Equities – a regional perspective

US

US economy continues to boom

Source: Thomson Reuters Datastream, 15.8.18

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.

At the beginning of the year, the US stock market traded at just over 18 times expected earnings per share. Since then, Wall Street has risen strongly but forecast company earnings have grown even faster. Today, the market is valued at less than 17 times expected earnings. The argument against the US has in recent years been that it is too expensive. It is hard to make that case today.

It is hard to overstate the impact of this year’s tax reforms. If you add together an estimated $700bn of cash being repatriated by American companies which no longer need to avoid high US corporate taxes, $120bn of consumer tax cuts, $80bn of corporate tax cuts and $100bn of new Federal spending, you very quickly get to a very big number. As one report I read recently put it: it’s raining money in the United States.

At the moment, a lot of that money is being used to pay down debt and boost under-funded pension schemes. In time, however, it will be turned to more shareholder-friendly uses. Capital expenditure will boost productivity and profits, share buybacks increase earnings per share, while anything left over can be used for M&A. The current 4% shareholder yield from dividends and share buybacks might rise to 6%, which will be around twice what an investor can earn from a US Treasury bond. In these circumstances, it is hard to argue against the US stock market.

The chart here shows the ongoing rise in consumer confidence in America. This reflects the fact that income tax has been cut for more than 90% of the population by a total of $120bn, or 0.6% of GDP. The jobs market is booming. Effectively America has been given a 3% pay rise. In due course this will encourage the Federal Reserve to choke off inflationary pressure with higher interest rates but that is probably tomorrow’s problem.

Of course, there are still things to worry about. Top of the list is what is going on in Washington. President Trump is delivering everything he said he would economically but the net is tightening around him politically. Key to his future in the White House will be the mid-term elections. If the Democrats can take control then impeachment might become more than vague speculation. But don’t count on it. A strong economy, delivering higher incomes and jobs, is not one in which America typically turns on its leader.

The US is one of the world’s more defensive markets. It is biased towards the growth stocks that investors shelter behind when the global outlook is unsettled. I expect the S&P 500 will continue rising to 3,000 and beyond. Investors’ enthusiasm for the US market will only be increased by uncertainty in emerging markets and a rising dollar, which increases returns for non-US investors. I have been cautious about the US in recent quarters because it looked expensive against other markets. However, the tax cuts and the trade tensions that a strong US economy has underwritten argue for a continuing bias towards the US.

Select 50 picks: There are plenty of ways to tap into the US on the Select 50. Obviously, this can be done via the US-focused funds like the JPM US Select Fund and the Old Mutual North American Fund. Less obviously, the global funds tend to have a heavy weighting to the US because of the contribution to global market capitalisation of US companies. We like both the Rathbone Global Opportunities Fund and the Fidelity Global Special Situations Fund.

Japan

Japanese shares becoming cheaper

Source: Thomson Reuters Datastream, 7.9.18. Price/earnings ratio of TOPIX index.

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.

The 9% fall in Japan’s Topix index from its peak this year is partly a reflection of its strong performance last year but it is also a consequence of an unhelpful, if understandable, shift in investor mood. Japan is more exposed than most countries to the ups and downs of global trade. It stands to lose more than most from the rise of protectionism. The use of the yen as a safe haven in troubled times has not helped as a strengthening currency makes Japan less competitive in global markets.

These factors have hit sentiment hard this year and net purchases of Japanese shares by foreign investors have given back all last year’s inflows and more. I don’t think this is justified by what’s actually happening on the ground. After a bit of a wobble in the first quarter, GDP growth recovered to 1.9% in the second three months of the year, well ahead of expectations. The size of the Japanese economy is now safely above the previous peaks in the late 1990s and just before the financial crisis.

The recovery is broad-based. Companies are spending more on growing capacity and labour-saving equipment to counter rising wage costs. Consumers, meanwhile, are benefiting from a tight labour market which prompted a 7% rise in bonuses this year. The employment situation has not been better in Japan for decades. This is leading to the strongest wage growth for more than 20 years. At 3.3%, salary rises are double the rate of a year ago. The participation rate is up, as women and older people enter the job market. Finally, there’s a more relaxed attitude to foreign workers in the tightest sectors like healthcare, agriculture and tourism. This is a sea-change in Japanese immigration.

On the corporate front, too, things are looking up. The return on equity at Japan’s famously inefficient companies is twice what it was only five or six years ago and there is scope for further improvement because Japanese companies are sitting on three times as much cash as their US and European counterparts. Company profits have more than doubled since 2012, fuelling a sharp rise in dividends and share buybacks.

