Global Equity
Over the past three decades, the global economy has become increasingly integrated. Advances in technology, transportation, finance, and communication have opened up previously isolated markets to the rest of the world.
Evidence of globalization can also be found in international financial markets. Investors are increasingly looking for opportunities beyond their national borders to enhance portfolio returns and reduce risk through diversification. This trend is apparent in the sharp decline in home equity bias, defined as the tendency for investors to allocate the majority of their portfolios to domestic assets.
While US investors placed only 2.9% of their portfolios in international equities in 1986, they had roughly 11% of their stock holdings abroad in 2001. The share of international holdings also rose in Germany, climbing from 8.4% to 39.7% over the same period. The most extreme example is Austria, where foreign equity assets grew from 13.3% of portfolios in 1986 to 77.3% in 2001. Below we will explore the benefits of global investing in greater detail and examine different investing styles. We will also evaluate the opportunities we currently see in global equity markets.
Global Investing: Country, Sector, and Currency Decisions
Most equity managers follow bottom-up stock picking strategies where they focus on individual company fundamentals and valuations. However, this approach can sometimes cause managers to miss the forest for the trees since changes in an individual company’s profitability may lag shifts in the macroeconomic environment. In contrast, a top-down macroeconomic approach that concentrates on country, sector and currency selection can give managers an edge in recognizing turning points in the economic cycle. This information can then be exploited to enhance portfolio returns.
Country:
Each country has a unique set of macroeconomic fundamentals that can impact financial market performance. The key variables we track include economic growth potential, corporate earnings growth, stock market valuations, central bank policy, budget and current account deficits, and the relative soundness of the financial system. After assessing these macroeconomic fundamentals, portfolio managers must decide which countries to overweight or underweight.
At the present time, the most attractive opportunities appear to be in emerging markets, particularly in Asia and Latin America. Flexible currency regimes, current account and budget surpluses, and large foreign exchange reserves have given countries such as China and Brazil the opportunity to implement counter-cyclical policies during a crisis for the first time in recent history. Their market valuations are still relatively attractive despite the recent run-up in equity prices. These countries also have reasonably healthy banking systems and have managed to avoid direct exposure to the global credit crisis. It is not surprising that they are leading the global economic recovery.
We expect Asia and Latin America to provide better relative returns given their stronger macroeconomic fundamentals. Moreover, due to their lower correlation with developed global equity markets, these regions reduce risk by offering investors diversification benefits. Correlation refers to the degree of movement in one variable given a movement in another and can range from -1 (perfect negative correlation) to +1 (perfect positive correlation). When two financial markets that are not perfectly correlated are combined, the probability of extreme outcomes (tail risk) is reduced as movements in one financial market are partly offset by opposing movements in the second market.
Between September 2008 and March 2009, equity prices plunged worldwide, causing cross-border correlations to rise precipitously. This behavior is not unusual during financial panics when investors typically fail to distinguish between the quality of assets. However, decoupling, or a decrease in correlation, is becoming much more evident as the global economy moves beyond the crisis phase. Cross-country economic growth correlations are significantly lower during non-recessionary periods. In addition, emerging markets in Asia and Latin America generally have a lower correlation with markets in the industrialized world. Consequently, investments in these regions may provide the best opportunity for investors to reduce risk and enhance returns.
Sector:
Sector selection is often intertwined with country selection since a particular sector can account for a significant share of the capitalization in a given market. For example, a portfolio that is overweight Switzerland may end up with overweight to defensive sectors such as health care (Roche and Novartis) and consumer staples (Nestle), as these sectors account for 35% and 22% of the country’s index, respectively. Knowledge of the sector breakdown for each country is critical to insure proper risk management. If necessary, a portfolio manager can neutralize exposure to a given sector through the use of exchange traded funds or by using a basket of stocks that does not have exposure to the sector.
