Is this a traditional financial recovery?

PortfolioConstruction Forum asks, is this the time to be buying or selling international equities? Tim Farrelly outlines some likely future scenarios.

As solid data has come out of the United States, and the European debt crisis fears seem to have eased, many commentators are coming to the view that the recovery in the developed world may be much stronger and more sustainable than had previously been anticipated.

This is in complete contrast to my own view that this recovery is not sustainable and that economic growth in much of the developed world will remain weak for many years.

Which path the developed world takes is a critical question for those considering their international equity exposures.

In our view, international equities are expensive at present.

According to our forecasting techniques, international equities will produce lower returns over the next 10 years than those available from term deposits.

If you accept this view, you would make no new investments in international equities and would, in fact, look to reduce your current international equities exposures to zero within 18 months to two years.

On the other hand, if you accept what can be described as the emerging sustainability consensus, you could increase our current forecast 10-year returns for international equities from 6.6 per cent per annum by an extra 2 per cent per annum on the basis that earnings per share growth will increase by around that much.

This would take our forecast returns for international equities above those of term deposits, and the need for action would be much less.

International equities: making the case

The case for solid returns from international equities can be broadly summarised along four themes:

• The recovery will be much more sustained than has been expected. Despite fears about deleveraging and debt, this will be a classic ‘V’ shaped recovery – just look at the improving numbers. The recovery will keep feeding on itself as confidence returns;
• Developed market companies will profit from the huge expansion of the emerging market middle class. Even if developed market growth is not quite as fast as usual, the overall global economy is still growing at a very fast pace;
• US companies in particular are cashed up, highly profitable and poised to take advantage of that expansion; and
• The strong Australian dollar means we are buying at bargain prices.

The recovery in developed markets

So far, this has looked like a normal, if somewhat sluggish, recovery. And so it should have because, to date, it has been a recovery driven by the normal factors, including low interest rates, stimulus from increased deficit spending from governments, inventory rebuilding, and a gradual return of consumer confidence.

If that was all there was to it, this would be a classic recovery.

However, our concerns about the sustainability of the recovery in developed markets are driven by the huge and escalating levels of government debt throughout much of the developed world – and, in particular, the impact that will have on growth when governments, eventually, move to address the issue.

The problem – as described in the Bank of International Settlements Working Paper No. 300: The future of public debt, prospects and implications – is that if current taxing and spending policies continue for the next 30 years, government debt in the US, the UK and Japan will be 440 per cent, 550 per cent and 600 per cent of gross domestic product (GDP), respectively.

Needless to say, debt levels like these will not happen.

If, for example, a country had debt of 400 per cent of GDP, interest payments would chew up 20 per cent of GDP if the country in question could get away with paying debtors 5 per cent per annum interest.

At a more likely 10 per cent interest cost, it would require 40 per cent of GDP to meet interest payments, meaning taxes – generally 25 per cent to 40 per cent of GDP – would be completely consumed by interest payments.

So it’s reasonable to expect that such debt levels will not be reached. Instead, these countries will have to make huge cuts in spending, or huge increases in taxes or, most likely, both.

To date, we have not seen any of these measures introduced in the US or Japan, which is why it feels like a traditional, if sluggish, recovery.

But when they are introduced, major slowdowns in economic growth are likely. In the UK, a partial austerity program has just begun.

This makes for a fascinating test case for the rest of the world. Within a year, we should have a clear idea of the impact of these types of measures but the early signs are that they will, in fact, stall the economy.

How long austerity measures can be deferred will be equally fascinating. But they are coming. It is a question of when not if.

Emerging markets to the rescue

Will developed market companies be dragged along by the emerging markets growth?

It’s a nice idea. But if it was absolutely reliable, Japanese companies should have been able to shrug off the impact of the slow domestic economy after 1990 and take advantage of Japan’s strong market position in the rest of the world.

What actually happened was that profits fell by 50 per cent over the next decade.

While this does not mean the same fate awaits US and European companies, it is a warning nonetheless.

Even if successful in emerging markets, there is a long way to go for most companies.

Only 5 per cent of S&P500 companies currently generate more than 20 per cent of their sales in emerging markets – not much of a base. Exposure to emerging markets will help developed market companies, but it won’t be enough.

Cashed up and highly profitable

Being cashed up is a good thing. But what will they do with the cash?

If you surveyed all US companies today and asked what their ambitions for domestic growth were in the coming decade, they would probably average out at well over 5 per cent per annum.

And they will invest to achieve that level of growth.

If actual growth in the economy turns out to be more like 2 per cent per annum, much of that investment will be wasted.

Similarly, some adventures into emerging markets will be successful, but many will also fail expensively.

Finally, US profits as a share of GDP are close to all time highs – typically, profitability falls from these levels.

It’s reasonable to expect the trend from here to be down to more usual levels over the next decade.

The falling dollar kicker

Farrelly’s believes the Australian dollar will weaken over the next decade – but that impact is already factored into our forecasts which assume that currency gains will add 1.9 per cent per annum to the returns from international equities over the next decade.

This is consistent with the Australian dollar falling to around US$0.82 by 2021. That may actually happen in a much shorter time, which would give a quick and large boost to returns. Or, it may take much longer.

If you believe that the resource boom will continue for some time and that the next move in interest rates is up, you probably should also believe that the Australian dollar is going higher, in the medium term at least.

It would not be surprising to see the Australian dollar at US$1.20 over the next year or two.

That is not a prediction, merely an indication of the amount of short-term uncertainty there is with respect to currency gyrations, as we would also not be surprised to see it at US$0.80.

In other words, those investing with high confidence of a medium-term currency kicker may end up being very, very disappointed.

Portfolio construction implications

If you accept the low developed world growth argument, it is time to move to the exits – slowly. Set a target weight in international equities, preferably at zero, and plan to be completely sold down within 18 to 24 months.

If you see your clients half yearly, you may choose to sell 20 per cent of their holdings now and then another 20 per cent each six months for the next two years.

If you see your clients annually, you could sell one-third now, one third in a year’s time and one-third in two years’ time.

There is no particular urgency. This is not a matter of timing, as we have no sense of when a downturn will occur.

From past experience, it could be anywhere from a month to five years away.

If markets come back to better value before you have completed your sales program, simply stop selling.

Finally, don’t invest new money in international equities. By all means, make an allocation to international equities – but leave that in cash until better buying opportunities arrive. They will, we just don’t know when.

And, of course, if you accept ‘the world recovery will just keep rolling’ thesis, there is nothing to do but to sit back and enjoy the ride.

Tim Farrelly is principal of specialist asset allocation research house, farrelly’s, available exclusively through PortfolioConstruction.com.au.