Equities riding in the slipstream of a global recovery

Private bankers view the start of 2014 with an increasing sense of optimism that borders on excitement, which they are expressing by going overweight equities.

Their investment destinations are, however, at first sight surprising to European clients who read every week in their newspapers about the decline of Europe when faced with leaner, nimbler competitor countries.

The answer to the search for strong stockmarket performance lies, say European private bankers, in their clients’ own back yard: not among the dynamic economies of Asia, or even among the mature but structurally higher-growth US, but in the ageing, indebted, low-growth economies of Europe.

JP Morgan, Credit Suisse and ABN Amro are all overweight Europe, as well as overweight equities in general – with the latter two both taking this stance in October. Coutts is overweight Europe ex-UK.

Private clients might ask why, if they must heed their bankers’ advice to enter the high-risk world of equities, they should invest in stocks listed in a region constrained by so many factors. Is this really the market to enter as investors stand on the edge of a New Year which may, if all goes well, be seen as the time that the credit crisis finally came to an end?

Global reach

JP Morgan Private Bank’s enthusiasm for Europe can be explained largely by one arresting statistic: 42 per cent of the profit of the average listed European company comes from outside the continent, JP Morgan research shows.

“European companies will be great beneficiaries of the global economic upturn,” says Raj Tanna, portfolio manager at JP Morgan Private Bank Emea in London. The bank has calculated that a higher proportion of this profit is from emerging markets than is the case for US counterparts. It cites the latter’s greater reliance on their huge domestic hinterland.

Private bankers say this desire for European brands will include both designer labels and mass consumer goods. “Emerging market consumers aspire to Western brands,” notes Mr Tanna. Wealth managers cite L’Oréal as an example of a producer of mass-market brands that will benefit from this, and Burberry as a case of a luxury brand set to gain further from the phenomenon.

Looking in more detail at European sectors, JP Morgan favours consumer staples, consumer durable stocks such as white goods and global service-sector companies such as hotel chains. These will all benefit from growing emerging market affluence, though the bank sees consumer staples as the most exposed to this of all. While hedge funds and other investors have concentrated on companies in peripheral member states, beaten down to ultra-cheap levels by the vicissitudes of the eurozone debt crisis, JP Morgan’s primary interest lies in big household names.

The bank also detects an improvement in domestic European economies. Because of this uplift in both foreign and home-grown demand, it predicts that next year will see profit growth among European listed companies for the first time in three years.

The brightening backdrop makes it a lot easier to persuade European clients to believe in European stocks as an investment proposition, says Mr Tanna. Many European clients have seen, through their own businesses, that Europe is “in a lot better shape than before”.

Wealth managers certainly see positive reasons to push clients into equities, but their enthusiasm is heightened by considerations pulling them away from other asset classes. An ABN Amro Private Bank lower-risk portfolio with a long-term benchmark allocation of 55 per cent to bonds and 30 per cent to equities is currently much more skewed towards equities – with a present allocation of only 37 per cent to fixed-income and 44 per cent to stocks.

“There are positive reasons for investing in equities, but there is a lack of alternatives as well,” says Didier Duret, chief investment officer at ABN Amro Private Banking. He settles upon Irish sovereign bonds as the ultimate example. In mid-November the 10-year offered a yield of only 3.6 percent, the month before the country was set to leave its emergency international bailout programme.

However, the return of the domestic economies of Europe to something approaching normality also motivates ABN Amro to advocate more investment in the region’s equities. This includes the UK and other European markets which, even though they are outside the eurozone, are still heavily dependent on trade with the currency union.

“It is almost ironic to say that people are optimistic because they expect growth of more than 1 percent in Europe,” says Mr Duret. “But what is important is the pace of change.”

