Mark Burgess

Global equity markets were largely unchanged in April, although this masked a fairly wide dispersion in returns at the sector level.

Earlier in the month, for example, technology stocks came under pressure and triggered a general slide in equities due to fears that valuations were overstretched. Tensions between Russia and the West also undermined investor sentiment. However, equity markets subsequently rallied strongly on the back of encouraging US data and some easing of geopolitical tensions before some disappointing earnings releases in the US, a deterioration in the Ukraine crisis, and fresh concerns over the economic outlook in China weighed on risk assets in the final days of the month.

Treasury yields fell with the 10-year benchmark yield ending April at 2.66%, compared with the 2.72% level seen at the end of March. At the end of the month, and as expected, the Federal Reserve continued to reduce its monthly bond buying by US$10bn to US$45bn. The central bank said that growth in economic activity had picked up recently, having slowed sharply during the winter. The Federal Reserve also repeated its ambition of keeping interest rates at very low levels, saying it would maintain interest rates “below levels the committee views as normal in the longer run” even after the US economy has improved enough to hit target levels of unemployment and inflation.

In the eurozone, Portugal returned to the bond market for the first time in three years, holding a successful auction of €750m. The auction was three times oversubscribed and 10-year government debt yields fell sharply to an eight-year low of 3.58%. Greece also returned to the bond market for the first time since 2010. It sold €3bn of five-year bonds at a yield of 4.95% and said the issue was eight times oversubscribed. At the end of the month, the yield on the Portuguese 10-year bond had fallen to 3.64%, while that of the Greek equivalent was down to 6.64%. Eurozone bonds in general gained over the month on speculation that concerns over deflation could cause the ECB to adopt new stimulus measures.

The J.P.Morgan EMBI+ Index (on a total-return basis) delivered a positive return as emerging market bonds continued to recover. Russia proved an exception, however, with tensions between the West and Moscow over the Ukrainian crisis hurting investor confidence in the country’s bonds. Moreover, the credit rating agency Standard & Poor’s cut Russia to BBB- with a negative outlook, placing it on the brink of junk status. Meanwhile, the MSCI Emerging Markets Equity Index (total return, local currency) was largely unchanged over the month.

We made no changes to our investment strategy over the month. We remain overweight equities as valuations are largely reasonable, although less compelling than was once the case. We also remain underweight Asian equities on concerns over China, while we are overweight Japan as valuations are attractive versus developed world peers. Although we remain overweight equities, it would be fair to say we are less optimistic than we have been. Having said that, the recent pick-up in M&A activity in areas such as pharmaceuticals should prove supportive.

Within fixed income, core yields are going to grind higher, and there is much less value in credit given how far spreads have tightened. Only emerging market debt appears to offer any real value, but given the risks in terms of China, geopolitics and the macroeconomy, we are wary of increasing our weighting at present. The good news is that the current environment is likely to continue to provide opportunities for stock pickers, which we aim to exploit.

by Mark Burgess, CIO at Threadneedle Investments

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Mark Burgess

In this latest outlook, Mark Burgess, Chief Investment Officer at Threadneedle Investments, assesses market activity so far this year and provides an asset allocation update.

• Threadneedle halves overweight in equities
• Increases underweight in Asian equities on China concerns
• Increases overweight in Japan

In our last asset allocation update, we framed the outlook for 2014 in the context of how bond markets deal with policy normalisation; what happens to emerging markets as a result; and whether corporate profits will meet expectations?

The first quarter has been a testing time for markets as they have grappled with the above, overlaid with an escalation in geopolitical risk, and ongoing concerns regarding the burgeoning Chinese credit bubble. Markets took serious fright in January and February, but risk appetite has returned and investor sentiment improved. In equities, with the exception of Japan, developed markets are now flat on the year, having been considerably weaker, whilst in emerging markets the picture is more mixed, albeit with a very significant rally in the last week. In fixed income, core yields are now rising again although at much lower levels than the beginning of the year, and are comfortably off the lows. Credit grinds ever tighter (can we still call it high yield at a 4 % yield?), and emerging market debt like its equity counterpart, has rallied strongly in the recent period.

