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As the world slowly recovers from the COVID-19 pandemic, investors are being reminded of the opportunities and diversification benefits of global equities. Jayson Forrest reports.
Gripped by COVID-19 and an escalation in geopolitical tensions, it’s hardly surprising that the past six months have been hugely unpredictable and volatile for global and local markets.
Recently, sentiment has turned negative on concern that the spreading coronavirus could force policymakers to slow the pace, or reverse, business re-openings, while the International Monetary Fund (IMF) downgraded its outlook for the world economy, projecting a significantly deeper recession and slower recovery than it anticipated in April.
Add to this an escalation in cyber ‘cold war’ tensions, increasing angst between China and the West, and a potential second wave of COVID-19, it appears volatility will continue to shape markets for some time to come.
According to Perks’ director Simon Wotherspoon CFP® and his colleague Jason Russo – Head of Investment Research at Perks – the impact of policy easing and the introduction of government stimulus packages cannot be overestimated. They believe the swift action by central banks has eased many of the tensions in financial markets that built up in February and March.
“Credit markets have reopened. Capital outflows have stabilised across emerging market debt and equity funds,” says Simon. “Meanwhile, governments have implemented significant fiscal programs that have gone a long way to relieve the worries over permanent structural damage and the scarring of economies that might otherwise have occurred during the period of lockdown.”
Jason agrees, adding that we have recently seen an unexpected recovery, as the share market continues to rise, spurred by government stimulus and a sense that the global economy is beginning to normalise, with tollways in the U.S. returning to January levels, while foot traffic in European malls is back to 80 per cent of their pre-crisis levels.
So, given this rebound in markets around the world, should financial planners be re-considering global equities as part of their clients’ investment portfolios?
Hedging against volatility
The Chief Investment Officer and Portfolio Manager at Bell Asset Management, Ned Bell, says planners should definitely continue to look at global opportunities. And while the impact of COVID-19 has not been as severe in Australia compared to other countries, he believes there are still some very good companies and sectors overseas that you just cannot access in Australia.
“We saw a big sell-off in March and that gave us a great opportunity, as an active manager, to pick up some of the best quality companies available. And I think we will get more of those opportunities. This is a really good time to buy high quality companies, particularly when they are out of favour.”
Despite the current volatility in the market, global equities continue to provide significant diversification benefits to an investor’s portfolio, particularly in respect to a typical Aussie equities investor, where most portfolios are heavily concentrated on a relatively narrow universe of banks and mining companies.
“When you look overseas, you can get exposure to high quality tech companies, healthcare and consumer discretionary stocks that you simply don’t get exposure to by investing in the local market,” says Ned.
It’s a view supported by Alex Pollak – the Chief Investment Officer and founder of Loftus Peak, a global funds manager with a focus on disruptive businesses.
“The global companies we invest in have products or services that are either not replicable, or not easily replicable, by companies in Australia,” Alex says. “For example, big cloud and data services companies, and businesses that have a global reach with their products.
“Investing globally means Australian investors have access to significant growth profiles that wouldn’t necessarily be available in Australia. The share prices of these global companies have performed well over a protracted period, but there is arguably still plenty of upside left.”
Jason agrees: “In Australia we have limited access to some of the rapidly growing tech sectors, with concentration typically in materials and financials. However, both these sectors face ongoing challenges, so investing overseas provides much broader access to growth sectors.
“Investing overseas in unhedged equities typically provides a ‘hedge’ in volatile markets. We saw this as the COVID-19 panic set in during March. Unhedged international equities held up much better than Australian shares.
“So, when you have the right combination of strategies that deliver returns in a smart way, it gives you a portfolio that is more resilient to changes in correlations and to market events, a role in which global equities plays a key part.”
As an asset class, Jeff Thomson – a portfolio manager at Alphinity Investment Management – agrees that diversification and access to greater investment opportunities are two compelling reasons to stay invested in global equities. But he also includes another important reason – relative value.
“Global equities offer good relative value compared to other asset classes. In a world of zero interest rates and a U.S. 10-year bond yield of approximately 60bps, the yield gap of global equities is below average, suggesting that it’s still a relatively cheap asset class,” Jeff says.
Strong market rebound
Yet, despite all the global volatility this year, markets have recorded strong rallies and are near their highs. It sounds counter-intuitive, but it’s something Ned cautions planners to be aware of.
“The reality is markets have overshot on the upside. I always think about what a market is pricing in and then what’s realistic in terms of what is being priced in. For example, if you look at the MSCI World Index, it’s basically back to where it was in October 2019. So, it’s pricing in a very similar outlook to what was priced in at October (pre-COVID), which does seem ridiculous.
