International equities: uncertainty a global certainty

Sovereign debt and other issues have emerged to create new challenges and uncertainties around allocating towards international equities, writes Damon Taylor.

Within Australia’s superannuation environment, investment into international equities has always held strong diversification benefits across both developed and emerging markets.

Yet in what can still be termed the global financial crisis (GFC) aftermath, overall market uncertainty means that offshore investment continues to be a bumpy ride and, according to Stuart James, senior investment specialist, international equities, for Aberdeen Asset Management, one requiring careful navigation.

"In general, global equities performance for the year to date has been fairly mixed," he said.

VIEW ALL

View all

"Returns for the start of the year were relatively healthy but since then there have been a number of aftershocks in Dubai and also in China.

"Over the last month international equities markets have been very nervous, so there’s a bit of uncertainty out there at the moment."

Commenting on how emerging markets fared compared to developed markets, James indicated that the equation was a tricky one.

"Long term, I’d say that emerging market fundamentals look better," he said. "They have much lower debt at all levels and generally have much stronger growth.

"Unfortunately, in the short term, if uncertainty continues, investors are likely to become risk averse and stick to the US dollar related stocks," James added. "And in turn, that kind of reaction will have an inappropriate impact on the market.

"For January through to April of this year, we’re talking about returns of -4.65 per cent for international equities overall and -1.25 per cent for emerging markets. So while emerging markets are still a little ahead, it certainly hasn’t been so clear cut this last month."

With a similar take on how international equities markets have shaped up since the beginning of 2010, James Soutter, senior portfolio manager, international equities, for Perennial Investment Partners, said that performance had been fairly mixed.

"We’ve seen large movements in global equities, which started off in January with quite a steep fall before recovery a couple of months after as better economic and company news came through," he said.

"Corporate news in places like the US has been incredibly strong and in the last reporting season we’ve seen companies’ reported earnings far outstripping analysts’ predictions.

"There’s also been a bit of an upward trend globally that’s been driven by good cost management through the down cycle," Soutter continued. "And we’re now seeing margin expansion and top line growth."

Unfortunately, Soutter said the global equities picture changed markedly towards the end of May.

"Nearly all of those gains have now been given up on a year-to-date basis and I’d say that every major market in the world is down, whereas at the beginning of [May], the majority would have been up, with the exception of places like Greece and Spain," he said.

"Just last night markets closed down 4 per cent but before then, it was basically break even.

"We’re now also seeing a very different shift in currency, and that’s having a very large impact on returns for Australian dollar investors," Soutter added.

"I’m looking at some bad markets here, with Spain down 22 per cent in local currency terms, Italy down 17 per cent and even Hong Kong down 10.5 per cent.

"The strongest performing area has virtually been the US; in only being down 2 to 3 per cent, it’s actually been the most resilient through this, followed closely by Japan."

Providing a background for recent US market stability, Soutter said the US and Japanese markets often constituted safe havens for investors looking to withdraw capital from risky assets in foreign markets.

"Certainly over the last month, developed markets have held up better, and that’s a risk aversion thing," he said.

"The corporate news coming through from emerging markets has actually been very strong, as it has within developed markets, but as capital gets withdrawn, it finds a natural home back in markets like the US, Japan and the UK.

"The only sure thing at the moment seems to be that there are interesting times ahead."

Emerging markets

But while judging emerging and developed markets might have been difficult in recent months, the story was somewhat different 12 months ago. A

t that time, global equities experts were tipping emerging markets to provide the lead out of the financial crisis downturn, and James believes such predictions proved accurate.

"Largely, emerging markets did provide the lead," he said. "Year to date, overall international equities have delivered 9.87 per cent as compared with emerging markets, which delivered 24.37 per cent, and that’s in Australian dollar terms.

"There’s no doubt that during 2008, emerging market shares were sold off more heavily," James continued.

"But since March of last year, we’ve seen people recognising the strong fundamentals in emerging markets, to the point where I’d say they’re now trading at a slight premium to developed market shares."

Taking a slightly longer view, Grant Forster, chief executive officer of Principal Global Investors (Australia), said that in delivering an average return of 6 per cent, emerging market growth rates had been reasonably consistent.

"In Australian dollar terms, emerging market returns have been 24 per cent for the 12 months to April and 12.5 per cent for the five years to April," he said.

"By contrast, the five-year figures for developed markets are 8.7 per cent, so emerging markets have certainly rebounded pretty well on an unhedged basis.

"Emerging markets didn’t go into the financial crisis anywhere near as much as developed markets," continued Forster.

"Commodities held and kept emerging markets afloat, and because of that resilience, what transpired was almost the reverse of what you’d expect."

