Global equities: Finding value in a post-QE world


Interview with Will Low, Head of Global Equity, Nikko Asset Management

Q: Over the past few years, we’ve seen valuation convergence, falling stock correlations and lower risk premiums. Given this environment, how do you search for companies that you believe will perform strongly and offer real value?

A: I think one of the most interesting things about the markets today is what is driving asset prices. One normally likes to look at it in terms of potential profit growth, but in reality it’s been all about quantitative easing (QE). Over the past few years, risk asset prices across the world have gone up quite dramatically and across the board. We’ve seen a massive convergence in terms of risk assets and risk spreads in the fixed income world, but also in the equity world, within sectors and geographies. Effectively, there’s been a race to find yield and return wherever it is, given that rates, particularly in the US, are anchored close to zero.

That has been the backdrop that we’ve had. Our dilemma as investors is that the scale of valuation appreciation has been pretty significant. The vast majority of returns in the last three years have come from that appreciation, basically a re-rating, and in the case of equities, price-to-earnings ratios (PEs) have gone up across the board. The question is whether the current situation will continue, with asset prices being driven to more elevated levels. In our view, with the end of QE and rate normalisation in the US, this is unlikely. As a result, we are looking for quality companies that can sustain and grow profitability in what is still a relatively lower-growth world. Features of such companies are strong franchises, evidence of growing cash reserves and the ability to deliver future returns and decent yield to shareholders. These are the characteristics that attract us, but in the current environment it requires considerable research and screening to find companies that will truly offer value.

VIDEO: Will Low QE and Rate Normalisation

Q: The stronger US dollar is starting to become a concern for many. How is this affecting markets and investment opportunities?

A: I think the strength of the US dollar has surprised some investors and many investment strategies are only just beginning to deal with it in terms of their investment process. US dollars are the reserve currency of the world. QE meant that more dollars were being printed and that not only led to the depreciation of the US dollar, but also funded capital flows, which drove up the price of risk assets in almost every corner of the world. The reality is that with the end of QE, that reserve currency is no longer being created in the same quantities. Now other nations are racing to repeat the US example, with QE in Japan and the European Union. The result is competitive devaluation in many other currencies and as a result there has been a preference for capital to move towards being held in US dollars, rather than seeking returns in other currencies elsewhere in the world.

That is creating a big divergence in terms of the investment opportunities compared with where we’ve been in the past five years. We are seeing the degree to which some economies and asset classes have been reliant on those cheap US dollars and now have to close that funding gap. For example, emerging markets and commodities, which typically benefited from the easy money, cheap dollar environment that QE provided, are beginning to suffer. As a result, we’re seeing a lot of pressure in areas such as Latin America, Eastern Europe and selected emerging markets. Likewise, some of the energy and commodity sectors which have been reliant on the strong terms of trade related to high commodity prices are now struggling and are likely to continue to do so for some time.

Q: The Fed has now ended its QE programme and rate hikes are on the cards, potentially as early as June. What do you think the market implications will be of the unwinding of QE and rate normalisation?

A: I think the normalisation of US rates is going to be quite significant for financial markets, which are clearly trading at a level that is relatively elevated by historical standards. Undoubtedly, they have benefited from the large amount of liquidity that QE has created, which essentially hasn’t been finding its way into the real economy – in most cases, it has been circulated within financial assets. Any degree of normalisation of the US yield curve, combined with an ending of QE, will have ramifications. Exactly what those will be is becoming clearer but obviously remains, to a degree, uncertain.

There are three factors that we are watching closely. The first is the strength of the US dollar and the effect that has not only on the US economy but on economies globally. Second is the capital flows to more challenged locations that have been reliant on cheap US dollar funding, with emerging markets being a notable example. The third factor that we are watching is the appetite for fixed income, particularly as the Fed’s normalisation could have some unintended ramifications for volatility. In the fixed income world, which is generally very much an over-the-counter market, many investors may find that as they try and move money out of such strategies, the exit door is somewhat more crowded than the entrance door was. As a result, there could be some notable volatility in some of the fixed income markets which, in due course, could very well have implications for other financial assets.

