Where to invest next?

Whether this latest twist is remembered as a bold strategy or more reckless bluster by Boris Johnson’s government will be down to posterity. What is for sure, coming amid the precarious next phase of managing the coronavirus, for the remainder of 2020 investing in sterling-denominated assets will be fraught with trepidation.

Uncertainty often equals opportunity, but the key is to pick attractively valued investments with a catalyst to re-rate. In the UK, there is the powerful combination of an unloved stock market and some unfashionable industries; and a weaker pound will once again increase the desirability of companies with overseas revenues.

This is the bull case, but investors aren’t limited to the UK in their search for upside, and around the world there are other pockets of equity market value to be had. Each has its own idiosyncratic risk, yet could come good and boost portfolios while the UK sweats on the outcome of Mr Johnson’s game of Russian roulette with the European Commission.

The coronavirus is a global pandemic, but economies still face unique challenges as they struggle back from it. Alongside Brexit risk, the eurozone is troubled by tensions between the frugal north and fiscally weaker southern states; political friction is possible in Japan following the sudden resignation of prime minister Shinzo Abe; the workings of China’s financial system remain opaque; Sino-US trade tensions won’t go away overnight; and there is the small matter of the 2020 US presidential and congressional elections.

Valuations fundamental in balancing risk and reward

Cheaper stock markets don’t necessarily outperform going forward; the US's Nasdaq has been expensive for years and yet the S&P 500 continued to trounce other country indices. What valuations do show, though, is the level of compensation investors expect for various known risks, and that should help investors decide whether, say, a no-deal Brexit for the UK is priced more fairly than the Democrats winning the White House plus control of Congress and increasing US corporation tax.

German asset management firm Star Capital rates 40 international stock markets on a variety of metrics to produce an overall value ranking. As of 31 August 2020, the UK was the 14th cheapest stock market, with the US the third most expensive.

Based solely on the cyclically adjusted price/earnings (CAPE) ratio, the UK market is 10th cheapest. Popularised by Yale professor and Nobel laureate Robert Shiller, CAPE looks at price relative to inflation-adjusted earnings over several years, smoothing performance over time.

While not an effective tool for market timing – high CAPE ratios don’t hint a sell-off is imminent – lower rankings have been a reliable indicator of forward rates of return in developed markets such as the UK and the US.

Other measures Star Capital uses include trailing price/earnings; price-to-cash flow; price-to-sales; and dividend yield. They also compute price to book value ratios from index constituents’ most recent financial statements. Data is collected for listed companies included in MSCI country indices and weighted by market capitalisation to calculate aggregate figures.

Finally, the relative strength (RS) of market prices over 26 and 52 weeks is considered. This is interesting as comparing prices to rolling averages can be a value indicator if they undershoot (the value argument would be to expect mean reversion). Relative share price strength signals momentum, too. If over a short period, such as one or three months, the RS is below one then negative momentum may have further to run. When, over these durations, RS is above one it often suggests more near-term upside is to be had.

Backward-looking data has limitations, especially as the Covid-19 pandemic and societal fallout is seismic for company earnings, but splicing several metrics together does take account of more risk factors. Furthermore, now companies have reported post-Covid results, the figures are becoming more useful.

Given the challenges facing companies, investors may put more weight on price-to-sales and price-to-cash flow. On the first of these measures, the UK market is still 13th cheapest, but on price-to-cash flow it comes in 21st.

Overall, the UK is certainly not dear, so from a pure value perspective looks attractive. Is now the time to overweight the UK stock market in your portfolio, though? It all comes back to the question of pricing risk and comparing Britain’s situation with its peers.

Germany provides a case point. Although its manufacturing output was hammered when the global economy shut up shop in spring, PMI data for the sector is now healthier than it was before the crisis. German shares rate more cheaply than the UK market and as the global economy recovers, demand for the country’s famed capital goods has scope to rise.

Risks faced by Europe’s economic powerhouse include deteriorating relations between China and the West and tougher trading conditions with the US. Both problems would be ameliorated if Joe Biden wins the US presidential race, which looks better than even odds right now, providing a catalyst for realising German value.

France is often compared to the UK as the two countries have similar-sized economies. Stock markets aren’t the same thing as a nation’s output, but Britain and France have the same weighting in Star Capital’s analysis. On their composite value rating, the UK market is more attractive (14th versus 25th) but there must be an appreciation of which sectors drive performance and their relative recovery potential.

The UK has a high weighting to financial companies, which are a mixed bag. Asset management businesses should do well in any recovery, but low bond yields create problems for insurers and banks, which will also have to count the cost of loan impairments in a tougher economic environment. On top of that, there are the geopolitical issues facing Asia-focused banks such as HSBC (HSBA) and Standard Chartered (STAN), as well as insurer Prudential (PRU).

Then there are the oil & gas and mining giants that are listed in the UK, many of which have also slashed dividends this year, weakening the case for holding them.