So how is this reflected in the valuation of the Japanese stock market? It’s not. The average Japanese share is valued at around 12 times expected earnings today. That compares with around 17 in the US and a bit less in Europe and the rest of Asia. The comparison when it comes to the ratio of share prices to companies’ assets is even more striking. Japan is more than twice as cheap as the US on this measure.

So what might trigger a re-assessment of Japan? First, the re-election of Prime Minister Shinzo Abe as leader of the Liberal Democratic Party later this month. Second, the delivery of double digit earnings growth, making company estimates at the beginning of the year of 2-3% look far too cautious. Third, continuing dollar strength.

There are risks, of course. An escalation of trade tensions would be extremely unhelpful. If Trump turns his attention to Japanese car manufacturers, that would be a game changer. A rising oil price is a danger for one of the world’s biggest energy importers. An emerging market crisis or major slowdown in China could not be shrugged off. But all of this is in the price. We have been positive on Japan for some time. After this year’s weakness, we are even more so.

Select 50 picks: We are spoilt for choice, with three good Japanese equity funds on the Select 50. The Baillie Gifford Japanese Fund regularly appears among our most popular funds but we also like Andrew Rose’s approach and long experience in Japan, which you can access via the Schroder Tokyo Fund.

Asia and Emerging Markets

Turkish lira to US dollar

Source: Thomson Reuters Datastream, as at 31.8.18.

Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value of an investment. Investments in emerging markets can be more volatile than other more developed markets.

It is wrong to generalise about emerging markets. The differences between economies are much more significant than the similarities. It makes no more sense to compare India and Russia, say, than it does the US and Japan. But investors always tar the whole investment class with the same brush and never more so than currently.

The MSCI Emerging Markets index has fallen by more than a fifth this year. Even as the US is enjoying record highs for the S&P 500 and Nasdaq, emerging markets are enduring a fully-fledged bear market. Is this justified?

Certainly, there are significant concerns. Largely, these revolve around US monetary tightening and the subsequent rise in the US dollar. This is typically a headwind for emerging markets for two reasons. It encourages capital flight back to the US where investors can receive an increasingly acceptable yield at much less risk than in the developing world. Secondly, a strong dollar makes it harder to service borrowings denominated in the US currency.

The risk is that emerging markets find themselves locked into a downward spiral, as weaker currencies stoke inflation on the back of more expensive imports. This creates a need to raise interest rates which further weakens economic growth and puts downward pressure on the currency. And so the vicious circle goes on.

This summer has seen a couple of extreme examples of this process in action. Argentina and Turkey both have a problem with dollar-denominated debt and a problem with inflation. Argentina has a reform-minded government but it has been slow to make unpopular decisions and finds itself in the arms of the IMF just a year after successfully issuing 100-year bonds. Turkey is in a worse place, with an autocratic leader who for too long refused to bow to international pressure to raise interest rates. The chart shows how the market has responded.

So, a key question for investors is whether we are in the early stages of an emerging markets crisis or simply witnessing an inevitable wobble as the world gets used to tighter financial conditions as the Fed begins to normalise policy. There are a few reasons to hope for the latter. Unlike in the late 1990s when emerging markets had currencies that were pegged to the dollar, had weak current accounts and low foreign exchange reserves, the developing world is more resilient today. Rising US rates need not be a problem anyway if the underlying reason for them is strong growth.

Look beneath the surface, too, and the outlook is not at all bad for a number of emerging markets. India appears to be benefiting from a weakening currency, with growth outstripping even China. The Modi government has pushed through successful reforms including the introduction of a countrywide sales tax. Taiwan’s GDP is growing strongly.

Even in China, where there is evidence that trade tensions and the authorities' desire to rein in credit growth are crimping discretionary spending, there are as many investors (mainly overseas contrarians) looking for bargains as there are (mainly local) investors running for cover. The Shanghai-Hong Kong Connect is witnessing big inflows into mainland A-shares.

Politics will continue to be a big issue this year. Brazil has an election in October which will indicate how serious the country is about underpinning growth and solving an unsustainable budget deficit.

As ever, this is a stock-picker’s market. China’s consumption story remains intact. In India, some sectors like banking have years of growth ahead of them. The beauty of risk-off phases like the one we are in today is that these secular growth stories can be bought at a sensible price.

Select 50 picks: The Fidelity Emerging Markets Fund has around 60% of its assets invested in Asia, which, trade fears notwithstanding, looks like it has the best growth prospects. We also like the look of the Janus Henderson Emerging Markets Opportunities Fund, with a focus on consumer defensive stocks, including those listed in developed markets like Unilever and Heineken.