VIDEO: Investing in Japan and Emerging Markets

Q: With qualitative and quantitative easing (QQE) underway in Japan, is your team finding value in that market?

A: In the case of Japan, QQE is now leading to reforms and improving returns for shareholders, in many cases for companies that previously had quite lazy balance sheets. Although this is already positive, we would suggest that the ‘third arrow’ of Abenomics is still flying and has yet to fully land on its target. Japan is changing, but it’s changing at a Japanese pace. Nevertheless, there is value to be found. We are discovering companies that are much more clearly adopting some of those reforms and ‘third arrow’ strategies to improve and grow returns for shareholders and as a result we’ve been moderately overweight the Japanese market for a while.

Q: Emerging markets have underperformed developed market equities for the past few years, are you still finding opportunities in those markets?

A: I think emerging markets are an interesting area. Historically, emerging markets have been lumped together and viewed as a single asset class and indeed that may have worked for investors in the past. However, we believe that considering emerging markets as a single asset class is rather simplistic and in fact, that view was the very thing that seemed to mark the top for emerging markets. We began to seriously question it two to three years ago when it seemed that almost every granny in Idaho was starting to buy emerging markets in their retirement plan. To us, that was a bit of a warning sign. Clearly, sentiment has changed quite significantly since then and the widespread appeal of emerging markets has waned somewhat.

As mentioned earlier, US dollar funding is a very important element because many emerging markets tend to be quite reliant on it as a mechanism for growing credit within their own economies. Given the rise in the dollar, this will certainly provide more challenges for these economies, so you have to be highly selective about which emerging markets you want to be exposed to.

We are much more interested in those markets that can sustain and grow their economies and are not as reliant on US dollar funding. For example, we are much more positive on India than Brazil, which is still waking up to the reality that the end of cheap funding and easy terms of trade related to high commodity prices is creating a very difficult environment that the country has yet to find a solution for. Given the tendency for most Latin American countries to be reliant on US dollar funding, we are not bullish on that market. However, we believe that crises are often the stimulators of reform and can result in more attractive investment opportunities. That’s one area where we will be focusing our energies from a research point of view. We don’t see the reforms yet, but the more a crisis develops, the more likely it is that change could take place.

VIDEO: Global Market Opportunities and Risks

Q: In your view, which sectors are providing the most interesting investment ideas at the moment?

A: Rather than being focused on sectors, we tend to try and find new, interesting ideas from a bottom-up perspective because that is the key part of our investment ethos. However, in terms of the sectors that have more attractive companies coming to the surface at the moment, Healthcare is one and to a certain extent the Information Technology sector, albeit very specifically some of the more software-related companies.

Q: Given the significant falls we’ve seen in energy prices, are you bearish on the energy sector for the time being?

A: We are not optimistic on the energy sector. In reality, I think many people underestimate the degree to which innovation within the energy sector is affecting the market, particularly in the US, where it is leading to falling break-evens in the shale industry. The new supply is going to start to be compressed with the fall in oil prices as some of the drilling activity falls back, but maybe not to the degree that many expect. The oversupply that exists in the energy markets today is probably going to remain for some time.

There’s also a geopolitical element, which has been one of the factors affecting the supply situation. In our view, until this situation changes, there will be too much oil in the world and prices will continue to be weak. Therefore, the cash reserves and yields that some people think will continue within the energy sector are going to dissipate much faster and to a much greater degree than many expect.

Q: Finally, what are the possible market vulnerabilities or risks that you and your team keep in the back of your minds?

A: There are two obvious risks from our perspective. First, as mentioned earlier, is potential illiquidity in the bond market. If we saw net redemptions in the fixed income world, given the degree of money that’s flowed into that asset class, particularly more recently in open-ended vehicles, we might see some volatility that could have implications for a variety of financial assets.

The second one is geopolitics. Forecasting geopolitical developments is obviously extremely difficult, but we believe that in due course, the volatility and collapse in commodity and energy prices, combined with the strength of the US dollar, could create ramifications for countries globally. This could potentially affect how they act from a geopolitical perspective.

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Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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