The French market is more skewed towards consumer goods and industrials so, like Germany, could benefit from an improvement in global trade. The recent strength of the euro does provide a headwind, as does the prospect of a no-deal Brexit, which isn’t bad news for the UK alone.

Europe isn’t expensive; Spain and Italy are the 7th and 9th cheapest countries, respectively. Their stock markets have a less significant global weighting, but listed international businesses could thrive on the generosity of EU fiscal stimulus, although that is under intense scrutiny by northern countries in the bloc. Overall, though, using an exchange traded fund to invest in the largest businesses listed on European exchanges (and spread country risk), looks like a good risk-reward trade.  

The UK market is historically cheap, but so are other regions

Mean reversion is a core tenet of value investing, so how Star Capital’s current CAPE scores compare with long-run average figures is worth noting. Undeniably the UK is cheap; the mean average 40-year CAPE of the UK MSCI index is 15 and the median of 14.8 is also above the 12.6 figure currently.

German shares are also below their long-run mean CAPE of 20.1, with the August 2020 figure of 17.3 a significant undershoot. France is on a CAPE of 18.3, versus its historic mean of 21.4. So, although there is a value case for UK upside, the same is true of other stock markets.

One significant country that UK investors are historically underexposed to in their asset allocation is Japan, a market that recently piqued Warren Buffett’s interest. Long-run average CAPE scores are not useful to assess Japan, as the effect of its 1980s bubble was so distortive, and its current CAPE doesn’t compare especially well to many developed markets. On price-to-cash flow and price-to-sales, however, Japan is at least as attractive as Germany, France or the UK.

Weighted 8 per cent of the global equity market universe, Japan ought to be too big to ignore. For many years the country’s GDP growth has stagnated even as it pioneered much of the modern monetary theory now being adopted worldwide to finance stimulus. Perhaps investors are put off by this and the valuation picture is hard to grasp.

Maybe people give up on what they don’t understand. Looking at its PE or dividend yield, Japan isn’t especially compelling, but then lower dividends attest to circumspect payout ratios and the balance sheet strength of many Japanese companies. An interesting question for would-be investors in Japan is what to do about the currency risk? Given the yen’s haven status, perhaps an unhedged exposure to Japanese shares is an added diversifier, although a weaker yen could weigh on gains during risk-on periods for asset markets.

Investors’ American conundrum

Many investors struggle with the expensiveness of the US stock market, which as well as being the third least attractive on Star Capital’s spliced value rating, has a CAPE way higher than its historical average. Using the MSCI country index score computed by Star Capital, the US has (between 31 December 1979 and 31 August 2020) a mean CAPE of 21.1 yet the current figure is 31.9, adding weight to the argument that the stock market has lost touch with reality.

Professor Shiller’s CAPE is based on the S&P 500 index and back-tested equivalents from 1871, and 17.1 is his long-run mean value for the US benchmark. From December 1979 the mean is 22.1 and comparison with the August 2020 figure of 30.6 tells the same story as the Star Capital data. That said, there is still some way to the 44.2 level the Shiller CAPE index reached at the peak of the dotcom bubble at the turn of the millennium.  

Some argue talk of a new stock market bubble is wide of the mark. Zehrid Osmani, manager of Martin Currie Global Portfolio Trust, acknowledges the US market is closer to the top of its historic CAPE range compared with European equities, but urges the need to “consider the constitution of the [S&P 500] index, given the sizeably increased weight of technology in the US market versus historic averages”.

Recent bouts of selling affecting US tech stocks is partly attributable to activity in the stock options market, as big institutions (notably Japan’s Softbank) have taken leveraged bets on continued growth. Added to that, tech is a crowded trade amongst inexperienced and more easily spooked retail investors, so the situation is combustible if future tech earnings fall short of expectations.

Despite this sensitivity, there remains a clear pathway for growth. In the view of Paul Niven, manager of F&C Investment Trust: “While current valuations leave little room for disappointment, the pandemic has accelerated many previous trends and consolidated the position of companies with strong financial and market positions.”

Performance the likes of which Microsoft and Amazon have delivered this year is in marked contrast to the bigger names on UK and other European markets. Buying the US is a growth play on the world’s greatest companies today continuing to lead the future. By contrast, buying the UK market is a judgement call on businesses that face structural challenges (like banks and oil & gas majors) or are in cyclical industries (like mining) realising value.

Risk-free returns are no more

Tech stock prices will pull the US market lower if the FANMAGs (Facebook, Apple, Netflix, Microsoft, Amazon and Google’s parent, Alphabet) post lower than expected profits in any given quarter. Yet, the other major factor in the high value placed on them is that, even when growth targets are missed, generally reliable FANMAG cash flows offer a compelling earnings yield in a world of low interest rates and negative real yields on government bonds.

