Are international equities worth a look?
A combination of strong-performing U.S. stocks and concerns about trade wars, geopolitics and lower growth rates overseas have many investors staying close to home. Time to reconsider? Portfolio Manager Thomas Banks offers his perspective.
Q: What international tailwinds have the potential to counterbalance the headwinds?
Growth in international markets remains bifurcated, with strong consumption offset by an ongoing contraction in the manufacturing sector. With low unemployment and historically low borrowing costs, the outlook for consumption remains positive. Weakness in manufacturing appears to be mostly related to political factors, in particular the U.S.-China trade war. If and when an agreement is reached, we believe there will be a rebound in manufacturing activity across the globe as businesses resume capital spending that currently is on hold. The strong U.S. dollar is an additional tailwind as it makes exports cheaper and drives higher translated profits for businesses that report in their local currency but generate a portion of their sales in dollars.
Q: How much is the U.S.-China trade impasse affecting international equities?
It remains the biggest source of uncertainty for international equities. What initially looked like a short-term dispute continues to drag on, forcing investors to keep lowering growth expectations. Roughly two-thirds of our investment universe is the eurozone and Japan, both of which are net exporters and count the United States and China as their two largest trade partners. Until a deal between the U.S. and China is worked out, we believe growth risks remain biased to the downside and that international investors should remain highly selective on a stock and sector level. We are underweight Industrials and Materials, the two sectors most dependent on a trade deal.
Q: Is China’s slower growth rate likely to reverse or is it a longer-term trend?
China’s GDP has been slowing gradually ever since it hit a post-crisis peak of 10.6% in 2010. Over the last four years, China’s growth has been very consistent, slowing from 6.9% in 2015 to 6.6% growth last year. This year, the rate of deceleration has picked up as the trade war between the United States and China drags on. China’s annualized GDP growth in this year’s second quarter was 6.2%, its slowest reported growth since 1992, prompting its government to cut its full-year growth target from 6.5% to a range of 6-6.5%.
For us, the fact that China has been slowing isn’t a surprise and has been consistent with our base-case scenario. What we’re focusing on is the pace of the slowdown – i.e. the “soft landing” vs. “hard landing” debate. China has been experiencing a soft landing and we expect this to continue over the next decade, although the shape of growth will evolve and be driven by consumption. One factor weighing on future growth is the sheer size of China’s economy. To continue growing over 6%, China needs to generate close to $1 trillion in incremental growth every year, equivalent to the total GDP of the 16th largest economy in the world. China’s debt level, now at over 300% of GDP, also could constrain the government’s fiscal policy efforts. Rising consumption should offset these headwinds. Final consumption as a percentage of GDP is still only half of China’s GDP, well below the level of most other nations, which typically generate two-thirds to three-fourths of their GDP from private consumption. The government continues to pass measures to stimulate consumption such as reducing value-added and personal income taxes along with providing incentives and rolling back restrictions in targeted industries like electronics and autos. While the slower growth rate is a long-term trend in China, we expect the slowdown to remain at a gradual pace and for China to remain one of the key contributors to global growth.
Q: What impact do you expect global central bank easing to have on international equities?
Global central banks have been in an easing mode since the 2008 financial crisis and the impact has been lower and, in some instances, negative rates, flatter yield curves, increased liquidity and higher asset prices. On a sector level, easing has been negative for Financials as net interest margins have contracted, putting pressure on earnings. The Euro Stoxx Banks Index currently is trading at a multi-decade low due to the adverse effects of central bank easing. Sectors that are perceived to be bond proxies including Utilities, Real Estate and Consumer Staples have been beneficiaries as investors have rotated into these sectors for their predictable growth attributes and relatively high dividend yields. Central banks globally have signaled a continuation of loose monetary policies and this will remain a headwind for banks.
Q: What about impacts from U.K. Prime Minister Boris Johnson and his Brexit strategy?
Boris Johnson has been the prime minister for only a few weeks, so we’re still trying to dissect his strategy. He has indicated a desire to either exit the European Union or negotiate a new deal before the current Oct. 31 deadline. Given the limited amount of time he has to negotiate a new deal and his pro-Brexit background, the odds of a no-deal Brexit clearly have increased. We believe visibility on the Brexit outcome will improve over the coming weeks now that Parliament has returned from recess, but we remain underweight the U.K. due to the political uncertainty.
Q: Where are opportunities to be found in the eurozone?
Given beaten-down valuations as a result of the trade war and to a lesser extent Brexit and Italy, we are overweight the eurozone and as fundamentals-based investors, continue to be positively surprised by the number of attractive investment opportunities in the region. The political uncertainty and decelerating growth rates tend to dominate the headlines but once investors move past this, the picture improves. We believe one of the biggest misconceptions around investing in the eurozone is that the region lacks opportunities in the Technology sector. Information Technology is our largest sector overweight and we’ve been able to find new ideas that fit our investment criteria across all of the Technology subindustries – software and payments in particular. We’ve also been finding opportunities in European Consumer Staples. Europe has some of the best spirits companies in the world, some of which we’ve been long-term investors in and others we’ve bought more recently. Spirits companies continue to have strong pricing power as consumers trade up to premium products, supported by a global shift toward higher-quality spirits even as overall consumption is trending lower.