“Going forward, we expect significant convergence in relative growth rates after a long period of US exceptionalism. Global investors are structurally overweight US dollar (USD)-denominated assets, and we believe there are both economic and geopolitical reasons for reducing these exposures over time. However, a further selloff in the USD may require definitive evidence of a deterioration in US economic growth.

“Meanwhile, there are multiple crosscurrents affecting the US bond market, which are currently balancing each other out. On one hand, the US economy is gradually slowing down. On the other hand, additional US fiscal easing at a time when the government debt level is already high is pushing bond yields upward.

“Despite a reprieve in tariffs, the trade war is far from over. We expect tariff rates to eventually settle at meaningfully higher levels than before the Trump administration took office. Tariffs lead to higher inflation and slower economic growth. Faced with stagflationary risks, the Federal Reserve (Fed) is likely to be cautious in reducing policy rates.

“Even though short-term recession risks have diminished, we expect US growth to slow significantly in the second half of the year. This deceleration is due to the tax-like impact of tariffs along with trade policy uncertainty also depressing investment and hiring. Federal workforce layoffs, lower immigration, and a decline in international tourism may contribute additional drags on economic activity. What is unclear is whether the weakness in growth will be significant enough to trigger a more aggressive Fed policy easing cycle amid elevated short-term inflation risks. At the same time, the eurozone economy will be supported by the significant monetary easing delivered over the past 12 months and the massive multi-year German fiscal stimulus package.”

On the outlook for global equities, Sorin Roibu, Portfolio Manager and Research Analyst said, “The global equity landscape is experiencing a fundamental shift as the era of US market dominance faces mounting challenges. With first quarter gross domestic product (GDP) turning negative and trade policy uncertainty weighing on growth prospects, the US economy appears increasingly vulnerable to stagflationary pressures from tariff-driven inflation and constrained Federal Reserve policy. This environment is driving what we call the “Great Expectations Reversal,” a strategic pivot away from overvalued US markets toward undervalued international opportunities.

“The US faces multiple headwinds: shaky consumer confidence, heightened trade uncertainty, and a challenging handoff from government to private sector leadership. While labor markets remain resilient, downside risks are increasing. Equity markets continue to shrug off these growing warning signs, with US market valuation levels back to historic highs.

“Europe is emerging as the standout destination, bolstered by German fiscal stimulus, attractive valuations, and resilient labor markets. European banks have already delivered exceptional returns, with some gaining 35% to 45% year to date.

“Within emerging markets, Brazil presents compelling opportunities with strong fundamentals and solid economic performance. Meanwhile, China offers selective prospects, particularly in companies benefiting from AI.

“With US market capitalisation-to-GDP ratios reaching levels last seen in 1929 and 1936, the risk-reward dynamic increasingly favours international diversification. We believe investors should consider reducing US exposure while capitalising on the fundamental strength emerging across global markets.”

Emerging Markets expert, Carol Lye, Portfolio Manager, Senior Research Analyst added, “Despite elevated uncertainty, emerging markets (EM) have performed well this year. Local currency markets are up over roughly 10%, and hard currency sovereigns and corporates have returned just over 4% and 3%, respectively, for the year to date. In local markets, currencies have contributed a little over 50% of the return, and we believe there is still room for further appreciation. The US dollar remains elevated from a valuation perspective, and the world is overweight dollar-denominated assets following years of outperformance. Some rebalancing out of the dollar and into undervalued or overlooked markets could benefit EM.

“From a regional standpoint, Latin America offers elevated nominal and real yields. We will be following the heavy election calendar for signs of shift to more centrist candidates, which could reinforce investor confidence and act as a catalyst for the region. Central European markets are well positioned to benefit from a departure from Europe’s recent economic stagnation, especially if fiscal stimulus and targeted industrial policy gain traction.

“A more aggressive trade rebalancing coupled with the cyclical and structural dynamics that are underway may expand opportunities in other EM. Some of these markets may be well positioned to benefit from a secular shift in global production and capital flows. US policy aimed at curbing state-subsidised overcapacity may accelerate the relocation of supply chains toward other markets, including EM economies. This trend could invigorate investment opportunities in infrastructure, local manufacturing, and upstream commodities across Asia, Latin America, and Africa.”

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Felicity Walsh

Leading research house, Lonsec Research has awarded Brandywine Global’s Opportunistic Equity Fund an inaugural ‘Recommended’ rating, indicating the research agency has strong conviction the product can meet its investment objectives.