When we consider the macro economic backdrop, the developed world is still on an improving trend, albeit at a slightly slower pace than we had expected at the beginning of the year. The Fed remains committed to an orderly ending of QE and expectations are now for short rates to start rising in H1 2015. It is difficult to know the impact of policy normalisation on the economy but it will be a headwind and debt remains stubbornly high. In Europe, deflation is rearing its ugly head and with a similar debt concern the ECB must surely be considering more imaginative policy options than hitherto. We would consider any new measures to be acting from a position of weakness. Arguably, given weak economic activity, a profoundly fragile periphery, and stubbornly low inflation, any new measures should have already been introduced. In Japan, Abenomics appears to have stalled, and the currency has stopped depreciating. Nervous of the impact of the consumption tax, the Nikkei has fallen sharply relative to other developed markets, in contrast to last year.

Perhaps the biggest conundrum is China. Over the last few years there has been an explosion of credit, facilitated by the shadow banking system. Retail investors have been enticed into an array of savings products promising heady returns where the underlying investments are often opaque. It is clear that the authorities are now concerned about this and investors are surely going to see an increasing number of these funds go bust. Looking back through history at economies that experienced a similar growth in credit, it is difficult to find one that ended well. At best we are likely to see a material reduction in China’s growth rate, however it could be much worse. Clearly the prolonged underperformance in Chinese equities has discounted some of this, and valuations are low relative to other markets. However the unwinding of the Chinese credit bubble could severely test the Chinese financial system, and unnerve investors further.

Consequently we have decided to halve our overweight in equities and move to a neutral position in cash. Equity valuations remain attractive, but they are less compelling than they were. We increased our underweight to Asian equities on the China concerns and increase our overweight to Japan on the belief that the impact of the consumption tax will be lower than feared. Although we remain overweight equities, it would be fair to say we are less optimistic than we have been for some time. Within fixed income, core yields are going to grind higher, and there is much less value in credit given how far spreads have tightened. Only emerging markets look like they offer any real value. But given the China issue and geopolitical and macro risks, we are wary of increasing our weighting at present. If there is good news, it is that the environment is likely to throw up opportunities for stock pickers which we aim to continue to exploit.

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Pickup in peripheral economies has contributed to a more positive general sentiment across Europe: Threadneedle

According to Threadneedle’s European equities manager Dan Ison, the traditional differentiation between the European “core” and the weaker “periphery” economies does not hold up anymore.

Economies such as Spain and Ireland performed much worse during the global financial crisis, with investment returns generally tallying this trend. However, over the past 24 months, those peripheral economies that have enacted dramatic reforms have started delivering better equity market performance compared to their “core” counterparts such as Germany and France.

Threadneedle’s European equities manager Dan Ison said:  “Last year saw a Phoenix-like resurgence in interest for European equities, with an interesting mix of winners and losers. The equity markets of Greece, Finland and Ireland performed best, while the UK, France and Italy performed worst. Germany, The Netherlands and Spain were somewhere in between. What can we glean from this? Generally speaking, those economies that have enacted the most dramatic economic reforms have delivered better equity market performance. Despite significant external pessimism about Europe’s ability for self-help, it has begun to work.

“The poster children of the Eurozone reforms are certainly Spain and Ireland. Both have exited their troika programmes. Spain can easily finance itself in open markets, and Ireland has recently conducted its first bond sale since the bailout. Unit labour costs, a good proxy for competitiveness, have fallen significantly from their peaks in both countries. Perhaps more importantly, their employment is now growing. Irish GDP saw a clear rebound, with particular strength in building and construction and investment in machinery and equipment.

“In contrast, the economies of France and Italy remain troubled. President Hollande recently conceded that France is overtaxed. Here is a socialist leader effectively calling for tax cuts and a slimming of the (very bloated) state sector. The country’s unit labour costs are flat. Italy remains a curious mix of reasonable economic data coupled with possibly the most baffling political situation in the developed world. The lack of strong government certainly hinders Italy’s ability to reform – despite being the eighth largest in the world, its economy has not grown in more than a decade.

