International equities - a new day dawns

With asset allocation high on the agenda for many superannuation fund trustees, Damon Taylor writes that international equities have become a focus based on the recent decline in the value of the Australian dollar. 

As Australian superannuation funds embark on a new financial year and the new challenges implicit in Stronger Super, a topic of conversation giving fund executives some respite from this may well be investment allocation. 

Indeed with continued and significant movement in global economies, the asset allocation split between domestic and international equities is a debate occurring within all funds and for Mark Wills, head of the Investment Solutions Group (Asia Pacific) for State Street Global Advisors (SSgA), one which recent market activity has done little to diminish. 

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“At the moment, the major issue from an asset allocation and global equities perspective is trying to make sense of the Fed’s position on the unwinding of quantitative easing,” he said. 

“I think it’s fair to say that that was the spark that triggered the current pullback. 

“And while Chairman Bernanke has probably prided himself on being very open on positioning and how they want to conduct operations, the range of reactions in markets has been more than a little surprising.” 

According to Wills, mere mention of the word ‘tapering’ in comments made by Ben Bernanke, Chairman of the Federal Reserve, in late May had already resulted in significant flow-on effects for global markets, particularly in China. 

“We’ve seen the Shibor (Shanghai Interbank Offered Rate) hitting levels of up around 13 per cent and moves in interest rates of 8 or 9 per cent in a day, which is quite remarkable,” he said. 

“It probably highlights some of the funding stresses that exist in China because it’s been almost the tip of the iceberg in terms of the very heavy investment pullback in the emerging markets part of the globe. 

“Europe, on the other hand, has been pretty subdued,” Wills continued. “All of its problems seem to be well known and, if anything, it’s skirted under the radar during this recent round of volatility. 

“And last but not least is Japan, where markets are waiting for the Government to continue rolling out the additional reform, spending and tax packages that they’ve got in the planning stages at the moment.” 

Adding further detail to Wills’ comments, Rob Hogg, Senior Consultant for Frontier Advisors, said that, as ever, events in the US had been significant across all global markets. 

“It’s impacted markets everywhere and the interesting thing is that what the US Fed does really affects almost everybody else,” he said. 

“So we’re going to sail into some seas where the US Central Bank will be doing stuff for their own domestic reasons, which of course is what they would and should do, but that may occur at a time when it just doesn’t suit the Europeans or the Japanese or indeed anyone else. 

“While we’ve had all of these central banks indulging in various types of unconventional policies which have supported liquidity and prices and so on – some of them quite different to what the US has done – if the US Fed starts moving ahead of the rest of these central banks, the impact from what they do will affect securities prices in all these other markets as well.” 

Yet in the midst of the ripple effect identified by Hogg, Greg Davis, chief investment officer for Vanguard Asia Pacific, was quick to point out that global markets were not without their opportunities. 

“People in general look at it and see economic growth as the primary driver of equity market returns, but the research we’ve done says ‘hey, it’s not really about what the economics are, it’s really what’s priced into the market,’” he said. 

“So the question is – are we overly optimistic or are we right in line with baseline expectations? 

“And if the market’s already pricing in a small amount of economic growth, you should still have an equity premium that you’re picking up by investing in a risky asset,” Davis continued. 

“Now, if you’re expecting 2 per cent growth and you end up receiving negative 5 per cent growth, clearly the market’s going to be disappointed in that and that’s going to be a downturn in equities. 

“But it’s really a function of what the market is already baking in and not necessarily the fact that it’s slow growth versus high growth – and for me, that’s what investors need to keep in mind.” 

Similarly, Steven Carew, head of research at JANA Investment Advisors, said that he looked at overseas equities the same way as he looked at any other asset class. 

“Which is to say that we look at its absolute and relative valuation and other factors around that,” he said. 

“So what are the fundamentals like, what’s the sentiment like and so on. 

“At the moment, for instance, we’re carrying a higher weight in overseas equities than we have at most times in the past and there are probably three reasons for that,” Carew explained. 

“One, the relative valuations are attractive. 

“And an example of that would be certain companies in Europe, companies that have good franchises and good growth but companies that are trading very cheaply because they just happen to be domiciled in Europe.” 

