Notes on Global Equity Markets

Transcription

1 Investment Team Update 31 January 2018 Notes on Global Equity Markets PERSPECTIVE FROM THE TEMPLETON GLOBAL EQUITY GROUP Market Overview: Stocks rallied in 2017 as investors looked beyond political turmoil and Federal Reserve Board tightening and wagered instead on global growth and earnings-accretive fiscal stimulus. Health Care: While concerns about generic competition, regulatory scrutiny and a consolidating payer sector pressured health care stocks in 2017, the sector continues to be characterized by high barriers to entry, favourable margins and strong innovation potential. Energy: A rising oil price and sector strength affirmed our continued focus on the sector despite fears of a glut earlier in the year. Norm Boersma Chief Investment Officer Tony Docal Director of Portfolio Management Mohan Kandiah Vice President and Research Analyst for the Templeton Global Equity Group Europe: European earnings were the highest since 2010 and manufacturing indexes the highest on record in 2017, suggesting the nascent cycle is accelerating. United States: US stocks still look expensive to us in aggregate. Tax reform could boost near-term earnings, but comes with risks, including wider deficits and political backlash absent clear middle-class gains. Japan: In Japan, stock returns have been improving, growth is materializing, corporate governance is improving, leverage is declining and we believe stocks are beginning to look cheap again. China: China faces many systemic risks, but policy resolve is high, and we believe bottom-up bargains persist in the consumer and service sectors. Outlook: After a false dawn in 2016, value lagged growth for the tenth year out of the past 11 in We believe this mature cycle will eventually change, and with it the adverse conditions plaguing value investors.

2 Market Overview 2017 was an interesting year. On the political front, we had a seeming inability to get things done in Washington. In Europe, there were major elections in France and Germany, both with populist concerns. North Korea remains an ongoing saga. There were central bank tightening worries, particularly in the US. All of this was pushed aside by very strong global growth, and the equity markets looked past all these concerns. For the first time this decade, we had sort of simultaneous gross domestic product (GDP) growth across all the major economies, with the headline number for real GDP growth of 3.6%. And the positive market reaction was notable for its strength and consistency. By sector, things were more mixed, but there was widespread positive performance, with economically sensitive sectors leading the way. At the top of the list was information technology (IT), materials and financials. The laggards, which were still up fairly strongly, included utilities, energy and telecommunication services. Value stocks significantly underperformed growth stocks, with the value index lagging the growth index by approximately 10% for the year. Health Care The last few years have been a struggle for the sector, with increasing regulatory and political scrutiny around drug pricing. Additionally, repeated attempts to repeal Obamacare throughout 2017 created apprehension among health care providers and investors alike. Lastly, generic drug manufacturers have struggled with increasing price competition. Health care expenses continue to rise, and hospitals and providers are under pressure to lower cost and drive efficiencies. While these pressures are not new, they have intensified in the US with the increased powers in the hands of payers. We feel strongly that as in the past, the health care industry will rise to these challenges, but it remains vital that new innovation, both at a product level and services, is designed to benefit outcomes and take out cost in the system rather than adding new cost. Those that fail to innovate will be subject to commoditization and, subsequently, margin pressure. With regard to branded-drug pricing, our view is that market forces have and will continue to dominate in exerting pricing pressure, especially in the competitive-drug category. This is why we tend to favour stocks that are significantly discounting competitive pressures, as well as companies whose products have limited competition or clearly demonstrate advantages over existing choices. We deal with price and competitive threats on a stock-by-stock basis. At the stock level, we want to capture as much of the earnings up-cycle as we can. At the same time, we consider a company s earnings duration. With pharmaceutical companies, the earning cycle is driven by innovation. Duration comes from patents, and marketing and distribution is also crucial to successfully commercialize new products. In our experience, the real winners are the stocks that are heavily discounting future growth, and price-to-earnings (P/E) is a good valuation metric. We also look at various other qualitative metrics such as free-cash-flow yield, balance sheet strength and so forth. We focus on opportunities that fall into one of three buckets: Businesses with tangible revenue streams that are mispriced due to near-term pressures or competitive threats. Innovative companies with pipeline optionality and overlooked research and development (R&D) that is meaningfully undervalued. Companies positioned to unlock value through effective restructuring (i.e., cutting costs to improve earnings). Overall, health care continues to be an attractive sector characterized by high barriers to entry, favourable margins and strong innovation potential. We believe our approach to investing in unloved and unappreciated quality businesses will be rewarded over time. Energy Despite the recovery in oil prices in the second half of last year, energy was the weakest sector last year after a strong run in At Templeton, we viewed short-term pressures a potential supply glut due to weaker seasonal demand, an excessive focus on US inventories, the lag between the announced Organization of the Petroleum Exporting Countries (OPEC) cuts and the actual delivery of crude oil, hurricanes in the US that shut refining capacity, and the ramp-up of shale production in the US as transitory and focused on the longer term. On the demand side, we have actually seen stronger demand growth last year and with strong global economic growth, we should see upward revisions to demand going forward. In our experience, the most reliable way to make money in resource sectors is to invest counter-cyclically along the supply curve, increasing leverage to the underlying commodity when it falls on cash costs and reducing exposures when the price rebounds higher than the marginal costs. We believe we ve managed this reasonably well over the past several years, and today are beginning to selectively take gains and reduce our exposure as the cycle matures. Europe We continue to see fewer risks and greater scope for outperformance in Europe than in the US going into 2018 for five reasons. 1. Growth. Economic growth on the continent continues to positively surprise, with Europe s purchasing managers index (PMI) ending 2017 at the highest level on record. GDP is being revised upward and unemployment is at a low. 2. Policy support. Despite recent messaging from the European Central Bank (ECB) regarding its intentions to scale back bond purchases and quantitative tightening, it s Notes on Global Equity Markets 2