ABN Amro forecasts eurozone GDP growth of 1.3 per cent next year, but with a risk to upside. Growth of 1.3 per cent will be pretty good if achieved, compared with the International Monetary Fund’s latest prediction that it will shrink by 0.4 percent this year. Private bankers credit this to continued strengthening of the structures for preventing eurozone crises. The process of creating pan-European processes for strengthening the currency union was given fresh encouragement by German chancellor Angela Merkel’s September election victory.

Given this progress, wealth managers believe Europe’s still relatively low valuation multiplies – long seen as a form of risk premium to allow for the possibility of another plunge into crisis – are no longer justified. Kevin Lyne-Smith, head of single securities research at Credit Suisse Private Bank in Zurich, calculates that at 11, the forward price-earnings ratio for the Euro Stoxx 50 is 15 percent below its long-term average.

The direct approach

Despite the attractions of European equities, several private banks still believe that one of the best ways of tapping into the growth of the emerging market middle class is directly through emerging market equities. Private bankers think this can be done either through individual stock selection or, for China and other markets seen as undervalued by standard measures, through investment in whole-country equity indices.

They acknowledge that clients are concerned about the recent dismal performance of many emerging markets – one private client manager refers to the need to “pacify” clients, who have complained about these markets’ poor showing in their portfolios. Most emerging markets also lack the firm sense of an economy and society emerging from trouble – one of the main considerations which draws private bankers to Europe.

They do, however, have their zealous apostles. BNY Mellon Wealth Management is moderately overweight emerging market stocks, citing the high growth rates of many of their underlying economies. Jeffrey Mortimer, director of investment strategy for BNY Mellon Wealth Management in Boston, acknowledges that they have not kept up with developed world equities this year, but “the fundamentals are slowly improving, and valuations have clearly become a rallying cry”.

With the tailwind of strong US growth, the emergence of Europe from recession, and China’s success in avoiding an economic hard landing,  he believes that “2014 could be a very good emerging market year”.

BNY Mellon is also overweight US equities, with a concentration on large-caps. This is based partly on a relatively bullish view of the US economy: its forecast of 3 per cent output growth for the next three years contrasts with what Mr Mortimer refers to as the “softer-shaped recovery” in Europe. The bank also sees US large-caps as a way of capitalising on robust global economic growth, including the same theme of the rise of the emerging market middle-class identified by JP Morgan and other banks.

Other private bankers now find valuations stretched, however. At almost 19, the S&P’s trailing price-earnings ratio is far above the long-term average of about 14.5.

Coutts also advocates heavy investment in emerging markets in the coming year. Niamh Wylie, portfolio manager at Coutts in London, asserts that at only nine times forward-earnings for the MSCI China index, China “remains quite a cheap market”. Ms Wylie acknowledges the disappointing recent returns in many emerging markets, but exhorts investors “to think of long-term factors such as the doubling of China’s middle class over the next decade”.

Private bankers also see Japanese stocks as benefiting from the general growth in global trade, although Japan does not have the same number of aspirational brands which attract emerging market consumers.

Conceiving of such grand themes as the rise of mass affluence in emerging markets means nothing, however, if clients are not prepared to buy into them by investing in swathes of the equity market.

Private bankers say that clients remain nervous about equities, following the sharp falls of 2008-9. For example, although Pictet Wealth Management has increased its equity allocations over the past year from 35-40 percent to 45-50 percent for mid-risk discretionary portfolios, it accepts that investors need to be encouraged to wade deeper into the choppy waters of the equity market – and stay there. 

“Client managers tell me they do not yet see a massive increase in the appetite for equities,” says Yves Bonzon, chief investment officer at Pictet Wealth Management in Geneva. He cannot, he makes clear, blame them for this: “After 10 years with two declines in excess of 50 percent in major indices, an appalling performance by equities, and a lot of volatility, clients have started looking for opportunities in all sorts of asset classes” – and if they have been prepared to invest heavily in equities, this has often been in high-dividend, high-quality developed world stocks. Such investment is, he says, “part of a broader story of volatility minimisation”.

