Prudential AM turns more positive on equities
Within a global multi-asset portfolio, Prudential Asset Management allocates a fifth of the holdings to Asia ex-Japan equities.
Kelvin Blacklock is the Singapore-based CIO for global asset allocation (GAA) at Prudential Asset Management. He oversees life, institutional as well as retail multi-asset funds of the firm. As part of his asset allocation role, he is a key contributor to detailed work on the global multi-asset funds with the in-house life clients. The GAA team manages around $21 billion in assets.
Blacklock joined Prudential Asset Management in 2001, and has been responsible for the establishment and ongoing management of three core investment areas: fixed income; derivatives and structured products; and asset allocation. These three teams now comprise 18 investment professionals and have established the fund houseÆs range of Asian bond products which now include an Asian US dollar and local currency bond fund, an Asian asset-backed securities fund and a synthetic Asian-centric collateralised debt obligation portfolio.
Prudential Plc provides insurance and financial services directly and through its subsidiaries and affiliates worldwide. It has around $510 billion in assets under management. Its Asian asset management business is among the regionÆs largest, with operations in 10 markets and around $68 billion in assets under management. Prudential Asset Management manages funds on behalf of a wide range of retail and institutional investors, including life and pension products sold by Prudential.
Blacklock shares with AsianInvestor his views on global asset allocation.
What are the main opportunities in global markets in the coming 12 months?
Blacklock: Many equity and credit markets have sold off sharply amid the prospect of a deep, protracted recession in the OECD and a sharp slowdown in emerging economies. Banks and consumers still need to deleverage and this will probably weigh on growth and profits for several years.
In spite of the pessimistic outlook for growth and profits, many equity markets now provide unprecedented compensation for risk, or margin of safety. A pessimistic outlook for the economy and profits does not necessarily equate to a pessimistic outlook for stock prices. Markets are forward looking and the trough in equity prices is likely to be well ahead of the trough in earnings.
Prudential Asset Management will look to scale into equities as they cheapen and will focus on markets that are trading at extreme valuations where we believe there is sufficient compensation for the risk.
How has the global financial turmoil affected your investment strategy?
Prudential Asset ManagementÆs GAA team adopts a qualitative macro process within a disciplined valuation framework. This approach typically works well over a 12- to 18-month investment horizon. While our approach is broadly valuation based, we have exercised a lot of qualitative judgmental overlay in our investment process during the US credit crisis. For example, most equity markets were trading at two standard deviations below the average 12-month forward earnings since the beginning of 2008.
We would have maximised our equity position in January 2008 if we had blindly followed the valuation signals. Therefore, qualitative judgment overlay on the sustainability of consensus estimates of expected earnings is necessary to avoid a value trap. Markets can remain cheap for a long period and valuation is a necessary but not a sufficient condition for stock market performance.
Recent market volatility showed that financial market returns are not normally distributed as assumed in almost all financial models, which has underestimated risk in a spectacular way. As such, it is necessary to have a more robust investment strategy and process to cope with these risks.
Have you made any major changes to your asset allocation?
Prudential Asset Management has been cautious on equities since the beginning of 2008 as we held the view that corporate earnings assumptions appeared overly optimistic given increasing evidence of a severe recession in the US and the rest of the world as the credit crisis has unfolded and spilt over into the real economy and corporate earnings. We invested on average about 30% of the portfolio in equity markets that we believed to be the cheapest.
We have, however, turned more positive on equities and increased the allocation since mid-September. We currently have a target equity weight of 65%.
Our optimism is premised on: First, the rapid and unprecedented policy response. Recent government actions to restore confidence in the banking system mean that we should avoid a depression with a rapid and chaotic deleveraging in our opinion. Instead there will be a prolonged recession with a slower, more orderly deleveraging which will ultimately be less costly, we believe. Second, automatic stabilisers; oil and commodity prices are plunging, lowering costs and inflation. This in turn will allow more rapid, aggressive cuts in interest rates, all of which will eventually stabilise growth; Third, extremely cheap valuations. Valuations across many markets are priced for the worst case scenario and appear to provide unprecedented compensation for the risks.
What markets do you prefer globally?
Prudential Asset Management favours assets or markets that are trading at extreme valuations as they provide unprecedented compensation for risk. These assets or markets include the equity markets of UK, Germany, Singapore, Turkey and Russia, US high-yield credit. We are also positive on Asia ex-Japan equities
The spread widening in both investment grade and high-yield bonds appears excessive relative to interest coverage ratios and historical excess of default spread levels and these assets now appear cheap. Implied defaults are higher than the actual default experience during the 1930s.