“The pickup in peripheral economies has contributed to a more positive general sentiment across Europe. In a recent survey, Germans revealed to be more optimistic about the future now than at any time since the mid-1990s. It also leads us to believe that it is not appropriate to talk about European “periphery” vs. “core” anymore when it comes to economic growth and equity returns.

“Economies which instituted the bolder and tougher reforms are now looking towards a significant pick-up in growth compared to 2013. We expect this top-line growth to drive improved earnings in 2014, helping them to catch up with other developed markets. Our earnings forecast stands at 10% for this year.

“All in all, it looks like the European theme for 2014 will be long sangria and panettone, short sauerkraut and champagne.”

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“The recent rise in bond yields, and the accompanying increased volatility, is potentially very informative about ‘what next’ for global markets. As we move through the next phase of policy responses to an over indebted and slow growing developed world, we have to consider how markets might respond to the withdrawal of QE, particularly in the US.
 
“The Fed minutes have started to cover what might prompt the authorities to reduce (or taper) the bond purchase programme and alongside some stronger data this has led to a rise in core bond yields. Whilst we do not expect short term interest rates to rise anytime soon, were growth to pick up and QE to be withdrawn or reduced, there is no doubt that the yield curve would steepen materially from here. The recent bond sell off is probably the first indication of how markets might respond to this environment. What is perhaps more informative is how the non-core bond markets have reacted. In particular the sharp sell-off in emerging market bonds is potentially a foretaste of what is to come if this trend becomes more substantive.
 
“Being short government bonds and overweight credit and EM debt feels very consensual, driven by a global search for income in a low yield world, and the move to the exit could very quickly turn into a stampede from what has historically been an illiquid set of assets. Although an improving global growth outlook is not necessarily our central case, the US continues to show signs of improvement, and as we move through the year, we move ever closer to QE withdrawal. Given the recent performance of EM, we think it is only prudent and sensible to start to reduce our large overweight in investment grade credit.
 
“The other hugely volatile asset class recently has been Japanese equities which have retreated from their highs of a couple of weeks ago. We are still at the very early stages of properly understanding the full consequences and impact of “Abenomics”. However, there is no doubt that the authorities mean business, and intend to do whatever it takes to stimulate the economy and the liquidity taps are well and truly open. Although the Yen has stopped weakening for the time being, it is now at a level where Japanese industry is very competitive, particularly against the other Asian economies. We expect there to be a substantial improvement in Japanese profitability and earnings and think the equity market selloff is an opportunity to increase our exposure. As a result we are slightly adding to our Japanese equity position and will look to increase on further market weakness.”

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So said Cormac Weldon, Head of US Equities for Threadneedle Investments while in a general discussion about why the United States’ ability to bounce back from economic setbacks is placing US equities firmly on the investment agenda.

“The American economy is once again demonstrating its ability to renew itself and is emerging from the credit crunch with a new technological revolution underway. Meanwhile, consumers are reducing their debt and corporate America is cash rich. Perhaps we shouldn’t be surprised at this turnaround because America has consistently bounced back from previous setbacks. This resilience has been underpinned by factors such as strong population and immigration growth, the mobility of its workforce and a robust productivity culture,” said Mr Weldon.

He went on to say that three key themes emerging from the US indicate that the economy is on the move – leading Threadneedle analysts to consider US equities well placed to deliver healthy returns to investors.

These three themes are:

• Cheap energy is driving economic growth. The shale energy revolution means that, unlike other industrial economies, the US now has increasing access to cheap oil and gas, which has the potential to drive industrial and employment growth for years.
• Dynamic labour markets are supporting industrial revival. Improving labour market conditions are being driven by a flexible labour force, and nowhere is this better demonstrated than in the automobile sector. Not so long ago the survival of GM and Chrysler was in doubt, yet today the big three Detroit automakers are reporting significant profits on the back of rationalised production, reduced capacity and lower labour costs.
• The banking sector is returning to health and the housing market is stabilising. Domestic banks have recapitalised, and while loan growth remains weak, the expectation is that it will pick up. Currently, while house prices are very affordable and mortgages are cheap, new household formation remains low. However this should change as new jobs are generated, people feel more secure about their employment prospects and the become increasingly confident that the homes they plan to buy will not fall in value.

