more flexible dynamic economies that have not built up overly generous welfare systems or given people iron clad job security, no matter what the performance of their employer has been. There’s lots of structural advantages. Sure, the situation in Europe and Japan could change, but I think it will need some real massive upheaval for this to happen. When we look at Japan, much is talked about Prime Minister Abe’s three arrows, really only the third arrow was of interest to us, which was structural reform. Frankly, very little has happened on that front. Enormous amounts of talk, but very little change has actually occurred. These are economies, both Japan and Europe, that need radical surgery.
Matt Smith – We’ve made the case for equities, the case for value and the case for opportunities in Asia, X Japan. Tony closes with a cautionary comment to consider when taking his advice on these topics.
Tony Cousins – I think value, as an indicator, is not a good timing tool. We look at a lot of historical data and can make a highly cogent case for owning inexpensive assets for delivering the best return. Value does not help you with market timing. We had a set of central bankers here who are determined that things are not going to go wrong on their watch and are really locked into this cycle of money printing. There seems to be a bit of disillusion with this, but there really don’t seem to be many alternatives. People talk about fiscal policy. Well, there really just isn’t that much capacity to expand fiscal policy. We would expect more money printing to occur and money printing will continue to inject liquidity into the system and may drive valuations to even more absurd levels in our views. Markets can reprice very quickly. When they do, those will provide tremendous buying opportunities. But we will have no idea when that is likely to occur.
Ben Jones – Hopefully, you’ve gleaned some insights from Tony’s perspectives today, and you’ll take those into consideration as you balance the risks and rewards of international investing for your clients this year. Thanks for listening to the episode and please let us know what you thought by e-mailing us at email@example.com.
Matt Smith – Many thanks to our guest, Tony Cousins, for his tips, insight and knowledge about this subject. You can read more themes for international investing in 2017 by downloading Tony’s paper from our show notes page at bmogam.com/betterconversations.
Ben Jones – Thanks again to our wonderful team behind the scenes at BMO including Pat Bordak, Gayle Gibson and Matt Perry, and at Freedom Podcasting including Jonah Geil-Neufeld and Annie Fassler.
Ben Jones – Thanks for listening to Better conversations. Better outcomes. This podcast is presented by BMO Global Asset Management. To learn more about what BMO can do for you, go to bmogam.com/betterconversations.
Matt Smith – We hope you found something of value in today’s episode, and if you did, we encourage you to subscribe to the show and leave us a rating and review on iTunes. And of course, the greatest compliment of all is if you tell your friends and coworkers to tune in. Until next time, I’m Matt Smith.
Ben Jones – And I’m Ben Jones. From all of us at BMO Global Asset Management, hoping you have a productive and wonderful week.
Disclosure – The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment professional about their personal situation. Past performance is not indicative of future results. BMO Asset Management Corp is the investment advisor to the BMO funds. BMO Investment Distributors, LLC is the distributor. Member FINRA SIPC. BMO Asset Management Corp and BMO Investment Distributors are affiliated companies. Further information can be found at www.BMO.com.