Are international equities coming back from the dead?

The international equities market saw asset values plummet and sustained periods of negative growth at the height of the GFC. However, as Janine Mace discovers, the turbulent times may be coming to an end.

After hair-raising market falls and periods of negative economic growth, international equity markets appear to be back from the dead. Although the road ahead may not be smooth, at least investment experts are no longer set to read the last rites.

This turnaround is the result of increasingly optimistic forecasts for the global economy, which in turn have boosted the confidence of international share markets.

The International Monetary Fund’s (IMF’s) April economic review predicted global growth of 4.2 per cent for 2010 (up from 3.9 per cent).

Emerging markets are expected to do best this year, with Chinese growth forecast at about 10 per cent. Growth in the US is also improving, with the IMF forecasting its gross domestic product to expand 3.1 per cent.

The improving economic outlook has given a big lift to share markets, according to CMC Markets’ market strategist Ric Spooner.

“It has been a great performance starting from a poor base. In the year to the end of March, there has been a 49 per cent increase in the MSCI Index,” he says.

The better-than-expected outlook continued to buoy most international markets in the March 2010 quarter. During this period, global markets rose 3.2 per cent, while developed markets were up 3.4 per cent.

The US, in particular, had a good quarter, rallying 5.5 per cent, while the performance of Japan at 8.7 per cent was a standout.

HSBC’s head of wholesale distribution global investment business, Geoffrey Pidgeon, believes risk aversion driven by the global financial crisis (GFC) has now largely dissipated. “International equities are catching up as global growth is returning,” he says.

“During the GFC underlying company fundamentals were cast aside, but now rationality has come back and traditional fundamentals are being used.”

Two-speed market performance

One striking note about the performance of international equities is the divergence between developed and emerging markets, according to Mark Nebelung, the Tokyo-based equities portfolio manager for Principal Global Investors.

He points out that while developed markets have risen 53 per cent over the past 12 months, the performance from emerging markets has been much stronger, with this market sector rising 81 per cent.

“Emerging markets have had a significant rebound as they had their house in order. The political stability in emerging markets has helped their performance and kept their economic growth sustainable,” Nebelung explains.

The pattern is the developed markets have been fairly consistent (US up 50 per cent, Europe up 57 per cent and Asia/Pacific up 51 per cent), with Japan lagging at around 30 per cent.

“Japan is always the first to underperform and the last to outperform,” he notes.

These strong market performances and improved economic growth predictions are encouraging positive forecasts for equity markets over the medium-term given that global economies appear to be shifting back into growth mode.

Vanguard Australia chief information officer Joe Brennan is upbeat about the current environment.

“When you look at valuations across all types of assets and where the market is now, it feels like the valuations and risks are as balanced as they have been for several years. Most measures are now quite normal compared to the previous situation,” he says.

Spooner agrees the investment settings are normalising. “Broadly, the 50 per cent increase in world markets was a recovery in valuation multiples, but now they have returned to values within the band of longer-term multiples. On balance, the optimistic outlook is the most probable one,” he says.

Corporate earnings to the fore

As economies and markets normalise, corporate earnings are becoming increasingly important.

“As the government stimulus measures are wound down, there will be a shift in focus from valuations to interest in earnings,” Nebelung says.

Spooner agrees earnings will be critical.

“In the next 12 to 18 months world markets will continue to be in a broad expansion phase, but because we have restored valuations, the growth rate will now be tied to earnings growth rather than being a valuation recovery. Stock selection will be increasingly important.”

Although analysts’ predictions are positive for corporate earnings, Aberdeen Asset Management senior investment specialist Stuart James has concerns.

“Corporates have been improving their bottom line by cutting costs, but not by growing the business or the top line,” he says. “The fear is you can only cut costs once. By the end of 2010 comparisons will be year-on-year, and if earnings are not coming through, it will disappoint the markets.”

According to James, the current consensus growth estimates for corporate earnings are sitting at a very strong 30 per cent to 35 per cent, and he says companies “will struggle to meet expectations”.

James believes the easy money has been made and companies will now need to deliver.

“Following the rally over the past 12 months, things are no longer cheap — they are pretty fully priced,” he says. “The opportunities are out there, but you will need to be more selective than before.”

Pidgeon agrees valuations in certain countries are now looking expensive, particularly emerging markets. “Emerging markets in general have earnings expectations of around 28 per cent, and now we need to see those earnings come through. However, although earnings expectations are high, China is still fair value,” he says.

Sovereign debt fears

When it comes to the outlook for international equities, the wild card is the ongoing market concerns about sovereign debt, particularly in Europe.