Germany and the UK are trading at multi-decade low valuations and we believe we are sufficiently compensated for the earnings risk and poor macro outlook. We have hedged the euro and GBP exposure given our view that they are vulnerable to weaker growth in the euro zone, the UK and substantial policy easing û some of which has already occurred.
Turkish equities, trading at four times forward PE, look very attractive and seem to be pricing in a lot of bad news. The current account deficit, corporate debt burden, a weak lira and rising global risk aversion are likely to dampen investor sentiment in the short term. We believe that current cheap valuations offer attractive return-risk trade off over the medium-term.
Russian equity valuation is cheaper now than during the 1998 debt crisis. In our view, the fundamentals are considerably better. Investors are concerned with Russian corporationsÆ ability to refinance their debts in this environment coupled with the governmentÆs ability to engineer a rescue plan and manage an orderly rouble depreciation. We believe RussiaÆs sovereign financial position û large budget surplus and foreign reserves û is much stronger now versus the 1998 debt crisis period and does not justify the current level of valuations. However, we are mindful of the risk of further deleveraging and emerging market contagion.
The Singapore equity market is trading at its cheapest valuation versus history and domestic bonds in more than 10 years. A structural economic transformation with more balanced growth drivers, as well as an entrenched domestic capex cycle should support earnings growth and offset the effect of weaker exports from an external demand slowdown.
AsiaÆs structural imbalances have improved considerably since the Asian crisis. While economic and profits growth is likely to slow sharply in 2009, we believe this is largely priced into regional equity valuations. Falling inflation should allow interest rates and risk premiums to fall in Asia. We remain positive on AsiaÆs secular growth outlook. Regional valuations are already close to past crisis levels.
Which markets are out of favour?
Prudential Asset Management remains concerned over US equity market valuation. The US has enjoyed a five-year goldilocks period of strong growth and low inflation. This led to a huge increase in profits to new cyclical highs. Growth and earnings are expected to fall substantially going forward. While the current forward PE ratio of 10 times suggests that that US is trading at some of the lowest levels seen in 20 years, we remain concerned about the cyclical level of earnings. If we adjust earnings to trend or through the cycle earnings û defined as the 10-year average of inflation-adjusted earnings û the US market has yet to cheapen sufficiently.
In previous crises, US equity valuations bottomed at lower levels than today. Therefore, the US market does not yet appear to be cheap enough for the risks. Credit is scarce, labour markets are weakening and business and consumer confidence has been replaced by overwhelming pessimism, global profits growth is likely to be very weak next year. This will continue to worry investors and lead to higher volatility; price falls in the US could drag down other global markets.
What are your market weightings within a global multi-asset portfolio?
US Investment Grade Credit û 10%
US High Yield Credit û 10%
UK Long Gilt Futures û 4%
Turkey Equity û 5%
Russia Equity û 9%
Asia ex Japan Equity û 20%
UK Equity û 12%
Germany Equity û 10%
Singapore Equity û 9%
Cash û 11%
What are the main challenges that you expect to face in the coming 12 months?
Governments globally are taking action to ensure that the financial system continues to work and the world does not collapse into depression. They are investing directly in banks to counter a shortage of bank capital, providing cash and guarantees on deposits and loans to counter a crisis of liquidity in money markets and easing monetary policy aggressively. Governments are also planning fiscal stimulus packages such as tax reductions or infrastructure investments/projects. While these are positive policy actions, it remains to be seen if these measures are effective as the credit market has yet to show signs of stabilisation.
Given the scale of the deleveraging and the breadth of the problem, the recovery in economic growth and asset prices might take longer than most of the recessions seen in the 20th century. Moreover, as the US, Europe and Japan are all falling into recession at the same time, recovery in these countries is unlikely to be as strong as the normal export led recovery seen in smaller countries. This suggests that there is still material downside risk to equity prices.
What are the main risks of investing in equities at the moment?
Many equity markets have sold off aggressively and now appear to provide unprecedented compensation for these risks and investors buying equities now should be well rewarded on a two- to three-year view. While there are positive signs that we may be near the lows for some equity markets, a sustainable recovery will be dependent on the US market bottoming which we do not believe has yet happened. US equities have yet to cheapen enough to reflect the risks of a deep 1982- or 1973-type recession in our view. In short, equity markets are likely to remain volatile in the short term.
