Chief Investment Strategist
The recent strong performance of U.S. equities, underperformance in the emerging markets, and volatility in Japan and Europe have caused some investors to question the merits of a globally diversified equity portfolio. While home country bias has been falling in major markets in recent years (with the notable exceptions of the United States and Australia), global investors still own a much larger percentage of home country equities than a market capitalization weighting would dictate. We believe that investors should continue to reduce their home country bias, and that an equity allocation based on global market capitalization is the lowest risk approach to realize global equity returns. As shown in Exhibit 1, the relative performance of the major developed regions varies considerably over time raising the risk of being overweight the wrong market at the wrong time. On a shorter-term basis, the best- and worst-performing markets vary widely each year, further increasing the risks of being over-invested in a poor-performing market. However, for those investors who are willing to take on additional risk, we do believe a tactical asset allocation approach that makes regional bets has the potential to add value over time.
EXHIBIT 1: IN AND OUT OF FAVOR
Source: Northern Trust, Bloomberg. Broad equities proxied by MSCI World Index. Regional equities proxied by MSCI United States Index, MSCI Japan Index and MSCI Europe Index.
Looking more closely at relative performance, Exhibit 1 shows the performance of the major developed regions versus the MSCI World Index since 1974. To smooth out performance, we show the trailing five-year relative performance of each region. We chose to look at developed economies in this analysis, given their longer history and similar risk profile. There are periods of relatively long-outperformance at the regional level with Japan and Europe outperforming the United States during the '70s and '80s, while U.S. and European equities trounced Japanese shares in the 90s.
However, if you bought the best-performing region at the end of any of the eight five-year periods studied, that region repeated as the best-performer only three times. If you had sold the worst-performing region at the end of the five-year period, that region subsequently underperformed in six of the eight periods (twice by the United States and four times by Japan). While this sample size is too small to be statistically robust, it gives some support to mean reversion among the better-performing regions. Also, longer-term return streams highlight the convergence of equity returns. Since the MSCI indexes were created in 1969, world equities generated an annual return of approximately 8.9%; U.S. stocks were up 8.5%, Japan was up 9.3% and the EU was up 9.9%.
The mean reversion observed in longer-term returns leads us to review the diversification features provided by a global approach to investing. As shown in Exhibit 2, shares outside the United States show higher overall volatility (measured by standard deviation). However, combining all three regions in a diversified portfolio actually brings down risk over the long time period. Clearly, diversification benefits are not always present (such as during the '08-'09 financial crisis, when correlations converged on 1 or perfectly correlated). To address this reality, we have evolved our strategic asset allocation work in recent years to embrace a risk control/risk asset framework that reduces the risk from overall volatility in risk assets such as equities. However, there is still value in normal times for a global approach to investing and it can be seen in the chart below.
EXHIBIT 2: MORE LEADS TO LESS
Source: Northern Trust, Bloomberg.
According to a 2012 study by Towers Watson, there has been clear progress in reducing home country bias among pension plans over the last decade. Among six of the largest pension markets (Australia, Canada, Japan, Switzerland, the United Kingdom and the United States) the percentage of equities dedicated to domestic shares has fallen from 65% in 1998 to 48% in 2011. There can be local mechanisms favoring domestic investing, such as the franking credit in Australia that provides a tax credit to the dividend recipient. While the 1% to 2% increase in income due to lower taxation is attractive, it may not be adequate compensation for the country concentration risk involved. There are also investor concerns about matching the currency exposure of a fund's liabilities with its assets but we find this argument unconvincing, especially for institutional investors. With larger plans being able to implement a currency overlay at an annual cost ranging from 0.05% to 0.10% of assets, this is a very justifiable expense to broaden the potential opportunity set to global equities. Additionally, currency movements frequently move opposite of local market equities prices with the recent action in Japan being a prime example.
In building equity portfolios, we start with the developed market opportunity set given its diversification properties. To that we also add an emerging market equity component not just for diversification, which it also provides, but also for the statistically-significant premium provided to the investor by taking on emerging market risk. Exhibit 3 shows the relative performance of emerging market equities to their developed-market counterparts. As can be seen, investments in emerging markets have provided significant outperformance since the inception of the MSCI Emerging Market index in 1988. Doing the math, emerging markets have provided an 11.8% annualized return, a 4.1% annual premium to developed markets over this same period.
As is apparent in Exhibit 3, exposure to emerging market equities is not without its challenges. For instance, an investor who came into the markets in January of 1994 would have been better off in developed markets for nearly six years before emerging markets once again started outperforming.