These themes all paint an encouraging view of the US economy, but Mr Weldon acknowledged that strong economic data isn’t the only factor to consider.

“Of course, a strong economy alone doesn’t always translate into rising share prices. But we are confident that US equities can deliver healthy returns to investors. The free cash flow yield of the US equity market compared to the yield provided by the US corporate bond market reveals that equities are at their cheapest level in more than 50 years. In addition, our bottom-up research has identified a number of very attractively-valued companies with excellent growth potential. Our focus is on companies exposed to faster-growing industries emerging from cyclical lows, and innovative growth companies with strong business models.”

Mr Weldon concluded by saying that, while the future for US equities looks rosy, challenges do remain.

“The Eurozone is top of mind given its uncertain political, fiscal and monetary situation,” he said.

“The possibility of an administration change in the US also has the markets concerned, in particular in relation to how the big issues of deficits and tax cuts might be addressed come November.

“Nonetheless, we firmly believe that US equities can make further progress this year. Positive factors include: continuing earnings growth in the mid-single digit range and the likelihood that profit margins will be stable; as well as the robust health of the corporate sector. In addition M&A activity has started to pick up and the valuation of the market is undemanding. For investors, now is the time to consider allocating to the US.”

26 July 2012

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Mark Burgess, CIO of Threadneedle Investments, said:

“As we felt they always would, having stared into the abyss, it appears that the European politicians have finally done enough to contain Greece for now. Given the large numbers of negotiating parties, the scale of the agreement is considerable and should be applauded. It has done enough to take the possibility of financial meltdown in Europe off the table. Haircuts will be taken, banks will be recapitalised and breathing space has been bought. We are not going to have a financial car crash, and against that backdrop, the rally in risk assets makes sense. Indeed equities are now back to the levels immediately prior to the market correction in early August. We have remained overweight equities and other risk assets throughout this period and would expect markets to gently rally further from here.

“What has not changed however is that the outlook for developed market growth is as challenged as ever. Europe will struggle to avoid recession next year, and the US will grow at less than 2%. Deleveraging will continue to provide a growth headwind as banks raise further capital and restrict lending. Developing market growth will continue to outperform, but will clearly be impacted by the developed world slowdown, as exports remain vitally important and consumption is still a relatively small part of economic activity.

“Within Europe, whilst breathing space has been achieved, the crisis has highlighted the Euro’s structural flaws; how does the system work without fiscal and political integration? Achieving this is going to be very difficult, and I would think will ultimately lead to a smaller Eurozone than today. Whatever the politicians think, taking their public with them on this is going to be impossible for many Governments. For Greece, even with the 50% haircut, they are still forecast to have net debt to GDP of 120% by 2020, not exactly sound finances!”

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Injections of liquidity into the financial system have been highly supportive of equities since the financial crisis.  The end of QE2 earlier this summer was therefore another factor behind the recent weaker trend in the market.  With little impending threat of deflation, we do not believe a third phase of QE is imminent.  However, the authorities have stated that interest rates will be on hold throughout 2012 and further stimulative measures should not be ruled out.

Having recently lowered our forecasts for US economic growth to 1.5% for both this year and next, we have also reduced our expectations for earnings growth.  We are now expecting 8% growth in earnings this year, with next year flat to potentially down.  US companies have a good track record of addressing their cost bases to protect margins in tougher times, and they are likely to take similar action on this occasion.  Nevertheless, low nominal growth provides a difficult backdrop for aggregate earnings growth.

With global sovereign risk concerns focused on the eurozone, European equities have underperformed the US, leaving the relative valuation of US stocks versus their European counterparts at above-average levels.  However, the current level is well below previous highs, suggesting that the US could continue to outperform in the absence of a solution to Europe’s problems.