For Carew, the second element was the Australian equity market itself. 

“We’re a bit concerned about the Australian equity market given that the Australian economy is in a different part of the cycle, particularly compared to say the US,” he said. 

“It’s slowing where other economies are moving into an accelerating growth phase. 

“But the third aspect has been the currency,” Carew added. 

“We’ve been holding more foreign currency exposure and prefer unhedged overseas equities to Australian equities. 

“So for those reasons, we’ve been a bit cautious on the Australian market and that’s steered us towards overseas markets instead.” 

Of course for some, a weakening Australian dollar may itself be a deterrent against offshore investment. And according to Wills, the global equities track record has been less than stellar in recent years. 

“If you think about global equities at 105 [Australian cents to the US dollar] or so, they look terrific,” he said. “At 92, they’re somewhat less interesting. 

“You go back 20 years and global equities have performed pretty badly for superannuation funds,” continued Wills. 

“And you’ve probably got two factors working heavily against equities for an Australian superannuation funds investor; number one, there’s no franking credits, where you have that lovely 150 basis points every day that you get out of bed. 

“But the second thing is that we’ve had this move from the Australian dollar over a very long period, from 48 cents to whatever the high was, 108 or 109, and there are also some pretty significant macro factors that affect an Australian investor, factors which are far less pronounced for other global investors.” 

In the current environment, Wills said that the key for investors was being discerning. 

“So I’m not saying carte blanche that you wouldn’t be keen on them but you certainly need to be looking at some reasonably specific areas of the world,” he said. 

“You need to be looking at regions where you think there are some engines of growth that simply don’t exist in the Australian equity market.” 

Looking at how global equities would fit into super fund portfolios over the longer term, Hogg said that a degree of rebalancing was somewhat inevitable. 

“Look, I imagine we’ll see, if not an increase in global equity exposures, most likely a reduction in Aussie equity exposures,” he said. “Certainly, there will be a bit of a rebalancing. 

“Most funds have more in Aussie equities than global equities, but it seems likely that there will be a bit of a move away from Aussie equities and that may go to global but it may also go to other sorts of things,” Hogg continued.

“Some of these floating rate debt instruments, for instance, may well get an increased share of the portfolio. 

“I think there’s a sense that, for a number of different reasons, funds would like a little less equity volatility, and they can of course do that by either having less equities or looking more at protection strategies; derivatives, options, related strategies.” 

The reality, according to Hogg, was that the domestic situation had fundamentally changed. 

“Behind all of this, there’s a concern that the Aussie economy and, by extension, corporate earnings have really been huge beneficiaries of a huge tail wind,” he said. 

“We’ve had, of course, the terms of trade, the whole China thing, and that’s been a huge positive. 

“Now they’re coming on balance, certainly less positive and maybe even negative, so we’ve had that come and go – but it had a huge impact on earnings through the mid-2000s,” continued Hogg.

“So look, I don’t think there’s any doubt that we’re facing ongoing deleveraging here. 

“When you put that together with the fact that we’ve had this 150-year terms of trade boost come and go, those two factors together suggest that Australian earnings growth, both earnings derived from Australian activities and global activities, might be a little bit less compelling than it’s been relative to a lot of these global markets.” 

Yet a softening Australian dollar has not been the only shift of significance for Australian superannuation investors in recent months. 

According to Carew, changes within the resources sector have already been a factor and may continue to cause concern for investors moving forward. 

“On the resources side, that concern I think still stands, that the Australian equities market is quite exposed to that sector,” he said. 

“And when you have China likely to have a slower pace of growth in the future, particularly compared to what it had during the previous 10 years, not to mention more risk around the Chinese economy as it tries to do this transition from an export/investment driven economy to a domestic/consumption driven economy, the impact of so many unknowns is significant.” 

Clarifying further, Hogg pointed out that a number of resources stocks had already underperformed in the eyes of investors. 

“The ancillary firms – the contractors and so on – they’ve been very, very badly burnt as well,” he said. “So I think the market’s just trying to get a better understanding and more clarity about the new leadership in Beijing. 

“On the surface, it seems that the Chinese are keen to grow the economy at a still reasonably solid but just slightly less rapid rate. 