The economic cycle also plays an important role in sector selection. The basic structure of the economic cycle consists of four stages: expansion, peak, recession, and trough. Different sectors typically outperform at different points of this cycle and portfolio holdings can be altered to take advantage of where a country is in the economic cycle. For instance, if a country is believed to be in the initial stages of the expansion phase, investors should consider an overweight to technology, as this sector usually leads during economic recoveries.
Technology investment tends to lead because it is a low cost way for companies to enhance productivity at the beginning of an economic cycle before they employ new hires or increase investments in heavy plant and equipment. The technology sector is also attractive today because companies in that space have healthy balance sheets after aggressively reducing debt levels in the aftermath of the tech bubble at the end of the 1990s.
Currency:
Currency decisions are independent of country and sector selections since economic performance does not necessarily parallel currency performance. In other words, a strong economy does not always imply a strong currency, nor does a weak economy signal a weak currency. Several factors are considered when deciding whether to implement a tactical overweight or underweight to a particular currency. In the short- to medium-term, the focus tends to be on differences between countries’ interest rates, economic growth prospects, and inflation outlooks. Fiscal and monetary policy stances can also be important.
In the long-term, current account balances, which are the broadest measure of a nation's trade and investment flows, often prove useful in forecasting currency movements. The current account balance reflects the aggregate supply and demand of a currency in the global market place. A current account deficit signals that a country is borrowing from abroad and therefore increasing the supply of its currency in the global market place. For a given level of demand, a high degree of borrowing will eventually translate into a weaker currency. The opposite is true for countries that run large current account surpluses.
Both the short-term and long-term factors point to further weakness in the US dollar, especially against emerging market currencies in Asia and Latin America, which have sounder macro-fundamentals. Though the US dollar benefited from a flight to quality during the financial panic between September 2008 and March 2009, now that risk aversion has abated, the dollar is drifting lower once again.
Where Are the Opportunities in Global Equity?
The first step to implementing a top-down global equity strategy is to develop a macroeconomic view of the world. Then the country, sector and currency decisions fall into place. Our current view is that the global economy appears to be stabilizing and financial markets are following suit. In fact, the second quarter of 2009 marked the end of a streak of seven consecutive negative quarters for global equity markets. The MSCI World Stock Index is up 19.2% year-to-date through Sept. 25, 2009.
The global economy seems to be reacting favorably to the countless monetary and fiscal easing programs initiated around the world. However, while a continued uptrend in economic data in the near term is expected, a sustainable recovery is still uncertain. Compared to the industrial world, most emerging markets had little direct involvement in the global credit crisis and therefore managed to avoid an outright decline in economic activity. For this reason, emerging markets are likely to be on a higher growth trajectory than developed markets. This may explain why the MSCI Emerging Market Stock Index is up more than 50% in local currency terms year-to-date through Sept. 25, 2009.
Developing Asia and Latin America seem particularly attractive given both their growth prospects and relatively positive fundamental outlooks. As a result, we are overweight these emerging markets. At the same time, we are overweight the technology sector as tech companies have healthy balance sheets and the sector tends to do well at the beginning of economic recoveries when companies are seeking to bolster productivity. Finally, we are underweight the US dollar for two reasons. First, the US economy was at the heart of the recent financial crisis and its banking system remains in fragile condition. Secondly, the decline in risk aversion in global financial markets has led to a reversal of the flight to quality which benefited the US dollar earlier this year.
Works Cited:
1. “Globalization: A Brief Overview.” Issues Brief. The International Monetary Fund. May 2008.
2. Amir A. Amadi. “Equity Home Bias: A Disappearing Phenomenon?” University of California, Davis. May 5, 2004.
Payden & Rygel’s Point of View reflects the firm’s current opinion. The investment strategy and investment management information presented to our readers should not be construed to be formal financial planning advice. Point of View is an informative journal designed to provide information to the general public based on our recommendations of investment management and investment strategies and is not designed to be representative of the needs of any individual investor. Please do not make any decisions about any investment management or investment strategy matter without consulting with a qualified professional.