By Patrick Cairns, 3 February 2015
Last year was a strange one for equity investors. There was a huge divergence of returns in different parts of the world, which made being in the right place critical.
Using figures from MSCI indices, the US market grew by a healthy 13.5%. However, just about every other developed market in the world lost money in US dollar terms. Japan was down 3.4%, the UK was 5.4% lower, and Europe fell 5.7%.
“This is the widest gap ever seen between US and European returns since the MSCI indices were created,” says Colin McQueen, senior portfolio maanger at Sanlam FOUR in the UK. “And there was a similar divergence in emerging markets.”
While Indonesia and India performed strongly, returning 27.5% and 23.7% respectively, Russia dropped by 45.9% and Brazil by 14.0%.
McQueen believes that geopolitics had a significant impact in causing this wide range of outcomes. The conflict in the Ukraine and the subsequent sanctions on Russia were putting pressure on that market even before the fall in the oil price, while the markets in India and Indonesia responded very positively to the elections of new leaders there.
It was, he says, a year in which politics probably had a bigger than normal impact on equity returns. This was due to the current environment, which is so characterised by uncertainty and low growth.
“In boom times markets are less critical of government policies,” he says. “But in a weak environment the challenges are bigger and policy mistakes are more impactful, so markets are looking for dependable leaders.”
The decline in Russian equities is perhaps the clearest example of how sharp the interaction between politics and economics became in 2014.
“In any year that the oil price falls heavily, Russia is not going to be the world's winning stock market,” McQueen says. “But the fact that the politics has been bad at the same time has doubled up the impact.”
He points out that the country is now facing this tough economic environment in a time when they have cut themselves off from the world economic system and money is starting to flow out of the country.
“Bad economics with bad politics is just very negative for markets,” he says. “And we still don't know what's going to happen next, so there is further room for this to run.”
The divergence in developed markets really happened in the second half of 2014 in response to aggressive moves from the European and Japanese central banks towards quantitative easing (QE). This happened at the same time that the US was exiting QE and talking about when it might be raising interest rates.
This led to the realisation that although the US recovery is taking shape, it is not yet strong enough to take the rest of the world with it. The dollar therefore strengthened appreciably as the US looked even more like a safe bet for investors, and cash was drawn back into the domestic market.
For McQueen, the divergence in emerging markets also has to do with the performance of a major economy – China. The economic slowdown there has meant a drop in commodity prices, which are so important to many developing countries.
“While China was growing, there was a strong linkage between a lot of emerging markets,” McQueen says. “It pulled along a lot of countries that were exporting commodities. However the years of uninterrupted growth in China are probably behind us, and that means that emerging markets will start to behave much more differently to each other as the domestic growth drivers and domestic politics become a lot more important.”
Although the US recovery remains the major global economic story, McQueen points out that the valuations of US equities are now close to historic averages and represent fair value. Stocks in the rest of the world, and Europe in particular, are however looking relatively cheap.
He says that in an environment like this, it's important not to equate a stock market directly with an economy. Since many companies have become more international and generate substantial profits outside of where they are listed, there is an opportunity to buy companies in Europe that are highly exposed to other geographies.
“We can take advantage of people selling down European markets,” he says. “We can buy things where are other people are not looking.”
One example in their portfolio is aircraft manufacturer Airbus. McQueen argues that Airbus and Boeing split the market for commercial aircraft about 50/50, and there is very little differentiate them in that respect. Yet the Airbus share price was down 35% last year, while Boeing was more or less flat.
With an order backlog that equates to nine years at current rates of production, there is little to suggest that the company won't continue to generate revenues and cash flow. It also has the advantage of selling in dollars, but having a cost-base in Euros at a time when dollar strength is a dominant theme.
Since Airbus is now trading at multiples appreciably lower than those of Boeing, McQueen sees this as one example of how it is possible to get exposure to the US economy much more cheaply through other markets. And this may be one of the most important considerations in a year where equity investing will once again be a tricky business.