Forster said it was also interesting to note that where the Australian equities market had delivered returns of 32.5 per cent to the end of April, investors had received 36.2 per cent from global equities, provided they had hedged their currency exposure.

He added that the less flattering unhedged global equities return was 7.4 per cent.

"So because developed markets tanked so badly, they’ve actually done pretty well over the last 12 months," Forster said.

"So whether we’re talking about emerging markets or developed, there are lessons to be learned here in looking very carefully at both currency risk and hedging.

"Investors need to acknowledge that risk and adopt a considered strategy."

Looking at emerging markets and their performance through the financial crisis more broadly, Soutter pointed out that some of the stronger markets were found well away from the more familiar Asian regions.

"Some of the stronger markets were actually in places like Brazil," he said. "Asia actually kicked off very early in that piece and, in the case of China, has been moving in a negative fashion since about June/July last year.

"So they ran very hard very early and have really come off since then," Soutter continued.

"The stronger markets have actually been in places like Brazil, where you’ve had strong internal demand, good mining projects and also a very agriculturally driven economy as well.

"If anything, the real reacted marginally stronger than the Australian dollar at that point, so you’ve had a market and currency that’s been marginally stronger than Australia’s, and I think returns reflected that."

Soutter said one of the things that had often pulled back emerging markets, particularly those found in Asia, were their links to the US dollar.

"So you’ve had the currency headwind but very strong underlying markets, which I think have definitely led the world through the last 12 months."

Domestic vs global

But while a number of fund managers were able to predict the steadier performance of emerging markets through the GFC, the reality for many investors was that there was little to pick and choose between domestic equities and their international counterparts.

As a consequence, the argument from a number of super fund executives was that equities portfolios could be viewed less distinctly, but according to Soutter, the composition and risk inherent in global equities dictated an independent approach.

"From my point of view, domestic and global equities have to be seen as two very distinct allocations," Soutter said.

"Equities may be similar across the board, but the composition and risk inherent in global equities versus domestic is very different.

"In terms of composition, the Australian market is based on two sectors in banking and resources, and they form its two drivers," Soutter continued.

"One is purely domestic, being the banking sector, and the other is very much overseas driven, being resources, but global equities give you far more scope in composition."

The reality, according to Soutter, is that by investing globally, investors can access industries, sectors and companies the likes of which are simply not available within Australia.

"The next consideration from an institutional standpoint has to be the diversification of risk in terms of hedging," Soutter said.

"So despite recent underperformance due to a strong Australian dollar, by having an unhedged portfolio you’re actually diversifying risk further by taking on the risk of different economies around the world.

"For example, you’ve actually got global equities giving a positive return in unhedged currency for the month to date," he continued.

"So while we’re looking at our portfolios and seeing them going up, the underlying investment is going down, and you’re getting what is essentially lower volatility in returns.

"In my mind, there are different risk and diversification elements inherent in global versus domestic equities, and I think that from a super fund standpoint, that has to be taken into consideration."

Stacking up medium-term global equities performance against that of the local market, James said that in Australian dollar terms, the disappointing performance of global equities had perhaps altered peoples’ view of the investment.

"Looking at the figures, we’ve got domestic markets delivering 8 per cent per annum over the last five years compared to global markets, which delivered about 0.6 per cent per annum," he said.

"And on that kind of performance, there will have been a number of investors who have shied away.

"The recent strength of the Australian dollar has really hurt local investors looking to go offshore," James continued.

"But people also have to be conscious of what happens in the resources sector.

"And in the long run, people do need to keep a diversified portfolio."

For James, the very different opportunity sets available in global equities demanded that they be viewed separately.

"Domestic equities investment may have the advantages of better franking credits and no currency risk, but the market is also quite narrow," he said.

"In international shares there are different markets and different cycles to play in both emerging and developed markets.

"It’s an altogether different game."

Of course, the advantages of domestic equities investment mentioned by James were those most often cited by institutional investors as well. Why wouldn’t they have a strong local bias on the back of a tax advantage and what have also been better returns?

And at the moment, it’s a question that James sees being answered far too easily.

"For that local bias to change, what we’d need to see first of all is strong international equities returns," he said.

"Like it or not, people are going to look at past performance, and at the moment, all the bad news seems to be flowing from offshore, where things locally have been faring much better.

"The main risk in the Australian market is an overdependence on the resources sector and some of the question marks out there on Chinese growth," James continued.

"And for many investors, that could certainly prove the tipping point for reconsideration."

Seeing similar potential for the Australian resources sector to prove a catalyst over the longer term, Forster said the Government’s response to Australia’s Future Tax System Review had done little to change the local investment environment.

"The tax advantages are still there, so I don’t expect super funds will look to a reduction of Australian equities exposure in favour of global equities any time in the next five years," he said.