“These [concerns] are weighing on investors’ minds, and in the second half they may have more of an impact on global equity markets,” James cautions.

Spooner agrees: “On balance, it seems the optimistic view is the right one to take for investors, but the risks are clearly pretty significant, and the key risk is centred on the high debt levels in developed markets.”

Any serious or unexpected problem is likely to cause major market volatility. “The capability of governments to deal with any new shock is very limited,” he notes.

Governments slowly winding back their stimulus measures and starting to pay back debt through increased consumer taxes are also likely to weigh down equity markets, James believes.

“I am doubtful whether private consumption can take up the slack from the government stimulus measures,” he says.

Nebelung agrees this is a concern. “Not a lot of countries have adequately addressed how they are going to work through the debt. There is a lot of political risk in how countries deal with their debt and economic growth going forward,” he says.

Emerging markets outlook

Given the concerns about developed markets and the recent outperformance of the developing markets, investors can be forgiven for expecting to see a strong ‘buy’ label on emerging markets. However, most experts are not predicting a repeat performance.

“Because of the stellar outperformance of emerging markets last year, there has been a shift,” Nebelung explains.

“In the first quarter emerging market investors began taking money off the table due to the speed of their rebound and valuation concerns. We expect emerging markets to take a breather. There are no significant downside risks, [but there won’t be the] outperformance we have seen.”

He is most optimistic about Asia excluding emerging Asia. “It has been the engine for global growth during the crisis and we do not see it stalling. There is also increasing optimism about Japan if it continues to see export growth. Its relative value makes it attractive, as it has low valuations and attractive corporate earnings,” he says.

James believes emerging markets have the best long-term prospects as they lack the debt overhang of developed markets and have younger, growing populations. “We are also seeing genuine economic growth in these countries.”

While he has faith in the Asian region, it is qualified. “Emerging markets are a better opportunity, but this is very stock specific. I don’t think buying the index over the next 12 months will give you the best return,” James says.

Brennan also sounds a note of caution. “There has been a lot of hype around emerging market Asia, and that is all well and good, but it is healthy to remember that growth is important, but what you pay for growth is also important. I am always cautious about investing based on past returns. Valuations always matter.”

An important factor will be how successful China is in curbing the dramatic growth occurring in its economy without slowing it too much. Nebelung believes the Chinese Government has taken a pragmatic approach to managing its local economy to date, and he expects this to continue.

“We expect to see them slow things down and are fairly optimistic about their ability to handle that,” he says.

Developed markets revive

Despite his positive view of emerging markets, Nebelung believes the best investments over the next 12 to 18 months may be outside them.

“We have no concerns over emerging markets as they are in good shape, but on a relative value basis, a few of the developed markets look good,” he says.

“In the developed countries, many companies were quick to reduce their operating costs as they went into the crisis, so they are likely to have a faster turnaround than previously.”

The US in particular is seen as an increasingly attractive prospect. ING Investment Management senior portfolio manager Gian Pandit believes there is fertile ground there for active managers, with the corporate scene still in the early stages of earnings recovery.

“The overseas economy, and especially the US, is a major laggard. We believe in a sustained US recovery in the second half of this year. US manufacturing has recovered strongly; the US dollar is at a cycle low; and corporates have a much improved balance sheet,” he explains.

Pidgeon agrees the US economy is looking up. “In the US, we are seeing solid growth indications and increasing capital expenditure. Unemployment is declining and there seems to be a floor developing in the property market.”

Nebelung believes the factor to watch in the US recovery is unemployment.

“The US could surprise as it is typically labelled as a consumption economy, but now it is like a more balanced economy. There is a lot of pent-up capital spending and restocking needed in the US economy, with a lot of unspent money from a business perspective,” he says.

The outlook for European equities is far less positive, with markets there weighed down by the sovereign debt issue. “We have two concerns. One is the sovereign debt issue and the other is that Europe lagged the US going into the crisis and they are likely to take longer to [recover],” Nebelung explains.

Looking closer to home

Investors comparing the relative outlook for international equities versus local stocks need to think carefully about the growing linkage between the Australian economy and emerging market Asia.

According to Brennan, this is a growing issue for investors. “In Australia there is a dynamic — and it is getting stronger — and that is this market is increasingly geared to emerging markets such as China, and the currency is tied to that,” he explains.

While the outlook for the Australian market is positive, James agrees there are concerns about the close ties between the local economy and the growth cycles occurring in emerging markets such as China.

“We could see some volatility in the Australian market if problems emerge with global growth,” he says.