Pictet thinks, however, that excessive fear of volatility risks harming customers’ portfolios. “Clients have to be able to define their mid-term strategy clearly, and then stick to it,” says Mr Bonzon.

“The single biggest factor in capital value destruction in wealth management is myopia. Clients construct portfolios for the medium term, but then change course. The best service you can give to a client is to say, ‘please, please do accept some reasonable degree of volatility’.”

Falls in equities and other risky assets of 5 and 10 per cent should be considered as nothing unusual, Pictet believes, within the context of long-term performance.

The long view

Other private banks are grappling with the same conundrum: how to persuade their clients to take a longer-term view. BNY Mellon acknowledges that while the perfect client might take a seven to 10-year view, some customers have become very short-term-oriented. Mr Mortimer credits this to a combination of greater “newsflow”, with clients glued to newspapers, websites and business channels in the 24-hour media age, and the “volatility scars” left by the turbulence of the 2008-9 financial crisis and the tech bust at the beginning of that decade. “They believe that any correction could lead to a full bear market” says Mr Mortimer.

On the other hand, private bankers also see volatility as, if not necessarily a friend, certainly a potentially useful acquaintance. Many took advantage of October’s partial shutdown of the US federal government, which roiled global stockmarkets – seizing the opportunity to buy on the dips. The rally in US stocks afterwards allowed private banks to take substantial profits built up in recent years on US equities, with the money in many cases recycled into the cheaper European market.

Making use of such volatility is not for the faint-hearted. It is time, however, for clients to remember Warren Buffet’s advice: be fearful when others are greedy, and greedy when others are fearful. They need, now, to take note of the second part of the maxim. 

Picking winners

For wealth managers the easy part is over. In many stockmarkets the great across-the-board surges in growth are largely or entirely exhausted. Now, more than ever, individual stock selection is essential, say private bankers.

This is particularly so in the US, given the rise of the Dow Jones Industrial Average to record highs. Research by BNY Mellon Wealth Management finds that in late-stage bull markets – a fair description, in its view, of the current US situation – correlations between stocks fall. Given that valuations are no longer uniformly cheap, it becomes harder for individual companies to impress investors. “We will start to have fewer and fewer names doing extremely well, leaving the rest of the market behind,” predicts Jeffrey Mortimer, director of investment strategy for BNY Mellon Wealth Management in Boston.

Jeff Mortimer, BNY Mellon Asset Management

BNY Mellon’s point is already borne out by statistics: the average correlation between stocks in the S&P 500 has fallen from close to 90 percent “in the dark days of the sub-prime and euro crises” to only 36 per cent, says Didier Duret, chief investment officer for ABN Amro Private Banking in Amsterdam. He cites figures from the Chicago Board Options Exchange.

Nowhere is the diversity of performance more apparent than for US bank stocks. Credit Suisse Private Bank draws a contrast between banks such as JP Morgan that have been hit by their concentration in the slowing fixed-income trading and mortgage markets, and Morgan Stanley, which has increased profits by beefing up its equity trading and asset management.

The need for good stock selection has become all the more pressing because of a new factor: the growth in huge fines imposed by regulators on both sides of the Atlantic, most particularly on individual banks. JP Morgan agreed in October to pay $13bn (€9.7bn) to settle claims related to mortgage bonds.

“Governments have an increasingly confiscatory attitude towards capital,” says Yves Bonzon, chief investment officer at Pictet Wealth Management in Geneva. “The costs are getting so punitive that in banking, only the biggest can survive. Other industries, including healthcare, face the same issue.”

Conventional wisdom holds that stock selection really comes into its own in emerging markets. Analysts’ coverage is spread more thinly, making it easier to find previously undiscovered treasures.

However, Coutts believes that active management can also unearth nuggets of value among European small and mid-sized businesses, which are often not covered extensively.

If private bankers are right in believing that stockpicking has become vitally important, it will be harder for clients to go it alone, managing their own portfolios through broad strategic allocations.