We believe that US banks are better placed than their European counterparts. The US banking sector is much stronger today than it was at the onset of the financial crisis and appears to be in a much better position to deal with the strains created by the sovereign debt crisis.  Compared with the same sector in Europe, US banks generally have lower assets in relation to equity, indicating the deleveraging that has already occurred.  They also have lower loan to deposit ratios, which means that they are less dependent on wholesale funding than their European equivalents.  While we remain cautious on the banking sector, this relative strength should stand the US market and economy in good stead if the eurozone debt crisis intensifies.

We are seeing a generational valuation opportunity with US equities attractively valued relative to history and to other asset classes before the recent turbulence, and the setbacks of the past weeks have magnified this attraction.  For example, using large-cap equity free cash flow yields versus Baa-rated corporate bond yields, equities are as cheap against credit as they have been since the 1950s.

Equity valuations patently include a high risk premium at these levels and, while there are genuine challenges facing the market, US companies have demonstrated in the past their ability to grow their profits over the long term.  Moreover, compared with previous periods of cheap valuation, equity investors today are buying a much higher quality asset with less debt and better free cash flow generation.  As such, we feel that these extreme valuations could represent a good long-term opportunity.

Current positioning
For some months we have been positioning our portfolios for a low growth environment and this stance remains in place.  We are focused on companies with exposure to secular growth trends; those operating in industries with high barriers to entry or with a product advantage.  These characteristics should help to deliver sustainable earnings growth despite the lacklustre economic backdrop. Examples include Apple Inc where we are expecting within the next year new versions of the iPhone and iPad and Visa Inc, the payment processing company, which benefits from secular growth in use of credit and debit cards.

We also continue to look for companies with strong balance sheets where the management is managing capital proactively, for example buying back shares, raising dividends or undertaking sensible corporate activity For example Philip Morris International, the tobacco company, has consistently bought back its own stock and recently increased its dividend by 20%.

Our stock selection efforts in light of these themes are leading to overweight positions in consumer discretionary and technology and underweights in financials, industrials and energy.

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The call came during the Certitude Global Investments national adviser roadshow where Threadneedle and its global equities offering was introduced to its adviser network,following the signing last month of an exclusive retail distribution agreement with Certitude.

Head of Global Equities at Threadneedle, Jeremy Podger, presented a strong case for adopting a true world view when it comes to equity investing. He cited issues such as the capacity constraints of the Australian equity markets and the increased internationalisation of companies in every region as two reasons to adopt such an approach. A third is the need to buffer against likely ongoing volatility – and that large, genuinely global organisations may be better able to weather than smaller, more localised organisations.

“For perhaps the past ten years there has been the view that you could in effect ‘switch’ from one market – say a developed market; to another – perhaps, emerging markets – and pick up gains that way,” Mr Podger said. “However with valuations having converged and emerging economies facing increased cost pressures, trying to capture growth only through emerging market equities won’t give you access to all the best opportunities available in markets globally.”

In essence, said Mr Podger, we are now facing a ‘three –speed’ global economy in which we have near-zero growth in the peripheral European states; sluggish growth in other parts of the developed world and strong but slowing growth in the emerging markets.

For investors, he said, the best way to capitalise on this growth is to look to genuinely internationalised companies – what he described as ‘citizens of the world’ – which have footholds in various markets and can capitalise on growth while minimising their cost base on a global basis. Companies such as BMW, Tiffany & Co, Burberry and Samsung which have positioned themselves to reap rewards from the growing consumer market in Asia while their traditional developed markets have been in the doldrums.

Craig Mowll, CEO and MD of Certitude, opened the roadshow stating: “As the government guarantee expires in October 2011, advisors will be challenged in how they will approach and manage their clients moving forward.

“Due to what we have been experiencing, investing globally will likely be one of the largest of those challenges. But with the likelihood of FoFA taking effect in 2012 and with investors being given a choice to ‘opt-in’, providing clients navigation and advice on 96 per cent of the world’s markets may just prove to be the best value planners can offer clients in a fee for service environment.”