UK

Brexit focus hits the pound

Source: Thomson Reuters Datastream, 7.9.18.

Past performance is not a reliable indicator of future returns.

The next six months are going to be a fraught time in the UK as we head towards Britain’s exit from the EU in March 2019. We should expect business investment to be put on hold as the ebb and flow of the negotiations with Europe leave us almost completely in the dark about what the post-Brexit world will look like. At the same time, a slowing housing market and subdued consumer sentiment paint a fairly bleak picture for the domestic economy.

What will this mean for the UK stock market? In line with our experience since the 2016 referendum, the exchange rate will continue to be a focus for investors. The high weighting of exporters and overseas earners in the UK market means that a weak pound tends to be good for the FTSE 100. This could go both ways and sterling is bound to fluctuate in line with the prevailing headlines. But overall, it is hard to argue for a big appreciation of the pound given all the uncertainty.

Leigh Himsworth, manager of the Fidelity UK Opportunities Fund, recently told me how he is positioning his portfolio towards higher quality companies with overseas earnings that can offer growth whatever happens with regard to Brexit. He has no banks, for example, because of the significant exposure to the UK consumer of the likes of Lloyds, preferring to get financials exposure via international groups like Prudential.

There’s little exposure to real estate but lots of technology. The UK may not have a Google or Apple, but there are lots of smaller tech stocks which offer overseas earnings and an immunity to tariff concerns. There’s oil because it benefits from a strong dollar. Online retailers like ASOS offer a way of playing the shift away from the High Street. Wizz Air provides euro earnings. Food producers like Cranswick and Dairy Crest can compete in a weak pound environment because their rivals are euro-based.

So, an exposure to the UK is not all bad but it does require you to look under the bonnet to see what is actually in a portfolio. As a rule of thumb, big and international is better than small and domestic. With UK interest rates likely to remain lower for longer, high yielders will continue to look attractive and the UK market is still a good source of yield.

Select 50 picks: The high quality, international focus described by Leigh Himsworth is well-captured on the Select 50 by Nick Train’s Lindsell Train UK Equity Fund. Brexit is not a major consideration when assessing the outlook for multi-national consumer stocks like Diageo, Unilever and Heineken, all in Train’s top ten holdings.

 

Europe

It has been a disappointing year for European equity markets, despite an apparently positive set-up at the start of 2018 when the region was our favourite on the back of an ongoing economic recovery, a better political backdrop, decent valuations and a supportive central bank. After a bit of a growth wobble in the spring, all those factors remain in place so the question is whether trade war fears - which remain the biggest cloud over European equities - have been overdone.

Clearly, trade matters a great deal to Europe. It has been estimated that industrial companies’ profit margins effectively doubled in the years following the signing of a raft of free trade agreements in the 1990s so any reversal of globalisation is bad news for a region which exports so much to the rest of the world. The big swings in the share prices of Europe’s car makers this summer as President Trump’s trade rhetoric ebbed and flowed underline how much is at stake.

Another headwind for sentiment in Europe is Brexit. Britain might not be quite as important as we would like to think on the other side of the channel but trade between the EU and the UK is very significant indeed. That almost certainly ensures that some sort of a deal will be thrashed out at the eleventh hour but, in the meantime, the uncertainty is a drag on sentiment.

That is the bad news. The good news is that valuations in the main reflect the challenges. On the basis of the Shiller measure of long-run valuations, Europe is in line with the average of the past 35 years or so. This compares favourably with the US where shares are much more richly priced. The ECB also remains very accommodating. The central bank has made it clear that interest rates will not be moving higher for at least a year. If the differential between US and European rates widens further, then Europe’s exporters will be helped by a weakening currency too.

Select 50 picks: For income-focused investors, 2018 fund pick the Invesco Perpetual European Equity Income Fund is a good choice. Growth investors could look at the FP CRUX European Special Situations Fund.

Important information: Please be aware that past performance is not a reliable indicator of what might happen in the future. The value of investments and the income from them can go down as well as up, so you may not get back what you invest. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment. Investments in small and emerging markets can be more volatile than those in other overseas markets. Reference to specific securities or funds should not be construed as a recommendation to buy or sell these securities or funds and is included for the purposes of illustration only. This information does not constitute investment advice and should not be used as the basis for any investment decision nor should it be treated as a recommendation for any investment. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. Fidelity Personal Investing does not give personal recommendations. If you are unsure about the suitability of an investment, you should speak to an authorised financial adviser.

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