Think global

Deciding where to invest your assets in equities, and in what quantities, is never straightforward, even in a ‘normal’ market environment. With the global financial crisis creating a huge upheaval in domestic and global equity returns, it is becoming even trickier to strike the right balance in a portfolio — and stick to it.

In November last year, a Mercer sector survey on Australian and global equities found that both domestic and global equities were posting negative returns, with the ASX 300 dropping by 6.3 per cent, while, according to the Morgan Stanley Capital International (MSCI) World Index, international equities dropped by roughly the same, dipping 6.1 per cent. Investors were fleeing from equities and going to cash.

One month later, in December, fund manager sentiment was turning around, with a Russell Investments quarterly investment outlook finding that 49 per cent of fund managers were bullish towards the global equities market compared to 30 per cent a year ago, while 54 per cent of managers were bullish towards Australian equities in the fourth quarter, compared to 32 per cent in the second quarter of 2008.

Investing in global equities itself is even more difficult, with a late 2008 survey by Watson Wyatt showing that fund managers expected returns in the sector to rise to historic levels within three years, despite a plunge in emerging market growth.

With investment sentiment changing so rapidly in reaction to the performance of the equity markets, some advisers may be finding it difficult to pick the right investment strategy in the current environment.

Domestic versus international

Knowing how much to invest into global and domestic equities is the first hurdle of investing and, faced with a financial crisis, some advisers may be tempted to turn to extremes to find value.

Last month, managing director of van Eyk Research Stephen van Eyk sent a letter to an adviser of one of the company’s major clients who threatened to leave unless he was allowed to advise only on Australian equities.

According to van Eyk, this adviser didn’t want to touch global equities as a class, as he believed that Australian equities have done and would always outperform global equities.

“A lot of his premise was that ‘if this happens then that will happen, and if this happens then that will happen’, and I agreed with him, but not if anything else happens [to affect the Australian equities space],” van Eyk said.

“I had to write him a letter about why it would be important to have some exposure to international equities.”

What lies behind the debate about the relative performance of the domestic and global equities sectors, and what van Eyk focused on when he wrote the letter, is the pricing ratio of non-traded goods compared to the price of traded goods.

The ratio of traded goods to non-traded goods affects how much investors make a move into global equities, or balance their portfolio more towards a domestic allocation, van Eyk explained. If the price of non-traded goods falls at the same time as traded goods stay buoyant, the ratio of non-traded to traded goods would crash, affecting the Australian equities sector.

“What is going to make non-traded goods [fall] would be the disastrous situation where people are unemployed, no growth, you’re in recession, people losing their jobs, so all sorts of prices, including housing, [have] crashed, and it’s pulling the price of non-traded goods down,” van Eyk said.

“That would be disastrous, you would think, for Australian equities, because if that’s coming down, there’s less demand for goods because everyone is unemployed; therefore, the demand for commodities falls, therefore our markets are influenced

by that, and the Australian dollar falls, as it did during this big downturn, so you’d be better off with some diversification overseas.”

On the other hand, if the stimulus that the Government was ploughing into the Australian economy paid off, consumer demand would rise, commodities would go up, and the ratio

of traded to non-traded goods would rise, which would in turn help domestic equities, van

Eyk explained.

Nick White, principal of Mercer Investment Consulting, said the concentration in the Australian index of financials and commodities led the company

to favour global equities over domestic equities.

“Essentially, we think the banks are still at risk of the usual problems of bad debts and subdued credit growth, and we generally see the Australian market as a late stage player in this area,” White said.

“With commodities, a durable increase in prices [of commodities] is more difficult without growth resuming in the advanced economies.”

Global stock was also undervalued compared to domestic shares at the moment, he added.

Asset allocations

Understanding the reasons behind the performance of domestic and global equities is one thing, but when it comes to how much of investors’ assets should be allocated to domestic or global equities, the amount differs widely amongst research houses and asset consultants.

Van Eyk believes the surging liquidity created by the Government stimulus would produce a volatile situation, and that investors need to diversify their equity portfolios, placing a 16 to 17 per cent exposure to global equities, and a 27 per cent weighting to domestic equities.

However, many investors went into global equities because they were looking for some diversification within equities itself. It was important for investors to remember that, because the Australian market was linked to the performance of the Chinese economy, the Australian economy would perform well at the same time that the Chinese market did well. Therefore, according to van Eyk, the diversification would only really occur in those parts of the global portfolio that weren’t so strongly tied to either economy.

Considering the continuing problems in the global economy, investors shouldn’t favour one asset class over another, noted Grant Kennaway, general manager — research at Lonsec.

“Lonsec just remains cautious that, while there has been strong recovery since the March slows … we still think there’re some risks [in the global economy], particularly until the banking sector’s settled down, so we’re not favouring one asset class over the other,” he said.