“If you’ve got a big economy, growing even at say 7.5 or 8 per cent or thereabouts, you’ve still got a huge growth in demand in terms of dollar and volume year after year,” Hogg continued. 

“But I think some of it is the market trying to work out just how keen the new leadership is to underpin growth or just how keen they are to shake out some of the excess. 

“Add Shibor to the mix and the result is a great deal of uncertainty about just how active or otherwise the policy makers there will be to enact policies that actually underpin growth.” 

Indeed for Olivia Engel, head of Australian active equities for State Street Global Advisers, the impact events in China are having on Australia’s resources sector should serve as a reminder for investors. 

The point, she said, is that it is the source of a company’s returns that is important, and not necessarily the country in which it is domiciled. 

“So when constructing portfolios in Australian equities, the point I’d make is that BHP is 9 per cent of our market and it ends up being 9 per cent of most people’s Australian equity portfolios,” she said. 

“That’s perhaps not surprising because the benchmark weight or the weight of a stock in the market is almost the starting point when deciding what allocation an active manager will give to that stock. 

“So the active manager will say ‘okay, I’ll go underweight BHP but I’ll still hold 7 per cent of my portfolio in it,’” Engel explained. 

“Now the reality is that is a major concentrated position in a portfolio and it’s just random chance that BHP happens to be domiciled here and therefore is part of the ASX. 

“I find that really interesting when you’re looking at the average portfolio and how the benchmark dominates that decision to invest.” 

Giving insight into SSgA’s investment philosophy, Engel said that it was also proof that building portfolios that were less focused on benchmark weights could provide very different results and very different return outcomes. 

“So it is absolutely right to say that it is what the company does and what drives its returns that is most important, not where it is domiciled,” she said. “If you’re looking at a global portfolio, that’s entirely true. 

“In terms of our focus, we are focused much more on characteristics rather than individual companies,” Engel added. 

“Our objective is to increase breadth as much as we can and to get exposure to as many companies as possible with certain characteristics, be they solid valuations, high quality, growth potential, strong sentiment, whatever. 

“So knowing the details – the in’s and out’s of every individual company – is not what our investment process is trying to do. It’s trying to get as much exposure to a broad range of characteristics as we can.” 

Looking to the future and the global/domestic balancing act super funds would be required to perform, Hogg said that the deciding factor would undoubtedly be the local market outlook. 

“It has to relate back to the outlook for Australia relative to the global market,” he said. “We’ve really had the best of times in recent years but moving forward, it seems likely that we’re set for a slightly less alluring outlook. 

“While that doesn’t necessarily mean that you want to have more global equities, it does more than likely raise questions about how much you want in domestic equities, whether you’ve got too much.” 

Yet for those funds looking to push further into global equities, Carew reiterated his advice that chief investment officers would need to be discerning. 

“We still have that preference for those quality companies that have strong balance sheets and market pricing power, those that are quite robust and strong,” he said. “And I say that because it’s a difficult world out there still. 

“But I suppose the more subtle change over recent months has been to recommend that funds have some reasonable exposure to value style in their portfolios,” Carew continued. 

“I say that because while a lot of those companies have been underperforming quite substantially, there are still some quite good companies in that space – and with the evidence of stabilisation and recovery in the US economy, they have a far greater potential to significantly increase their earnings. 

“There’s potentially some good upside from them and so we think it’s a good idea for funds to make sure they’ve got exposure to that effect in their portfolios.” 

According to Davis, for those super funds weighing up their options in global equities, the guiding light had to be diversification. 

“At the end of the day, this market, just given the growth and the expected growth of superannuation here and the relative size of the Australian share market, over time some of that money will inevitably go to the international markets,” he said. 

“I think it’s an evolution that happens in every market and I expect that to continue because the investors, at the end of the day, realise the diversification benefits and they recognise that we’re talking about a local market which is very heavily concentrated in two major sectors and a very small number of securities. 

“The point we always try to make is around diversification and ultimately making sure you keep that long-term perspective,” Davis continued. 

“Every day we’re going to get news headlines that have market-moving impacts and things of that nature. 

“But if you set up your investment goals and set up your strategies, then all that’s left is sticking to it – making sure you do so in a low-cost way.”

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