“So, the index is now pricing in a U-type recovery, suggesting that the COVID-19 crisis will subside, which it’s clearly not and actually seems to be getting worse. And it’s also pricing in a very sharp earnings recovery next year, which looks increasingly unlikely.”
But why have markets rebounded so strongly?
According to Alex, it’s a result of a relatively small number of very large disruptive companies, like Amazon and Microsoft, that have driven the market higher during the current coronavirus pandemic.
“Two months into the COVID-19 pandemic, Microsoft discovered that elements of its two-year growth plan for the digitisation of services had happened in just a few weeks. This acceleration of digitisation, which enabled people and businesses to continue operating remotely, is what lit a bonfire under the stock prices of some of these companies.”
It’s a view supported by Jason, who says much of the rise in markets has been concentrated on those companies that are perceived to have been the beneficiaries of the shutdown.
“Global equity markets, which have now bounced back to be close to flat for 2020, are being led by the winners in this new environment, such as IT and e-commerce,” he says.
However, while tech stocks have carried the markets back to near all-time highs, it’s worth remembering that over 60 per cent of stocks are still more than 20 per cent away from their pre-pandemic highs.
“So, while companies like Amazon, Netflix and Microsoft have thrived, many stocks have been left behind in the recent rally. This bifurcation, or separation, now sees the top five stocks – Facebook, Amazon, Apple, Alphabet and Microsoft – account for more than 20 per cent of the U.S. market’s entire value, which is the most concentrated it has been in history,” says Jason.
As a result of this rebound in equity prices, valuations have reached high levels again.
“Most equity markets now trade at 24-month forward P/E ratios not seen since the lofty days of the late 1990s. We see downside risks in the near term, followed by modest returns in equities, albeit better than in most other assets,” says Jason.
Despite investment companies talking about an economic recovery, how this happens will be shaped by the long-term effects of COVID-19, which are still being played out.
So, where does that leave investors?
When investing in global equities, Ned believes it’s important for investors to decide what type of style exposure – growth or value – they want with their investments.
“However, we think there is a lot of risk at either end of that spectrum. So, while those momentum driven growth stocks – like Amazon, Netflix and Tesla – are currently doing well, they are very expensive. They are basically on a forward P/E of 27x earnings, which is the most expensive they have been in about 10 years,” Ned says.
“But at the other end of the spectrum, the value stocks, which are typically associated with companies that have stretched balance sheets and are generally poorer quality, will suffer most from an earnings perspective.
“So, you need to be looking at proven active, fundamental managers that are good stock pickers in times of market volatility,” Ned says. “In these uncertain times, solid track records matter.”
It’s a view shared by Alex: “Naturally, investors need to do their due diligence in terms of the quality of the manager. And while it’s important to look at the track record, investors should also be reading the commentary that the fund manager is producing. You should never be invested in something that doesn’t make sense to you.”
The approach taken at Loftus Peak is one that invests in “great business models”. Examples of this are e-commerce companies, like Amazon and Alibaba, which enable remote shopping, so affording some protection from exposure to COVID-19.
“E-commerce companies were already a great place to invest because they significantly slimmed down the cost of the transaction – for example, they don’t pay expensive rent in shopping malls – but have also clearly been beneficiaries of the contactless environment we now find ourselves in,” says Alex.
With COVID-19 showing no signs of abating, how should planners be thinking about a potential second wave of the pandemic, particularly in relation to corporate earnings in 2020 and 2021?
According to Ned, the most vulnerable stocks are the poorer quality ones. Specifically, he refers to stocks in the hospitality and travel sectors.
“These are the types of companies that have been significantly impacted by the pandemic and there will be bankruptcies. We can expect to see a lot of restructure and earnings losses in these sectors. You want to avoid these vulnerable and poorer quality companies altogether, because looking into next year, that’s where there is the most downside risk to earnings.”
However, the flip side to that are the higher quality companies that have largely not been affected by the COVID-19 pandemic. These include the big healthcare companies, tech companies and some of the consumer staple companies.
“These types of companies simply don’t have the earnings downgrade risk that you see at the very cyclical end of the market,” Ned says.
Jeff agrees but also remains bearish in his short-term outlook on corporate earnings.
“If you look at corporate earnings starting at the beginning of February this year through to now, we’ve seen estimates for the MSCI World Index slashed by 30 per cent. Prior to COVID-19, analysts were expecting 6 per cent earnings growth in 2020, but now earnings are expected to contract by 24 per cent. In fact, we expect global GDP to contract this year by at least 4-5 per cent, and the U.S. and Europe are likely to be significantly worse,” he says.