"The only other point here is that if commodities come off, it could lead to a drop in the Australian dollar and may mean change in the next few years.

"But even so, it would have to be meaningful change to tip the scales away from the domestic market."

Governance

However, beyond the question of what could tip the balance of superannuation investment in favour of offshore markets is the obvious need for good corporate governance and transparency when investing globally.

These considerations were highlighted among the lessons learned post-GFC, and for Soutter, the experience has shown that there remains reason for both caution and vigilance.

"I actually sit on an ESG [environmental, social and governance issues] committee and when looking at global equities, the landscape of corporate governance changes tremendously from markets such as the UK, with good corporate governance, to markets such as Indonesia which, though very attractive, have very poor corporate governance and a lot of family ownership," he said.

"So you’re often trying to weigh poor corporate governance against what look like good companies.

"As a fund manager, we actually go out and see companies and question them about corporate governance, and the issues that come up are in board structure, the independence of the board and so on," Soutter continued.

"But I think fund managers have a job to ensure they’re putting pressure on companies to make sure appropriate governance and transparency is there."

Adding to his comments, Soutter pointed out that Australia had not been immune to corporate governance problems and regulation breaches during the GFC.

"You only have to look at ABC Learning to see an example of what was systemic across the globe in there being just too much easy money allowing leverage," he said.

"Regulation and corporate governance is something that is vitally important, and perhaps more of an issue in international equities because you’re looking at a far greater landscape.

"In the domestic market you have the level playing field of dealing with one regulator, one government and one set of accounting rules, but in global equities the challenge is to marry them all up."

In line with Soutter’s comments, Forster said there was certainly room for tighter regulation around global equities corporate governance and that there was no reason why fund managers themselves could not influence improvement.

"People in the old days worried about governance and transparency in emerging markets but I think we’ve seen in the last few years that the issues can come from the US and developed markets just as easily," he said.

"Enron, for instance, is probably proof that problems can occur anywhere.

"Personally, I know we’d welcome increased regulation as a result of the incidents we’ve seen through the GFC."

According to Forster, one of the facts many people did not realise was that within the US market, less than 30 per cent of trades actually went through the New York Stock Exchange.

"So as a consequence, a number of trading issues have developed that have fundamentally changed the way the US market trades and functions," he said. "And I don’t think the regulators have been able to keep up.

"In the case of super funds, they should be looking to their managers to makes these calls, but we’ve also been pushing for these sorts of changes to even the playing field."

For his part, James admitted that the GFC had brought home the importance of good corporate governance and transparency for most, if not all, investors.

"When markets are going up, people don’t focus on these things," he said. "And it’s only when the tides go out that you realise people have been swimming naked.

"Corporate governance has definitely improved for emerging markets, but there really isn’t any other way to handle the situation than to have fund managers who go over everything with a fine-tooth comb," James continued. "Because the reality is that disasters can still happen."

James said that in a number of cases, the events of the last 18 months hadn’t really been countered.

"The solutions thus far have really been about accounting, about moving debt," he said.

"People are trying to repair balance sheets, but the reality is that it’s going to take time and honestly, I don’t think we’re out of the woods yet.

"In this kind of environment, investors should be seeking those companies that have good management teams, good balance sheets, low gearing and a good track record," James continued.

"Also look out for revenue mismatches where companies have their revenue in local currency but have their debt in foreign currency or vice versa.

"At this point in time, investors don’t need to be taking unnecessary risks."

Times have changed

But while the bumpy ride for global equities seems set to continue, the one certainty seems to be that the days of vanilla investment into the United States and United Kingdom are well and truly over.

Opportunities in offshore markets are everywhere and, according to Soutter, that is a fact well recognised by fund managers.

"We tend to think that the MSCI benchmark, so the one used most often in Australia, has become totally outdated," he said. "Where it is still 50 to 55 per cent North American stocks, globalisation has made countries that were ignored 10 years ago vitally important.

"The world is a different place, with companies in emerging markets delivering far higher returns, and we don’t think the MSCI reflects that," continued Soutter.

"Places like Korea and Taiwan, for instance, are still considered developing, but they’re seeing a great deal of growth and have much lower debt.

"They’re markets we should all be investing in and I think it’s surprising that they haven’t seen greater allocations."

Offering similar advice, James said that investors needed to think about removing global equities labels entirely.

"Just because a stock is classified as emerging, that doesn’t necessarily mean it’s going to be riskier," he said.

"Australia has done very well, but it’s a very small part of the global economy and I’d advise investors to look beyond the vanilla and beyond the traditional.

"There are different investment themes and opportunity sets everywhere, and in a diversified portfolio it makes a certain amount of sense to embrace them."