Prudential Asset Management is managing this risk by slowly scaling into equity markets as they fall and investing in markets that are trading at extreme valuations where we believe there is sufficient compensation for the risks.
Blacklock joined Prudential Asset Management in 2001, and has been responsible for the establishment and ongoing management of three core investment areas: fixed income; derivatives and structured products; and asset allocation. These three teams now comprise 18 investment professionals and have established the fund houseÆs range of Asian bond products which now include an Asian US dollar and local currency bond fund, an Asian asset-backed securities fund and a synthetic Asian-centric collateralised debt obligation portfolio.
Prudential Plc provides insurance and financial services directly and through its subsidiaries and affiliates worldwide. It has around $510 billion in assets under management. Its Asian asset management business is among the regionÆs largest, with operations in 10 markets and around $68 billion in assets under management. Prudential Asset Management manages funds on behalf of a wide range of retail and institutional investors, including life and pension products sold by Prudential.
Blacklock shares with AsianInvestor his views on global asset allocation.
What are the main opportunities in global markets in the coming 12 months?
Blacklock: Many equity and credit markets have sold off sharply amid the prospect of a deep, protracted recession in the OECD and a sharp slowdown in emerging economies. Banks and consumers still need to deleverage and this will probably weigh on growth and profits for several years.
In spite of the pessimistic outlook for growth and profits, many equity markets now provide unprecedented compensation for risk, or margin of safety. A pessimistic outlook for the economy and profits does not necessarily equate to a pessimistic outlook for stock prices. Markets are forward looking and the trough in equity prices is likely to be well ahead of the trough in earnings.
Prudential Asset Management will look to scale into equities as they cheapen and will focus on markets that are trading at extreme valuations where we believe there is sufficient compensation for the risk.
How has the global financial turmoil affected your investment strategy?
Prudential Asset ManagementÆs GAA team adopts a qualitative macro process within a disciplined valuation framework. This approach typically works well over a 12- to 18-month investment horizon. While our approach is broadly valuation based, we have exercised a lot of qualitative judgmental overlay in our investment process during the US credit crisis. For example, most equity markets were trading at two standard deviations below the average 12-month forward earnings since the beginning of 2008.
We would have maximised our equity position in January 2008 if we had blindly followed the valuation signals. Therefore, qualitative judgment overlay on the sustainability of consensus estimates of expected earnings is necessary to avoid a value trap. Markets can remain cheap for a long period and valuation is a necessary but not a sufficient condition for stock market performance.
Recent market volatility showed that financial market returns are not normally distributed as assumed in almost all financial models, which has underestimated risk in a spectacular way. As such, it is necessary to have a more robust investment strategy and process to cope with these risks.
Have you made any major changes to your asset allocation?
Prudential Asset Management has been cautious on equities since the beginning of 2008 as we held the view that corporate earnings assumptions appeared overly optimistic given increasing evidence of a severe recession in the US and the rest of the world as the credit crisis has unfolded and spilt over into the real economy and corporate earnings. We invested on average about 30% of the portfolio in equity markets that we believed to be the cheapest.
We have, however, turned more positive on equities and increased the allocation since mid-September. We currently have a target equity weight of 65%.
Our optimism is premised on: First, the rapid and unprecedented policy response. Recent government actions to restore confidence in the banking system mean that we should avoid a depression with a rapid and chaotic deleveraging in our opinion. Instead there will be a prolonged recession with a slower, more orderly deleveraging which will ultimately be less costly, we believe. Second, automatic stabilisers; oil and commodity prices are plunging, lowering costs and inflation. This in turn will allow more rapid, aggressive cuts in interest rates, all of which will eventually stabilise growth; Third, extremely cheap valuations. Valuations across many markets are priced for the worst case scenario and appear to provide unprecedented compensation for the risks.
What markets do you prefer globally?
Prudential Asset Management favours assets or markets that are trading at extreme valuations as they provide unprecedented compensation for risk. These assets or markets include the equity markets of UK, Germany, Singapore, Turkey and Russia, US high-yield credit. We are also positive on Asia ex-Japan equities
The spread widening in both investment grade and high-yield bonds appears excessive relative to interest coverage ratios and historical excess of default spread levels and these assets now appear cheap. Implied defaults are higher than the actual default experience during the 1930s.