EXHIBIT 3: EMERGING MARKETS RISK PREMIUM
Source: Northern Trust, Bloomberg. Emerging markets proxied by MSCI Emerging Market Index; developed markets proxied by MSCI World Index. Data through 8/31/2013.
Emerging markets are currently undergoing a cyclical slowdown, tied to the continuing transition of the Chinese economy, slower export markets and domestic challenges in several key economies. In addition, the financial markets focus on Federal Reserve tapering has reversed investment flows to emerging economies, weakening currencies, and creating inflationary concerns. As we reviewed the five-year outlook for global economic growth and inflation this summer, we did modestly reduce our expectations for emerging market growth from 5.1% to 4.8%. While our forecast for Chinese growth of 6.9% is already well below the International Monetary Fund estimate, this should still prove to be a substantial growth driver for both other emerging market and developed economies. Also, with U.S. growth forecasted at 2.5% and developed ex-U.S. at just 1.2%, we expect emerging market growth to continue to be more than twice the rate of the developed economies. Reflecting the increased maturity of the emerging market economies, our expected risk premium over developed equities was set this year at 2.7%, below the 4.1% realized since inception of the index. We review valuations later in the report, where we show emerging market equities to be currently at the low end of historical valuation levels providing some valuation support to the long-term return potential.
In the early part of this report we covered the strategic case for global investing, an important feature of which is avoiding the risk of being concentrated in a region that significantly underperforms the global equity markets. However, we do think that there can be tactical opportunities to overweight/underweight different regions based on the fundamental outlook. Of course, this approach requires incurring increased risk in pursuit of potentially better returns. For example, U.S. equities have generated a total return of 71% over the last 3 years, as compared to just 33% from European stocks (as represented in local currencies by the S&P 500 and STOXX 600, respectively). As the European financial crisis unfolded and policy makers grudgingly advanced piecemeal solutions, investor sentiment soured on European assets and the stocks underperformed. As we debate the markets, we focus on monetary policy and economic momentum as two major drivers of return. Exhibit 4 shows the current central bank policy rates and policy outlook for major developed and emerging markets.
EXHIBIT 4: WHO'S HANDING OUT MONEY?
Source: Northern Trust, Bloomberg.
Led by the U.S. Federal Reserve, developed central banks have been flooding markets with liquidity to ease financial conditions and support growth. A stated objective of the Fed has also been to boost asset values in an attempt to create a wealth effect and boost animal spirits. Low inflation has allowed this extraordinary intervention in the United States, Japan and the European Union. However, emerging market central banks have a tighter inflationary environment, with inflation running above targets in important economies like India, Indonesia, Brazil and South Africa. Chinese monetary policy is tighter than would likely otherwise be the case due to concerns over total credit growth in the economy. Additionally, the jump in U.S. interest rates over the last several months in anticipation of less accommodative Fed policy is leading to capital flowing out of emerging markets pressuring currencies and likely pushing policy makers to consider higher interest rates in reaction. Over the next year, we expect the most accommodative policy to come from the developed markets outside the United States specifically Japan, the UK and Europe. We believe the Fed has moved toward a tightening bias, which for the next year will just mean growing its balance sheet more slowly but not touching interest rates. We would put the emerging markets on the restrictive end of the spectrum, as we are seeing rate increases in countries like Brazil and India, and slower credit growth in China.
Monetary policy can be a bridge toward a stronger growth outlook, but ultimately economic fundamentals must carry the day. Equity markets do tend to follow the trends in economic growth (for example, there is a strong relationship between U.S. equity prices and the manufacturing purchasing managers index (PMI)). Additionally, there is a good relationship between the PMI and earnings growth six months later. While emerging market growth held up relatively strongly after the financial crisis, the recent momentum has swung toward the developed markets. The strongest recent momentum is occurring in the United States and United Kingdom, while Europe has moved into expansion mode after a six quarter recession.
EXHIBIT 5: WHERE'S THE MOMEMTUM?
Source: Northern Trust, Bloomberg.
The developed markets continue to work through a long-term deleveraging process, which is keeping overall growth rates below historical norms. So while the United States and United Kingdom are currently reporting elevated PMI numbers, we would expect some natural moderation to occur. As an example, the jump in the 30-year mortgage rates in the United States from 3.4% to 4.4% over the last three months already appears to be putting a little damper on the housing market. We would also expect the level of improvement in the European numbers to moderate, as the level of structural reform remains fairly low and their exposure to emerging market demand is relatively high. All-in-all, we expect the developed economies of the United States, Europe and Japan to report solid economic growth that should support risk taking in those markets. We expect emerging market growth to be disappointing, although the market impact is not expected to be serious as this has become the markets overall expectation and is reflected in valuations. Based on this fundamental outlook, we currently favor developed market equities over emerging markets. Most recently we increased our exposure to EAFE equities at the expense of emerging markets, as the European and UK economies gain momentum and monetary policy looks set to remain accommodative.
