Events around the world since the beginning of May have shown how fragile the recent market recovery was, and investors may feel that it is still not the right time to get back into the market, particularly the international market.
There is no doubt that the effects of the global financial crisis are still being felt. With most economies now entering a period of ‘stimulus withdrawal’, problems that had been hidden are starting to emerge.
Certainly the earnings growth over the last 12 months has largely been generated by margin expansion and lower credit losses, rather than more sustainable factors such as growth in market share.
For major advanced economies, there are three main lingering consequences of the crisis that are still to play out before a sustainable and long term recovery can be established.
1. Impaired US and UK household balance sheets. Households in the US and UK are no longer prepared to spend more than they earn, which has created a major sea change in borrowing mentalities. This has resulted in significant disruption to exporters of goods and services.
2. Damaged banking systems. Most banks are still not in a position to resume lending as they repair balance sheets. This poses a particular threat to small and medium sized businesses.
3. Massive public debt. Arguably the most significant consequence is the global debt resulting from the bail-outs of many companies and the expenditure poured into helping developed economies avoid catastrophic collapses. For many developed nations who ran budget deficits in the good times, this has created major issues and they can't inflate their way out of the problems. As a result of the enormous global stimulus packages, most people can now expect higher taxes for some time to come, while governments and businesses must deal with lower levels of consumer spending in the coming few years.
Another potential issue is that job growth, both in the US but also in Europe and Asia, continues to be unimpressive. There is also a real danger that government over-regulation and involvement in areas they have not previously participated in will create mistakes. This has certainly been the case in Greece.
The problems in Greece cannot be underestimated. Issues of creditworthiness for a globally integrated economy have a tendency to escalate and infect other susceptible countries.
In the past we have seen many governments default on debt in emerging economies (Russia for example) but it hasn’t caused huge issues because foreign institutions were willing to re-lend to these emerging economies.
However, in the case of Greece, this debt is almost all within the Euro zone which means that Germany and France have no choice but to bail Greece out because it is their banks which are owed the money. These costs will significantly constrain Europe’s growth over the coming years. The upshot is that much-needed fiscal reform may be at hand, albeit not in the manner of their choosing.
In emerging economies, the biggest challenge rests on their ability to wean themselves off the export-led growth they have traditionally relied upon as the demand from the developed world wanes. China is a good example of this.
On the other hand, the positive for such emerging economies is that they have very strong government fiscal positions and unlevered consumers.
However, the China story is one which has yet to fully play out. In our view, there is something not quite right in China and investors should be wary for a number of reasons.
1. Unprecedented government support. The government has been very active in supporting certain industries and sectors, but this does carry risk. For instance, the government has pushed forward the sales of cars, resulting in immediate but unsustainable growth that will jeopardise growth for the coming years (see chart below). Carrying excessive inventory is costly and will come back to bite the economy. The government is also propping up property in a similar fashion which we believe is not sustainable.
2. Limited consumer support. China is not an economy where consumers can drive a recovery. Compared to the developed world, where consumers spend up to 60 percent of their income, Chinese consumers spend a far more modest 20 percent. This means that Chinese consumers are unlikely to support the economy’s growth in the same way that consumers could do in the US or the UK, or even Australia.
3. Poor sharemarket investment. China is awash with liquidity, but this money is not going to the sharemarket as people still don’t want to invest in local shares. This is a real concern to us at Wingate.
As a result of these issues, we have positioned our portfolio to shield investors from the potential downside in China. We believe it will be very tough to engineer a soft landing there.
The story is much stronger in Australia, as it has been for some time. The current conditions suit Australia well because we have strong trade relations with both emerging and advanced economies. And of course, our public finances are also in much better shape than most.
However, making the right kinds of investment in this environment is very tough for Australian investors. Many of our companies operate across a wide variety of global markets which means they are potentially vulnerable to problems that arise there.
If anything, it has become more important than ever before to look at the individual circumstances of each company and where and how earnings are generated, rather than just relying on the broader patterns of the country in which the company is domiciled. All investors should ensure they have developed a logical strategy for their portfolio that allows them to assess company characteristics and valuation as key inputs.
At Wingate, we do not favour regional investing as countries and companies are globally integrated, and to focus on a specific region usually results in unforseen risks being taken or opportunities foregone.
Our approach is to invest in companies where there is limited reliance on factors outside the company’s control – for example, a booming economy. Our largest holdings are therefore in the companies that don’t need much to go right in order to make money. These include companies such as Coca Cola, EDF (a French utility company) and Chugg Insurance US. These businesses don’t need new customers to grow their market share, or to make changes to their businesses – yet their valuations are exceptionally cheap.
There are now good opportunities to buy shares in quality, international companies at good prices. Many companies have experienced share price stagnation due to price to earnings contraction, but their long term growth remains intact, making their valuations attractive. This combination should lead to good absolute and relative performance.
Take Coca Cola as an example. This is a truly global company, with around 80 percent of its earnings coming from outside North America. It has numerous sources for growth, and its valuation is the lowest it has been in 20 years. Even on conservative assumptions, its earnings per share could grow approximately 10 percent per annum for next five years.
For us, the currency situation is a headache, although it’s a boon for consumers. We have believed for some time that there was more chance of the Australian dollar falling rather than rising. This is because of support from a strong Australian economy (on a relative basis); a higher interest rate differential; a strong China; and strong equity markets. All these factors now appear to be at or near their peaks, with risks emerging.
As long term investors we have always been anti-hedging because over the longer term it reverts back. We believe it is riskier to hedge than not to hedge because you can’t time it.
It’s difficult enough to justify a diversification from Australia and then, by locking in a conversion rate, re-taking sovereign risk - which is what hedging would accomplish.
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* Chad Padowitz is chief investment officer at Wingate Asset Management, an international equities joint venture partner of Australian Unity Investments.