Germany and the UK are trading at multi-decade low valuations and we believe we are sufficiently compensated for the earnings risk and poor macro outlook. We have hedged the euro and GBP exposure given our view that they are vulnerable to weaker growth in the euro zone, the UK and substantial policy easing û some of which has already occurred.
Turkish equities, trading at four times forward PE, look very attractive and seem to be pricing in a lot of bad news. The current account deficit, corporate debt burden, a weak lira and rising global risk aversion are likely to dampen investor sentiment in the short term. We believe that current cheap valuations offer attractive return-risk trade off over the medium-term.
Russian equity valuation is cheaper now than during the 1998 debt crisis. In our view, the fundamentals are considerably better. Investors are concerned with Russian corporationsÆ ability to refinance their debts in this environment coupled with the governmentÆs ability to engineer a rescue plan and manage an orderly rouble depreciation. We believe RussiaÆs sovereign financial position û large budget surplus and foreign reserves û is much stronger now versus the 1998 debt crisis period and does not justify the current level of valuations. However, we are mindful of the risk of further deleveraging and emerging market contagion.
The Singapore equity market is trading at its cheapest valuation versus history and domestic bonds in more than 10 years. A structural economic transformation with more balanced growth drivers, as well as an entrenched domestic capex cycle should support earnings growth and offset the effect of weaker exports from an external demand slowdown.
AsiaÆs structural imbalances have improved considerably since the Asian crisis. While economic and profits growth is likely to slow sharply in 2009, we believe this is largely priced into regional equity valuations. Falling inflation should allow interest rates and risk premiums to fall in Asia. We remain positive on AsiaÆs secular growth outlook. Regional valuations are already close to past crisis levels.
Which markets are out of favour?
Prudential Asset Management remains concerned over US equity market valuation. The US has enjoyed a five-year goldilocks period of strong growth and low inflation. This led to a huge increase in profits to new cyclical highs. Growth and earnings are expected to fall substantially going forward. While the current forward PE ratio of 10 times suggests that that US is trading at some of the lowest levels seen in 20 years, we remain concerned about the cyclical level of earnings. If we adjust earnings to trend or through the cycle earnings û defined as the 10-year average of inflation-adjusted earnings û the US market has yet to cheapen sufficiently.
In previous crises, US equity valuations bottomed at lower levels than today. Therefore, the US market does not yet appear to be cheap enough for the risks. Credit is scarce, labour markets are weakening and business and consumer confidence has been replaced by overwhelming pessimism, global profits growth is likely to be very weak next year. This will continue to worry investors and lead to higher volatility; price falls in the US could drag down other global markets.
What are your market weightings within a global multi-asset portfolio?
US Investment Grade Credit û 10%
US High Yield Credit û 10%
UK Long Gilt Futures û 4%
Turkey Equity û 5%
Russia Equity û 9%
Asia ex Japan Equity û 20%
UK Equity û 12%
Germany Equity û 10%
Singapore Equity û 9%
Cash û 11%
What are the main challenges that you expect to face in the coming 12 months?
Governments globally are taking action to ensure that the financial system continues to work and the world does not collapse into depression. They are investing directly in banks to counter a shortage of bank capital, providing cash and guarantees on deposits and loans to counter a crisis of liquidity in money markets and easing monetary policy aggressively. Governments are also planning fiscal stimulus packages such as tax reductions or infrastructure investments/projects. While these are positive policy actions, it remains to be seen if these measures are effective as the credit market has yet to show signs of stabilisation.
Given the scale of the deleveraging and the breadth of the problem, the recovery in economic growth and asset prices might take longer than most of the recessions seen in the 20th century. Moreover, as the US, Europe and Japan are all falling into recession at the same time, recovery in these countries is unlikely to be as strong as the normal export led recovery seen in smaller countries. This suggests that there is still material downside risk to equity prices.
What are the main risks of investing in equities at the moment?
Many equity markets have sold off aggressively and now appear to provide unprecedented compensation for these risks and investors buying equities now should be well rewarded on a two- to three-year view. While there are positive signs that we may be near the lows for some equity markets, a sustainable recovery will be dependent on the US market bottoming which we do not believe has yet happened. US equities have yet to cheapen enough to reflect the risks of a deep 1982- or 1973-type recession in our view. In short, equity markets are likely to remain volatile in the short term.
Prudential Asset Management is managing this risk by slowly scaling into equity markets as they fall and investing in markets that are trading at extreme valuations where we believe there is sufficient compensation for the risks.
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