Yet, despite this, markets remain forward focused on what a post-recession recovery will look like over the next 12-18 months. And according to Jeff, the good news is that recent data suggests that it is increasingly likely we’ve seen the bottom of the recession.
“Global economic activity troughed in April, coinciding with the peak of the lockdowns. Since then we’ve seen quite a strong recovery, although there are likely to be more twists and turns ahead,” Jeff warns.
“And while we expect further downside to overall earnings expectations in the short-term, the market may continue to focus on strong ongoing policy support and a potential U-shaped recovery into next year.”
Alex believes the recovery will be led by a number of companies that, despite some damage, won’t be as badly hurt as many other companies due to COVID.
“If you look at Microsoft, the stock has been hitting all-time highs because its products have become more important in a world that is more digitally focused, and this is pre-COVID. In this new environment, companies like Amazon, Apple and Microsoft have seen their share prices go up, because they are the types of companies that are part of the solution to working and living remotely due to the coronavirus crisis.”
To ensure it picks the right investment opportunities, Loftus Peak looks for companies that have a well-thought-out and proven modern business model, as well as companies that are able to continue to deliver their services even with market challenges, like COVID-19, and are not hamstrung by their particular business model.
“We look for companies with fantastic business models because that leads to solid profit growth, which leads to good balance sheets. That means they are in really healthy positions to withstand difficulties, whether they be short duration or long,” Alex says.
Key themes shaping up
When it comes to future gazing, the one thing experts agree on is that volatility is likely to remain in the market for some time to come. That volatility is likely to be predicated on a number of key themes. These include:
Earnings reporting season
The U.S. earnings reporting season kicks off in July. This will largely be the first time the market gets commentary from companies on the impact of coronavirus over a full quarter of COVID-19 related conditions.
U.S. presidential election
One topic that has fallen off the radar is the upcoming U.S. presidential election. However, since the start of the COVID-19 crisis in the U.S., the contest has become much closer.
Global trade tensions
Rising tensions between the world’s two largest economies – the U.S. and China – continue to deteriorate, which will affect markets and could lead to delays in reopening economies.
There is a subset of the market which can be classified as ‘winning businesses’. These are businesses in sectors like IT and e-commerce that were already doing well pre COVID-19, and have travelled through the coronavirus crisis largely unscathed.
The global recession will only accelerate the headwinds and potential demise of ‘challenged businesses’, including traditional retail business models and some energy companies dependent on fossil fuels.
With so much volatility, uncertainty and opportunities in the market, Simon says there are three key messages that investors should keep in mind when allocating to global equities.
Firstly, he says, they should take a long-term view and not be panicked by short-term volatility. Secondly, maintain adequate portfolio diversification given the broad range of possible outcomes. And thirdly: “Be prepared to be offensive when others are fearful, and defensive when others are greedy.”
Top 10 opportunities
The following companies represent some of the more exciting growth opportunities available to investors in global equities.
1. Activision Blizzard
A U.S. video game company, with online games including Call of Duty, World of Warcraft and Guitar Hero. It is well positioned, with strong cyclical and structural tailwinds.— Jeff Thomson
Amazon, one of the big four disruptors focused on e-commerce, cloud computing, digital streaming, and artificial intelligence. – Alex Pollak
3. American Tower
American Tower is a U.S. real estate investment trust, and an owner and operator of wireless and broadcast communications infrastructure in several countries. It is a key beneficiary of the 5G rollout. – Jeff Thomson
The Blackstone Group is a leading alternative asset manager, with top quartile long-term performance and a pristine balance sheet. – Jeff Thomson
5. Booz Allen Hamilton
A specialist IT consulting business, the main clients of Booz Allen Hamilton are the U.S. Department of Defense and intelligence agencies. – Ned Bell
One of the largest chocolate manufacturers in the world, Hershey is a relatively defensible business, as it produces products that hold up well in volatile markets. – Ned Bell
This U.S. retail supermarket, Kroger, is relatively inexpensive and it has been a big beneficiary of COVID-19. – Ned Bell
A global cloud provider, Microsoft’s products and services allow businesses to significantly cut cap expenditure related to their technology needs. – Alex Pollak
A U.S. company that has been at the forefront of mobile connectivity globally, effectively enabling in all areas of businesses. – Alex Pollak
Xilinx is a U.S. technology company that develops highly flexible and adaptive processing platforms. – Alex Pollak