3 likely to be very gradual and highly conditioned on continued systemic stability. The ECB s single mandate is price stability and we believe it s likely to remain one of the world s more dovish central banks in 2018 and beyond as policymakers struggle to meet inflation targets. 3. Earnings and valuation. We see scope for additional upside in Europe coming from both earnings growth and multiple expansions. The ongoing rebound in European profits was responsible for some 95% of equity returns in 2017, suggesting that sceptical investors are still unwilling to attribute a higher multiple to improving fundamentals. At year-end, continental Europe traded at a 40% discount to the US on normalized earnings, more than double the normal discount. 4. Increasing investment. The backdrop of easier fiscal policy, a still-accommodative monetary policy and a falling savings ratio should all further government fiscal spending and accelerating private-sector investment on the back of high capacity utilization. 5. Still-declining political risk. Euro sceptics continue to flag political risk as a major potential headwind, but we don t find the region comparatively more volatile than other parts of the world. On the contrary, the trend over the course of 2017 largely favoured the resolution, not escalation, of political risk. In Germany, significant progress was made toward salvaging a Merkel-led coalition. In France, President Macron is progressing steadily with the reforms he outlined in his election campaign, including already enacted labor reforms and forthcoming enhancements to social security and tax competitiveness. Elsewhere, political developments grab a lot of headlines in Spain and Austria, but in neither case do we see a material risk of a serious regional destabilization. Even in the UK, investors seem to forget that the corporate sector is largely multinational. Prospects for a pragmatic Brexit deal characterized by mutual compromise and benefit are likely being underappreciated amid the noise of the negotiation opening s early salvos. Political risks in Europe certainly haven t disappeared, but they have receded and look increasingly less likely to destabilize the region s gathering cyclical, economic and market upturn. US Tax Cuts The short-term impact of US tax cuts seems uniformly positive, but the longer-term consequences are more debatable. The cuts are debt-financed, and the question is: Does that short-term growth turn into long-term growth and more revenue on the government side, and does that offset some of the costs of lowering the rates? From a sector perspective, there are some obvious big winners: largely US domestic-focus firms in the financials and consumer discretionary sectors and some stocks in the industrials sector. In energy, services and refining companies are also beneficiaries. China We continue to find selective value in China. Looking forward, Chinese officials will have to continue to tame financial excesses and transition to a more sustainable economic model by deleveraging, de-risking and closing excess capacity. They will also attempt to ward off a potential debt crisis and curb property market excesses. Of course, China will have to do this while credibly projecting its growing military and economic heft to the outside world. It s a big job and one that could easily beget crisis should the sheer scale of the systemic imbalances in China s economy overwhelm even the most powerful policy measures. In the meantime, the region does offer a compelling combination of high organic growth and cheap valuations, though we have largely stayed clear of state-controlled sectors like real estate, banking and utilities, all of which have high leverage and overcapacity. We have also avoided sectors with excess valuations, which has kept us away from some but not all of the internet stocks that led China s bull market last year. We believe the best opportunities in China exist among the lowly valued H- share stocks in consumer and service sectors likely to capture an increasing share of China s future economic growth. Japan Real GDP growth rates have been improving for eight consecutive quarters, which is the best run for over a decade, and earnings for the Nikkei have gone up with that per share and recently reached the highest level since Even on the corporate governance side, things are improving and that s all supporting the markets. When you look at the Japanese market from a valuation perspective, the return on equity (ROE) is roughly in line with Europe, with price-to-book about a third higher than Europe. So it s still somewhat more expensive, but, relative to its history, looking very reasonable. We are finding some new names in Japan, happily searching through the market and taking advantage of opportunities as they occur. Value Investing The value resurgence proved to be something of a false dawn as global value lagged global growth significantly in 2017, marking it the worst year for value in two decades and the tenth year of underperformance in the last 11. We never thought this would be a smooth, straight-line recovery, and so we aren t excessively worried about the recovery in growth. It looks to us like we are still bouncing along the bottom of the most severe period of value underperformance in our careers. This has obviously been challenging, but it makes us extremely opportunistic about the future prospects. Sir John Templeton once said, The time to buy is when the remaining holders have finished selling, and it sure feels like that with value. So there s the it s so bad, it s good dynamic going on here that has worked well in the past, and we expect it will work well in the future. What makes us so confident that it will work again? First, because it always has eventually, and if we have learned anything Notes on Global Equity Markets 3