“This is the fund’s first rating since its launch in Australia just last month and we are delighted to receive this recognition from local ratings agency Lonsec,” Felicity Walsh, Managing Director, Franklin Templeton Australia said.

“This is an important milestone for the strategy and to have Lonsec’s rating at this stage of our launch is testament to the strength of the investment process that has been in place for over 10 years,” Walsh added.

In its report, Lonsec highlighted several key strengths of the manager’s investment process. “The rating reflects the well-experienced portfolio management team and their ability to leverage its internally generated stock research,” said Lonsec.

The firm also earned praise for its “well-established and coherent macroeconomic research process” – a cornerstone of Brandywine Global’s approach. By seamlessly integrating their robust macro analysis with comprehensive bottom-up company evaluation, the manager demonstrates a skill for identifying attractive investment opportunities across the capital markets.

The Brandywine Global Opportunistic Equity Fund invests in in 60 to 100 global companies, limiting stock position size to 5 per cent at purchase, and aims to outperform the MSCI ACWI (in AUD).

Lonsec was impressed with the experience of both portfolio manager and director of fundamental research James Clarke, and portfolio manager and research analyst Sorin Roibu.

“Specifically, Clarke and Roibu have comparable level of experience relative to other fundamental value peers, with both individuals having access to an adequate analyst capability with whom they have collaborated for a prolonged period of time,” Lonsec noted.

Brandywine Global’s distinct investment approach combines top-down macroeconomic analysis with rigorous bottom-up fundamental research to identify undervalued companies. The strength of their investment process is evidenced by an impressive 10+ year track record managing global equities. Of particular interest has been the team’s ability to generate consistently strong returns in an environment where growth stocks have continued to outperform, all while staying true to the value philosophy.

“The manager’s scale and heritage as a global asset manager focused on value strategies provides further support,” Lonsec said.

Lonsec commended the manager’s overall ESG policy framework and disclosure which were aligned with peers.

“ESG has always been an important part of our process and we are pleased that Lonsec recognises this too,” Brandywine Global portfolio manager and research analyst Sorin Roibu said.

According to Roibu “Brandywine Global takes its commitment to social responsibility seriously, and the Fund has a number of sustainability screens in place.”

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European bank stocks are also attractive, but we would be selective in which banks to invest.

Brandywine Global, part of the Franklin Templeton, notes this was a banking crisis that Europe hoped to avoid even as panic spread from the US.

“Still, we believe the global banking sector remains much safer,” says Sorin Roibu, Portfolio Manager and Research Analyst at Brandywine Global.

Roibu says: “The recent banking industry events in the US and Europe have brought back memories of the 2008 global financial crisis (GFC). In the span of just over one week, two banks failed in the US while another remains on life support, and one bank failed in Europe. For the week ending March 10, the top six US large money center banks lost approximately 14% in market value; US super-regionals lost around 26% in value; and smaller regionals lost over 30% in market value. European banks lost 12% in market value for the same period, according to FactSet research.

“This crisis was not supposed to happen. After all, banks today are significantly better capitalised than they were going into the GFC. Risky exposures also have come down significantly and some, like subprime mortgages, have been essentially eliminated. Every year, banks undergo rigorous stress tests that model their businesses through severely adverse economic scenarios, and banks generally pass with flying colours. So, what went wrong? And do we see further risks to the outlook for the banking sector or opportunities in the aftermath? There are plenty of similarities among bank crises, but each one is a little different. It is especially important to understand the differences.”

“The first domino fell in an area that was never thought of as a significant risk: an investment portfolio comprised of Treasury bonds and government-backed securities, which by definition are assumed to carry no credit risk. They do, however, carry interest rate risk. Most of the time this risk is not a big deal, unless we see a significant rise in rates as we did in 2022 into this year. The Federal Reserve’s aggressive tightening cycle caused significant mark-to-market losses on these securities. These are paper losses that over time will mature at par, resulting in recovery of the mark-to-market loss. The caveat here is that losses become real if the bank must liquidate the portfolio. In addition to unrealised losses on the banks’ available-for-sale (AFS) and held-to-maturity (HTM) portfolios, the failed institutions also had other idiosyncratic risks. The first bank failure exposed a significant number of uninsured deposits, deposits in excess of the $250 thousand FDIC insurance limit. Company filings for Silicon Valley Bank showed approximately 88% of total deposits at year end 2022 were uninsured.1

“Further concerns about concentrated bank clientele, either limited to specific sectors or narrow geographic regions, also emerged, putting smaller US regional banks under pressure. As nervous depositors looked to withdraw uninsured accounts, a perfect storm emerged. The banks had to liquidate portfolio securities at current bond prices, taking big losses, which reduced the banks’ liquidity. Mounting losses resulted in a panic among depositors, who all rushed for the door. The result was a textbook definition of a run on the bank.

