The rotation into more attractively-valued regions and sectors of the world, which began in mid-March with the high profile volatility in US internet stocks, persisted throughout the second quarter.
Performance of indices over 1yr
Source: FE Analytics
Long out-of-favour sectors such as energy dramatically outperformed while the outperformance of the US, which has been a persistent trend in place since late 2010, moderated during the quarter.
The sharp decline in first quarter GDP in the US, the weakest quarter since the recent recession, was to some extent the result of the harsh winter, but it also called into question the consensus view that US growth would greatly exceed that of other regions.No doubt the lofty valuation the US market had reached may also have served as an impediment to further material gains.
Sentiment on the emerging markets has materially improved in recent months, following an extended period the region was out of favour.
During most of the past year or two, investors were deeply concerned about growth trends in China, political issues in many emerging-market countries and the impact of tighter US monetary policy on these economies.
By contrast, investors viewed the US as having a structural advantage and able to “decouple” from other economies, growing strongly while other regions, particularly the emerging markets, languished.
The use of the term “decoupling” is ironic as when this term was first used in 2010 it was at a time when the US and Europe were expected to languish amid massive government debts and lacklustre economies while the emerging markets were expected to grow strongly, due to low levels of government debt and growing consumer spending power.
However, the world is becoming increasingly globally integrated, making decoupling a dangerous theory on which to allocate capital.
The products emerging-market companies make are typically purchased by developed market consumers.
The pressure the developed market consumer was under in 2010 was sure to be felt in the emerging markets, just as the more recent improvement in consumer sentiment in the US and Europe will also clearly be felt in the developing world, particularly the more export oriented economies such as China.
The improvement in sentiment is most clearly seen in flows into emerging-market equity mutual funds where there have been consistent and substantial outflows over the past year, which peaked early in 2014.
However, these flows have now reversed with money flowing into emerging-market funds since mid-March.
Emerging-market equities have traded at substantial valuation discounts to developed markets for an extended period, but the recent reversal in fund flows leaves us confident that sentiment has indeed begun to shift, and emerging-market equities have historically outperformed the developed market following periods of substantial outflows.
Performance of indices over 3yrs
Source: FE Analytics
During the quarter, my fund’s exposure to continental European defensives, such as toll roads and utilities, was materially reduced as these stocks rallied strongly, as peripheral European sovereign bond yields plunged, leaving valuations unappealing.
The shift in investor sentiment on peripheral Europe has been dramatic during the past two years and gives a hint of what may happen regarding the emerging markets.
The strategy continues to avoid large cap, developed market, defensive income stocks, such as consumer staples and health care, as yield-hungry investors have forced their valuations to unappealing levels.
In addition, “bond proxies” such as these tend to struggle amid rising rates, which undoubtedly will occur if the recovery persists.
In contrast, more cyclical income stocks perform much better as they are not used as a substitute for bonds and their inherent cyclicality means that their profitability will be boosted by the economic recovery that is driving up interest rates.
These well known, mega-cap defensives have been replaced in the portfolio by stocks we feel will prove just as resilient should the recovery falter, but whose valuations are much more attractive compared to historical norms.
These would include satellite operators, which have long term contracts with media providers, as well as mid cap wind farm operators.
Exposure to large-cap US tech companies has increased, as these companies have begun to materially increase dividends.
Many of these large-cap tech companies are also quite diversified, with large installed bases of their products providing cash-flow visibility and resilience comparable to traditional defensives, such as consumer staples, but at far more appealing valuations.
The recent rotation in markets has been powerful, but the spread in valuations remains wide with the US trading at over 18 times trailing earnings according to MSCI, while the P/E [price-to-earning ratio] in the emerging markets is just over 12.
As a result this rotation may persist for an extended period.
We feel the world is indeed healing after the shock of the global financial crisis, but this improvement has been aggressively priced into some regions, most prominently in the US, while not being priced at all in other regions, such as the emerging markets.
Based on current valuations, we would expect the US market to struggle to maintain upward momentum even if the economic recovery is as robust as expected.
The US market’s lofty valuation could also leave it vulnerable should a geopolitical issue derail the recovery.
In contrast, expectations in the emerging markets remain low, but emerging-market equities now look compelling, as valuations are attractive, the concerns over the impact of US Federal Reserve (the Fed) tapering should now fade and emerging-market currencies have recently stabilised.
Equities in general continue to look attractive versus bonds, particularly riskier, high-yield bonds whose yield advantage versus equities has steadily dwindled in recent years.
We feel an equity fund that seeks robust income using a systematic, valuation-driven investment process that is skewed to the parts of the world that remain attractively valued is well suited for such an environment.
Ryan (pictured on page one) has headed up the £357m Lazard Global Equity Income fund since its launch in October 2007.
Performance of fund, sector and index over 1yr
Source: FE Analytics
The fund is ahead of its IMA Global Equity Income sector average and MSCI AC World benchmark over three and five years, and top-quartile over the past 12 months.