After the tremendous run in global stock markets since 2009, questions are aplenty about whether stocks are overvalued. The Shiller cyclically adjusted price earnings ratio (CAPE) is currently 23.5, compared with a median of 15.9 over the last 130 years. This ratio looks at average inflation-adjusted earnings over the last 10 years, a period which includes two of the worst earnings recessions in the last century. This measure also doesnt look at the valuations in a relative context, which we think is essential considering that investors are usually weighing the alternatives available at the time of investment. When interest rates are low, as they are today, investors have historically been more willing to accord higher valuations to stocks.
Valuation is not a good timing device, but we do believe it impacts future returns. In our annual capital markets assumption process, we include historical cash flow yield analysis as an input to projecting next-five-year equity returns, wherein we find a statistically significant contribution to returns from starting valuations. When looking at current valuations vs. history (Exhibit 6), global stocks are at or below long-term average price-to-earnings (P/E) levels. Looking at U.S. valuation data going back to 1955, the market is trading in-line with its historic average P/E of 16.6 times.
EXHIBIT 6: VALUATIONS FAR FROM EXTENDED
Source: Source: Northern Trust, Sanford Bernstein. P/E data for developed markets is from 1975 forward, P/E data for EM and all P/FE data is from 1988 forward. Current as of 7/31/2013.
When we updated our five-year capital markets assumptions this summer, we reduced our U.S. equity forecast to 7.1% (from 8.5%) due to the strong performance over the prior year, while increasing our forecasts for other major developed markets. Europe ex-UK was increased to 7.8%, the UK was increased to 8.4%, and Japan was boosted to 5.8%. So while this reduced our overall developed equity market return forecast from 7.8% to 7.4% (due to the heavy U.S. weight), the forecasted returns are more dependent on developed markets outside the U.S. To reach our emerging market forecasted return of 10.1%, we added our assumed risk premium of 2.7% (compared to the 4.1% historical average) to the developed market equity return forecast of 7.4%.
Let us wrap up with some thoughts about global equity market investing in the future. As the economy and financial markets continue to globalize, will the way investors access equity exposure also change? To understand the current landscape, Exhibit 7 shows that global markets are comprised of an 87% allocation to developed markets and a 13% allocation to emerging markets. Within developed markets, a little over half of the market cap is domiciled in North America while Europe is about half the size of North America and Asia is about half the size of Europe. However, perhaps more interesting is the breakout of the global opportunity set by source of revenue. Here, we can see that the breakout better aligns with economic output. For instance, the United States makes up 28% of the revenue pie (22% of economic output) while emerging markets make up 32% of revenues (31% of economic output); other regions are similarly aligned.
EXHIBIT 7: GLOBAL MELTING POT
Source: Source: Northern Trust, MSCI. Data as of December 2012.
As companies diversify their revenue streams and financial statements provide more transparency into revenue sources, we believe investors will begin to look beyond country of domicile a theme we call Asset Classes without Borders. This has two primary implications. First, investment decisions based on the current country-of-domicile classifications require a full analysis of end-demand composition. For instance, those who expect continued secular decline out of Europe, and therefore shun European stocks, may be surprised to know that only half of revenues actually come from Europe. Second, investment products will evolve to be more focused on how securities in the global opportunity set can be packaged to provide certain attributes to the portfolio. For instance, structuring a portfolio to provide income through high-quality companies; providing inflation protection through upstream natural resource companies; gaining access to risk factors with statistically significant return premiums. The investment community is increasingly embracing this approach to investing. For example, MSCI has launched Economic Exposure Indices to reflect the performance of companies economic exposure, irrespective of domicile. The MSCI World with Emerging Market Exposure index includes the 300 developed companies with the highest exposure to emerging markets, allowing investors to target this fast growing part of the world economy.
While global investors have been whittling down their home country biases, most remain too heavily invested in their local markets. While some of this is simple inertia, it is also attributable to domestic policy (e.g. Australian franking credits) and misconception (a belief in the need to match currencies of assets and liabilities through investments, instead of utilizing a currency overlay). We believe the lowest risk approach to realize the global equity risk premium is through a market capitalization weighted approach, which eliminates the risk of overweighting a poor performing region. For those investors who want to actively position for regional performance differentials, we do believe a tactical approach can add value over time. Finally, we expect investment practices to continue to evolve in coming years as investors better target their desired exposures through new indexes or investment management products moving away from the traditional index approaches that are too tied to a companys domicile or place of listing.
Special thanks go to Tanya Mookerji for data research.