4 in Templeton s 60-plus years it is ignore history at your peril. Indeed history continues to suggest that buying stocks at the right price is virtually all that matters when it comes to long-term return potential. A recent study by BSA Research dating all the way back to 1871 separated the markets into five different valuation brackets, from the most expensive to the least expensive, and the study, which was updated through the end of 2017, shows an almost perfectly inverse correlation between starting point valuations and long-term returns. Indeed, the cheapest stocks delivered the strongest returns over five- and 10-year horizons, and the most expensive stocks delivered the weakest. It may take time, but valuation works. The second reason we think value is poised for comeback is that value is historically cheap. Value has underperformed by the most on record in terms of magnitude and duration of underperformance and significant catalysts exist, including a global growth pickup, rising interest rates and now all manner of potentially procyclical stimulus including tax reform, deregulation and infrastructure spending. The third factor that gives us conviction in value s eventual resurgence is policy resolve. Indeed, the old mantra, don t fight the Fed, also works in reverse. While we don t believe that the withdrawal of extraordinary central bank policy will be particularly smooth or one-directional, we do believe normalization will remain a policy goal. Why? Quantitative easing and zero and negative interest rates have exacerbated income inequality, contributing to the highest levels of global populism since World War II. Inflated asset prices are a threat to systemic stability, and falling unemployment and rising inflationary risks will also likely contribute to the rolling back of financial repression as data-dependent central bankers cite improvements toward econometric targets as justification to begin to transition policy. For all these reasons, we continue to feel that this will turn around, that the underperformance of value versus growth is likely to end and that value investors will once again be rewarded for their patience. WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. Notes on Global Equity Markets 4

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