“Loss of confidence and liquidity shortages are the common killers of banks. History suggests that once a bank run starts, it is hard to contain and can spread to other banks. There is a self-fulfilling nature to bank panics, and as we saw over the past few weeks, in this digital age they can spiral rapidly.

“The panic spread quickly to the European banks, pushing a long-ailing financial institution over the cliff. To be clear, this failure and arranged sale to a rival had nothing to do with the problems at US banks and more to do with mismanagement over the past decade. We believe this failure was going to happen sooner or later; the recent crisis of confidence just sped up the process.

“Despite the selloff in European bank shares, we see little similarity between the drivers of the US and European banking crises. In fact, for the first time in a long time, European banks’ liquidity situation appears in better shape than that of their US counterparts. Post-GFC, European bank regulators introduced liquidity requirements to hold banks to standards aimed at ensuring lenders could survive substantial stressed liquidity outflows. In the US, large-cap banks, those with assets above $250bn, also known as Systemically Important Financial Institutions (SIFI), have similar liquidity requirements in place. However, in 2018, the US regulators rescinded some of the requirements for banks with assets under $250bn, including some of the short-term liquidity requirements. This is where the problem started, and where, we believe, it will remain contained.

“Despite the current fears in the marketplace, we believe that the global banking sector remains much safer than it has been in the past. Most importantly, the regulatory toolkit has evolved and allows regulators to address these crises quickly and more effectively.

“In other words, we believe this situation shall pass and with minimal risk of escalation and contagion like we saw during the financial crisis of 2008.”

He adds: “In the US: In response to what happened, we expect bank regulation in the US will likely increase with greater emphasis on small and mid-size regional banks. We also expect the earning power for smaller regional banks to decrease due to rising funding costs.

“In Europe: Meanwhile, we expect the European bank woes to be limited to one specific case. Not only do we feel the risks in Europe are largely idiosyncratic, but we see several characteristics that distinguish the European banking sector from that of the US, which should keep broad contagion at bay:

“European banks generally hold more cash, and securities comprise a smaller portion of balance sheets for these banks. Therefore, European banks have not had to sell securities at a loss to meet liquidity needs. The European Central Bank (ECB) maintains established facilities to provide liquidity, which can be accessed quickly by banks. European banks’ lending and deposits were more constrained post-pandemic, and they did not grow as rapidly as in the US.

“Once investors realise that the current situation is not a repeat of the 2008 GFC, we think confidence will be restored, and banks can return to business as usual.

“Given our bearish outlook for the US economy and the US dollar, we generally remain more constructive on global equities. We see growth in China, with its recent reopening, continuing to recover post-pandemic, which should shift relative growth away from the US. Furthermore, we expect the European economy to fare better than the US economy on a relative basis, which should also be positive for European banks.

“The US market remains our biggest underweight, and our exposure here skews more defensive. Among US banks, we prefer the large, money center banks. These banks have much stronger deposit franchises than their regional peers. In fact, they have been the beneficiaries and recipients of deposit flight from smaller banks. These banks are also considered safer and carry an extra regulatory burden to prevent failure, unlike banks with $250bn in assets or less, which are not subject to the same standards and rigorous oversight requirements.

“European bank stocks are also attractive, but we would be selective in which banks to invest. There is a wide difference between the quality of banks, as we have recently witnessed in Switzerland and in Germany over the past couple of years. There are also regional macro differences that carry implications for earnings of banks exposed to those respective countries. We prefer a select number of banks, predominantly in France and Spain, which have high-quality management and diversified business exposures.”

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Endnotes:
Source: Barr, A. “Silicon Valley Bank is a particularly scary failure. Here’s why.” Business Insider. March 10, 2023.

Definitions:
Mark-to-market (MTM) is a method of measuring the fair value of accounts that can fluctuate over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution’s or company’s current financial situation based on current market conditions.

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