Equity valuations must be contextualised by their relationship to other asset classes, especially safe government bonds. US Treasuries are considered free of default risk, as well as being highly liquid (although a breakdown in trading was one of the key reasons the Fed intervened so decisively in bond markets in March).

The difference between the implied forward rate of return from shares and the yield on government bonds is known as the equity risk premium (ERP) and so long as it adequately compensates investors for owning shares, buying a slice of companies’ profits makes sense. Since the Fed’s Open Markets Committee reduced its target federal funding rate to between 0 and 0.25 per cent, the yield on benchmark 10-year USTs has tumbled to around 0.7 per cent, which casts a favourable light on the US stock market.

Going back to 1900, research by academics Elroy Dimson, Paul Marsh and Mike Staunton (in a data series first published in their book, Triumph of the Optimists and updated annually in the Credit Suisse Global Investment Returns Yearbook), US shares have offered a 6.5 per cent annualised real (after inflation) rate of total return. This equated to a real equity premium over US Ttreasuries of 4.4 per cent a year.

Over the past few decades, a secular bull market in bonds has meant the US the equity risk premium (ERP) between 1970 and the end of 2019 was slashed to 2 per cent (and was negative in the 2000s), but since government bonds have been astronomically expensive since the 2008 global financial crisis, the Credit Suisse Yearbook shows the ERP recovered to 5.6 per cent in the 2010s.

While it is wildly optimistic to suggest the US market can repeat the 10.6 per cent real annual growth rate it achieved in the 2010s (which came off the 2009 low and was underpinned by quantitative easing and a technology profits boom), arguably bond prices have even less room to rise. This means US shares are still attractive.

Société Générale’s Cross Asset Research team has calculated that, as of the end of August, this is certainly the case. Working out (from the current market price, a splice of forward earnings estimates and long-run growth rates, and company payout ratios to shareholders) that US shares imply a 6.6 per cent rate of return, they subtracted the 10year US Treasury yield at the time, to give an ERP of 6 per cent.

Based on SG’s data analysis going back to 1980, the current implied premium has US shares looking historically cheap versus bonds. So, although when equities are considered as an asset class in isolation the US market doesn’t seem compelling versus other regions, as part of a multi-asset portfolio you shouldn’t dismiss it. This is important, because the US accounts for around half of equity market capitalisation worldwide, so being out of it could lead to significant underperformance.

SG: “Time to look at emerging markets after a lost decade”

Overall, developed equity markets are looking cheap relative to a weighting of their local 10-year government bond benchmark yields. The SG research calculates the implied DM equity premium to be 6.3 per cent versus a 30-year average of 4.1 per cent.

As well as supporting the case for equities in developed market asset allocations, the SG report also suggests how investors can position themselves for emerging market upside. They note that although the premium for emerging market equities over developed markets has narrowed, the longer-term growth prospects of these regions remain greater and, crucially, the narrowing of growth expectations versus developed markets appears to be bottoming out. Signs that recent US dollar strength is ending also helps emerging markets.

Interestingly, SG’s analysis shows that the current average equity premium for emerging markets is, at 5.5 per cent, only a little above the 20-year mean. This, they say, has largely been driven by Chinese equities rebounding strongly as the country recovered from Covid-19. There are more secular factors, too.

Improving access to China A-shares (those listed on Shanghai and Shenzen exchanges) has driven down the cost of equity for Chinese companies. As China is approximately 40 per cent of emerging markets, this has an impact on multi-country indices.

Moves to open China’s $35tn bond market to outside investors provides further subtext for asset allocation. MSCI China index offers an historically low premium versus government bonds but, as China’s capital markets liberalise, and more buyers drive up the price of debt, will this continue?

Returning to Star Capital’s composite value rating, MSCI China is the sixth most attractive equity market, which reflects geo-political tensions but also offers up an intriguing opportunity; China is not likely to diminish in importance as the 21st century progresses.

For its part the SG team urges caution on emerging markets in general, with its risk-adjusted measure (the ERP divided by one-month equity volatility) still indicating investors should prefer emerging markets bonds over shares. Of course, retail investors have fewer ways to access the emerging markets bond market, especially in local currencies (although our top 50 ETFs this year has a dollar-denominated option).

At least understanding the local risk dynamic is useful before buying into emerging market shares. The opinion of the SG authors is that the resilience of China and Taiwan (where shares look more attractive than bonds) is a good place to focus for adding EM equity exposure.

Plenty of opportunity to spread risk

So, while it is true value investors are being offered quite the inducement to buy UK-listed shares, both in absolute terms and relative to UK government bonds, the risk to reward trade-off for other stock indices around the world looks attractive. Investors have an international buffet of risks to choose from, so as the UK dices with realising some of its worst-case Brexit scenarios, it is worth looking elsewhere. Especially as these days exchange traded funds and investment trusts make it easy to think globally.

The world's best value markets and regions

Table source: Star Capital Research, Thomson Reuters Datastream, MSCI; ERP by Société Générale Cross Asset Research