Although up until 2007, Australian equities outperformed the global space, the severe correction in the Australian currency last year was one of the drivers of relative performance for investors in the global sector, such as foreign hedge fund investors. That performance was beginning to unwind with the strengthening of the Australian dollar, affecting global equities performance, Kennaway explained.

He cautioned that investors be aware of how they are getting access to global equity and whether the products they are investing in are going to be impacted by fluctuations in the dollar.

Balanced investors need to be slightly underweight for both domestic and global equities, Kennaway said, with a 22 per cent allocation to both sides.

Fiona Trafford-Walker, managing director of Frontier Investments Consulting, said they were recommending holding an allocation of 20 per cent in global equities, compared to a 30 per cent holding in domestic equities.

The Australian market was very narrow due to its link with China, and while global equities was similar, considering its links with China and the US, it was a much more diverse marketplace, Trafford-Walker said.

James Tsinidis, investment analyst at Zenith Investment Partners, said the company has always advocated equal use of both international and domestic equities in their portfolios as a result of the risks of concentration in the domestic market from dominant players such as BHP Billiton and the banks.

Emerging markets versus developed markets

In 2008, the MSCI Emerging Markets Index, which tracks 746 companies in developing markets, dropped by 54 per cent, the worst annual result since the creation of the index. Meanwhile, emerging market investors

withdrew $48.3 billion in funds from the sector during the same period, investing in safer, more traditional assets such as US Treasury bonds. The downturn in the growth of the emerging markets was seen as the driving factor, with demand for resources plunging.

However, by November, sentiment had recovered, with a rebound in emerging market equity prices due to the massive fiscal stimulus packages introduced by the governments of developing countries.

The attitude towards the health of emerging markets seems to be continuing. A Standard & Poor’s international

equities survey from May this year found that fund managers believed capital inflows to emerging markets would recover sooner than those to developed economies, thanks to the strong underlying economic fundamentals and fiscal policies of the developing nations such

as China.

This is a popular view among research houses and asset consultants. Trafford-Walker said that, although the US and Europe are huge and entrepreneurial, they still have a lot of structural issues that they need to work through.

“We are tilting the portfolios towards emerging markets, in particular towards emerging Asia, because we think that, as a long-term investor, there are some very interesting return premiums to capture there,” she said.

Van Eyk said his company had a “big chunk” of its global equities portfolio invested in emerging markets, 8 per cent of a 17 per cent portfolio.

“We have this scenario where inflation will pick up, because demand will pick up, and there will be growth in these regions … relatively better than that in developed markets,” he said.

The developed economies have a lot of problems that they still have to deal with, he noted.

The fiscal stimulus packages being passed by governments around the world couldn’t continue to be funded by borrowing money, as economies such as the US could end up owning up to 100 per cent of its gross domestic product, a similar amount in the UK, and up to 120 per cent in Japan, he said.

Eventually they would have to repay the money they had borrowed, and find other ways to fund future stimulus packages, and that would have a negative effect on their economies.

“Instead of borrowing money, they’ll raise taxes, and the market will start worrying about that as well, so people’s after-tax income will be lower, they’ll start consuming less again; it’s going to take the edge off growth.

“So who is going to do worst? The people who are going

to raise taxes the most or

the people who will have the biggest interest rate rises, and that’s the US, the [UK], Japan, and all the leading economies,” he said.

Lonsec held the same view, according to Kennaway. While Lonsec didn’t favour emerging markets over the developed economies, he had no doubt there were more positive signs coming out of China and Asia in general compared to the other economies.

“There are still a number of issues in the US, given what’s happening with unemployment in the US and also they’re running unprecedented levels of budget deficits,” he said.

Corporate earnings were the real driver of the equity market returns, and their outlook remained unclear,

Kennaway said, with earnings still under pressure in the

developed markets.

White said that Mercer Investment Consulting was currently neutral between the emerging and the developed markets on the basis of valuations.

“There’ve been considerably strong returns coming through in emerging markets, so we’re unlikely to put a relatively attractive call on emerging markets versus overseas shares at the moment,” he said.

There is currently more potential to pick up stocks that have a range of attractive characteristics, such as stronger growth potential as well as being cheap by valuation, White said.

Tsinidis said that it seemed to be a key theme among most of the fund managers he had reviewed to be overweight in Asian equities, but there were some managers he found who were seeing better opportunities in Europe.

Trafford-Walker warned that, although there was strength in the emerging markets, it was important not to pay too much for stocks that became overpriced very quickly, such as Chinese or Indian stocks.

But the current situation did not mean the end of investing in the developed markets, Trafford-Walker noted.

“If you look at the US, it’s an enormous country, very entrepreneurial, there are a lot of rewards for innovation and I think that they’ll get back on their feet, probably more quickly than some think.”

“Some people argue that the US is in long-term decline, and I can see that argument, but the long term may well be 50 or 100 years ... I don’t think it’s in the next five to 10 years,” she said.