As we look toward 2017, the general near-term outlook for international equities continues to appear somewhat mixed, given a combination of global macroeconomic risks. In our view, some of the larger risks include possible instability relating to Brexit and the eurozone, deleveraging in the largest emerging markets, and uncertainty created by the recent U.S. presidential election as well as upcoming elections in Germany and France.
But no matter if the equity outlook is positive, negative or mixed, the Invesco International and Global Growth team takes a bottom-up view of investment opportunities – assessing companies by their Earnings, Quality and Valuation (EQV) characteristics. Below, I discuss the trends that we’re seeing, and how those look through our EQV lens.
Developed markets: A ‘lower for longer’ approach to interest rates
In the U.S., the Federal Reserve has reduced its outlook for future interest rate increases in 2017 and 2018, indicating that rates will remain lower for longer. In Europe, the European Central Bank has kept its stimulus program unchanged, a signal that that policymakers don’t see an immediate risk to recovery in the region. And in Japan – amidst the backdrop of falling inflation, rising long-term bond yields and an appreciating yen – the Bank of Japan unveiled new monetary tools in September, deciding to keep long-term rates near 0% and inflation about 2%.
Emerging markets: Slower growth on the horizon?
The expectation that U.S. interest rates would likely stay lower for longer helped to improve investor sentiment in emerging markets (EM) in 2016. Firming commodity prices helped as well. However, some of the larger EM economies, such as China and Brazil, are in need of an extended period of de-leveraging, in our view. This process would likely trim their growth rates going forward, and thus keep commodity prices more subdued.
Slower growth in China would also act as a headwind to many smaller East Asian economies that are more heavily dependent on exports to that country. As a result, many of these emerging economies may remain highly dependent on a continuing U.S. recovery for incremental growth in the year ahead. This challenging economic backdrop may bring ongoing volatility and stock market dislocations, thus providing more attractive buying opportunities for long-term investors like ourselves.
Regardless of the macroeconomic environment, the team remains focused on applying our EQV investment process that seeks to identify attractively valued, high-quality growth companies.
Earnings. The difficult earnings environment we’ve experienced in the last few years started to improve during 2016, as the pace of global earnings-per-share downgrades slowed. While we still saw negative revisions in Japan, Asia ex-Japan and EM toward the end of the year, the U.S. and Europe experienced upgrades in both earnings and sales. Given the heavy export focus, many Japanese companies have suffered from the yen appreciation. Asia ex-Japan has been impacted by strength of the U.S. dollar as a number of Asian currencies closely track the U.S. dollar.
The net earnings upgrades in Europe are the first since 2010. They’re primarily driven by the U.K., where the weakening currency is the main driver, but we’re also seeing positive revisions in Switzerland, Germany and Spain. Whether or not this will continue is difficult to tell, but currency-driven revisions are typically short-lived and most likely need improving economic fundamentals to be sustainable.
Our team is often asked whether we hedge currencies. We don’t hedge our currency exposure in any of our strategies for four main reasons:
- While foreign currency exposure introduces some volatility over the short term, we don’t believe it has a significant impact on long-term performance.
- In our view, one of the key benefits international funds can provide Canada-based investors is to lower correlations to the Canadian market. Hedging currency exposure increases the correlation, thereby lowering the diversification benefit.
- Currency hedging is also redundant to a large degree because many foreign companies have global operations with exposure to many different currencies, and they often hedge their own currency exposure directly.
- Finally, hedging is costly and can introduce unwanted leverage to a portfolio.
Quality. Companies’ return on equity (ROE) has been trending down since 2012 on a global basis and is showing no signs of improving. Improvement is unlikely to happen before we get a top-line recovery. Having said that, the strategies we manage all have ROEs that are about 5% to 10% higher than their respective benchmark indexes.
Valuation. Because markets are up and earnings are down to flat, most regional valuations rose during 2016. Overall valuation levels in developed markets continued to appear full despite the heightened macro risks and a challenging outlook for the earnings growth in the year ahead.
If you look at valuation dispersion as a way of indicating where you might find opportunities, emerging markets look most attractive – although less so than in the beginning of 2016, due to the strong bounce in emerging markets – and the U.S. looks the least attractive.