Mr Mowll cited issues such as falling cash rates along with the strong Australian dollar and the need for greater diversification as popular reasons for investors – and especially high net worth investors – to be looking off shore.

Mr Mowll said that it was in light of such upcoming issues that Certitude began looking for a world class international equities equity manager. Starting with a universe of 4,000, Certitude worked with a global research house to produce a high quality shortlist – which led to signing the five-year exclusive distribution agreement with Threadneedle.

“This complements our existing offering with our other investment partners, Lighthouse Partners and Marshall Wace Gavekal,” he said.

“Bringing Threadneedle on board with their global equities offering rounds off the picture and enables advisers who are so minded to present a far fuller and more balanced array of investment options to their clients. It’s an offering we are fully expecting to be taken up strongly given the current market and as more advisers become familiar with the rigour of Threadneedle’s processes.

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Diane joins Threadneedle on 12 September from Columbia Management, a fellow asset management subsidiary of Ameriprise Financial, where she is a New-York based Portfolio Manager for US equities. Diane has had a 28 year career, specialising more recently in value portfolio management of US equities. She joined Columbia Management in 2001, and co-managed large and mid-cap value mutual funds and institutional portfolios.

Nafis joined Threadneedle on 25 July from Morgan Stanley’s Investment Banking Division, where he was an analyst in the UK Mergers & Acquisitions team gaining a broad range of M&A, restructuring, credit and equity experience.

The appointments bring Threadneedle’s US Equities team to a total of eight, with three fund managers and five analysts. The team works closely with Threadneedle’s other investment teams through its collaborative investment process. Threadneedle manages over £7bn in US equities. By value of assets, 100% of its North American OEICs, SICAVs and pooled pension funds have outperformed their peers or benchmarks over 3 and 5 years, and 88% of these funds have outperformed over 1 year (to end May 2011).

Cormac Weldon , Head of US Equities, commented: “We are pleased to have Diane joining us from Columbia Management. She has a proven track record in managing US equities funds with a focus on value management. We take a team-based approach to fund management, with a culture of open discussion, debate and sharing of ideas, and I’m confident that Diane and Nafis will provide valuable input to this process.”

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We therefore see recent volatility as an investment opportunity, with the market overlooking a number of favourable developments set to benefit Chinese equities for some time to come. Recent concerns that the economy might be cooling miss the fact that this is exactly what the authorities have been trying to achieve. We agree that China will see growth slowing down going into the second half of this year, but that surely was the point of policy tightening! We are not concerned about a ‘hard landing’, past experience (notably the previous two slowdowns) shows China has been successful at achieving ‘soft landings’.

With deep cash reserves, the government is willing and able to spend its way out of a potential hard landing. Meanwhile, the country’s fiscal debt to GDP remains low at around 3%, giving the government ample financial strength to provide fiscal stimulus should the need arise. First quarter growth came in much stronger than expected, so it is a good sign that second quarter GDP is likely to dip below the high levels that we saw in the first quarter. We still think GDP growth is likely to be at 8% to 9% per year. At these levels, the expansion will continue to support a number of the themes that have made China such a rewarding place in which to invest.

Key themes include

• Infrastructure: Fixed asset investment growth in 2010 was mainly driven by government-related infrastructure investment.
• Consumpation: With consumption growth expected to continue, companies with strong brands and pricing power should be underpinned by robust top-line growth – helped by inflation. 
• Automation: One of the aims of the latest five-year plan is to focus on increased mechanisation.  Although manufacturers are facing wage pressures, productivity gains are still outpacing increases in labour costs.

Evidence of a global deceleration at a time of moderating growth in China has prompted fears of a hard landing for the country by some investors. However, according to Threadneedle’s Gigi Chan, many of the factors worrying investors are more apparent than real. Whether looking at sectors benefiting from still strong growth or industries less favoured by the five-year plan, the key to maximising performance continues to lie in a stock-by-stock approach to portfolio construction. Investor nervousness illustrated by the recent market volatility provides an ideal environment for stock picking.

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