Managers still back US equity bets

The US stock market’s strong performance has not put it in bubble territory, says Northern Trust international CIO Wayne Bowers.
Managers still back US equity bets

Despite an almost six-year rally in US equities, the asset class does not pose outsized risks to investors, said Wayne Bowers, London-based CEO and CIO for international asset management at Northern Trust.

“Fears of a massive bubble are overblown,” he told a recent AsianInvestor conference in Singapore.

Several factors are keeping risks in check, including stable amounts of leverage in developed markets, particularly among financial institutions; the rapidly increased capital rules for banks worldwide; and regulatory constraints on aggressive lending and trading practices.

Throughout post-World War 2 history, wars, natural disasters and financial crises have had only temporary and ephemeral impacts on markets, Bowers added. Therefore investors, particularly institutions, should leverage their long-term outlook and take advantage of dislocations.

So what does that mean for equity markets? Long-term equity valuations in the US and Europe were fair to expensive, Bowers said, while Japan and emerging markets looked cheap.

Northern Trust has maintained risk overweights for the past two years, he added, but last quarter it did scale back modestly on concerns over Japan’s recent rating downgrade and questions over the efficacy of the European Central Bank to administer stimulus.

But this is more a pause than a retreat, as Bowers hopes economic bad news can create cheaper entry points into developed-market equities. For investors with a dollar base, however, the weakening of the euro and the yen against the greenback do create challenges for a total return.

That is one reason why Northern Trust remains overweight US equities, despite the S&P 500 Index’s run. The index’s post-financial crisis low of March 5, 2009 of 682.55 points has since risen 204% to close at 2075.37 on Friday, December 5. It is up even on a 10-year basis, by 73%.

Sanjay Natarajan, institutional portfolio manager at MFS in Singapore, also sought to debunk the idea that equity markets in the US had risen too far, too fast. He said that, based on annual performance data going back to 1870, the S&P 500’s performance this year was average.

Natarajan cautioned that simple index performance could not predict future prices. In the long term, equity performance depends on general economic growth plus the earnings potential of specific companies. On that basis, he dismisses the argument that US stock indices have risen simply because of US Federal Reserve Bank monetary stimulus.

He does acknowlege that the macro story looks scary for US equity investors, given diverging central bank monetary policies, peaking profit margins for many companies and slow or mediocre economic growth projections.

However, he is sceptical that the Fed will raise interest rates in 2015, lest that cramp the US’s improving economic expansion. Also, comparing US price-to-earnings ratios to bond yields, the data suggests stocks are priced for a low-growth environment, not for a boom.

On average, US equity return on equity (RoE) is 16%, which is superior to other markets, Natarajan noted. This has been achievable despite many years of stagnant wage growth, a phenomenon that pre-dates the financial crisis. RoEs in Euope and many emerging markets, on the other hand, are declining – without structural reforms being implemented, Natarajan said these markets would underperform the US over time.

Governments that can fulfill a reform programme, perhaps including China, the Philippines and India, should enable the benefits to flow to their listed companies’ earnings. But those that rely purely on currency tactics or quantitative easing, such as Japan, look cheap but may stay that way.

And even healthy emerging markets may appear to have inexpensive equities, but these index averages hide the reality that the stocks which global investors desire, those catering to rising middle classes, are extremely expensive (think health care or consumer staples).

Ulrich Behm, head of Asia Pacific at Vontobel, said this was because stockpickers were buying corporate earning stories, not GDP. Therefore many of the best “emerging market” stocks are companies in developed markets that receive a large chunk of revenues from emerging-market consumers.

Indeed, it is Europe that offers some of the best emerging-market plays. Several managers cited the likes of Nestle, Richemont, Diageo and LVMH, which earn anywhere from 35% to 40% of revenues from emerging markets – and are also well-run, quality businesses that should provide a steady compound return.

The US economic recovery should also be good for select Asian companies, particularly those that export. “Emerging-market companies with quality export businesses can sell more to the US,” Behm said.

Those Asian countries that are big importers of oil, from Japan to India, should also benefit in ways that boost companies’ profitability.

Peter Ryan-Kane, head of portfolio advisory in Asia Pacific at Towers Watson, said lower energy prices would mean lower food prices, and that would mean more money in consumers’ pockets. Added spending power would benefit some Asian companies as well as Western multi-nationals.

Not everyone is keen on the EM story, however. Northern Trust’s Bowers remains underweight emerging markets and companies tied to natural resources, which face a slowing China and a strong dollar, in which most resources are priced.

He said the US market faces fewer headwinds than others. The earnings power of its companies may no longer be “stellar”, but they also face fewer problems, and that is why he remains overweight US equities.

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