29/01/2007
The Benefits of a Globally Diversified Portfolio
Some UK assets have enjoyed above average returns during the last three years. In our view this is unlikely to be repeated in the medium term. To enhance returns going forwards, investors could diversify overseas, in order to benefit from stronger earnings growth from equities and lower inflation for bonds than is likely from the UK. One issue for multi-asset investors, however, is whether to hedge excess overseas currency exposure. Our analysis suggests partial hedging is the most optimal solution.
Summary
So what are the benefits of overseas investing for a UK based investor? In this article we examine the issue in a number of ways. The forces of globalisation open up pitfalls and opportunities for UK investors investing overseas – we discuss how UK investors can navigate such forces. We think UK investors need to consider the extent to which overseas equities have a high domestic sales exposure as well the degree to which growth sectors are represented within these stock markets. A consideration of valuation differences across a range of assets, as well as the corporate earnings and inflation outlook are also discussed. When UK investors come to consider currency exposure we suggest a strategy that may be the most optimal.
Going global
The global economy has become more integrated over a number of decades as trading and investment links between countries have deepened. The creation of the North American Free Trade Area (NAFTA) in 1994, the euro in 1999 and the expansion of the EU over several decades including into Central and Eastern Europe in 2004, have all been influential in this process. In recent years the co-ordinated expansion in many of the world's major economies, and China's emergence as an industrial superpower within an Asian region that has shrugged off the late 1990s regional crisis, have been powerful drivers. This has been reflected in the pick-up in world trade growth. Another important piece of the jig-saw is the proliferation of the use of the internet. This has proved to be a strong dis-inflationary force acting on the traded goods and services sectors, and has made it an easier and cheaper way for business and individuals to communicate. All these trends can be characterised as important factors in the globalisation of the world economy.
Given these trends what are the implications of the globalisation process for the investment decision-making process of UK based investors? One issue is the fact that economies are much more cyclically coordinated. Over the last five years for example, the correlation of the business cycle in the G3 economies, US, Japan and Germany has reached 77%, compared to 56% in the five years before then.
Recently, these links have been reflected in investors' perceptions that the world economy is starting to enter a co-ordinated slower growth period. To some extent this has been driven by the monetary tightening in the US where interest rates have risen by 4.25% in two years and bond yields had up until summer 2006 backed-up. In addition, the end of quantitative easing and subsequent withdrawal of liquidity by the Bank of Japan from the Japanese financial system, as it prepared to raise interest rates from zero, has been another liquidity constraint investors have had to overcome. One obvious concern for UK equity investors is how exposed they would be to this sort of slowdown, either from overseas share holdings or holdings of UK companies with strong overseas sales.
As an example, table 1 shows the likely impact on export and GDP growth for many of the world's important economies in 2006 and 2007 if US consumer spending 'soft lands'. Here we assume spending slows steadily from 3.5% p.a. in Q1 2006 to 1.5% p.a. in Q1 2007, before accelerating again to 3.5% p.a. by the end of 2007. We make use of the Oxford Economic Forecasting (OEF) model of the world to test the likely reaction of other economies to this US consumer slowdown. Within the model we assume that there is no interest rate response from the Federal Reserve to a slowing consumer environment, and also that the US dollar remains stable.
The impact of our US consumer slowdown scenario is most noticeable in Asia. China, for example which has seen very strong economic and export growth, partly because of the buoyancy of the US consumer, could see export growth slow by nearly 2% in each of the next two years. Interestingly, this would only just dent the recent 20% annual export growth rate.
For the more mature economies, the adverse effect ranges from 0.5% to 1.6% off export growth in 2007. This is not an inconsiderable impact. For GDP growth rates, the impacts range from a material 1% reduction in Chinese growth in 2007 – it is currently growing 10% p.a., to between only 0.1% and 0.2% off UK or European economic growth. This latter impact is negligible in the context of growth rates of 2%-3% pa.
These models suggest that despite the increased trend towards globalisation, a material slowdown in US consumer spending would only have a limited impact on world economies and export growth, outside of parts of Asia.
Capturing overseas sales
As we have shown globalisation has gone from being more than just a buzz word a decade or so ago to an accepted driver of the world economy and an important economic consideration for UK based investors. One question this raises is how these forces could impact on the decision of UK investors looking to buy assets overseas?
As the world's largest economies have become more correlated, so too have their stock markets; the world's three largest stock markets for example have been directionally correlated 87% over the last five years, compared to 39% for the previous five years before that. Low and stable inflation has also meant bonds markets appear linked more with investors' expectations about the direction of the US Federal Reserve's monetary policy (the world's most powerful central bank and interest rate setter), as well as that economy's inflation and growth outlook. Drivers closer to individual markets such as expectations of rising domestic interest rates from, say the ECB, appear less important.
To some extent UK investors in equity markets are already exposed to the globalisation of the world economy, without needing to invest in overseas assets. UK equities have 55% of their sales coming from overseas with 45% from the domestic economy. Another consideration is China's emergence as an industrial super-power resulting in increased demand for commodities. This has impacted on the UK mining and oil stocks which make up a quarter of the FT All Share index. Although the European and Japanese stock market have less overseas sales exposure – 35% and 11%, respectively - it is clear that global demand from places such as China and the US for capital goods has benefited Japanese and German engineering, machinery and technology companies and hence their equity markets.
To sum up, UK investors can benefit from Japanese, US and European stocks markets that are exposed to domestic rather than overseas sales. UK based investors by buying into these markets are potentially including uncorrelated exposures to the UK stock market, within their portfolios, which could be beneficial.
Low asset returns ahead?
What sort of returns might investors expect from different markets? Multi-asset UK investors have enjoyed stronger than average returns in recent years, following the end of the equity bear market. UK equities have returned 17% per year over each of the last three years when adjusted for inflation, against 5.3% on average in each of the last 100 years. Bond returns, again adjusted for inflation, have been 3.1% vs. 1.3%, again over 100 years. Cash has given 1.6% vs. 1.0%. Corporate bonds have seen 4.1% against an average 6.3% per year since 1997, while property has also been strong in achieving 17.7% vs. 6.5% since 1987.
We can make a prediction of likely returns over the next 10 years for different assets. The process involves using current valuations versus history and current yield as the principle source of asset return. This suggests equities, again in real, inflation-adjusted terms, will only manage 5.5% on average a year, against 2% p.a. from cash and bonds and 4% p.a. from property. This suggests that the trends of the last three years of being Heavy equities, but less so Property and Light Bonds and Cash should again be favoured in the longer term. However, the out performance could be less, and volatility of returns over short periods will become more important, especially if, as we predict, the world, but especially the US economy, slows into the first half of 2007.
Given that UK investors have been used to historic high returns from equities and property in recent years, they may consider overseas assets to try and maintain this performance over the next few years. For UK investor to do this, they will need to be convinced that overseas assets have stronger fundamental support.
Overseas drivers compared
How do the fundamental drivers of UK and overseas assets compare? UK investors by investing in overseas equity markets during the last 10 years would have enjoyed the benefits of superior corporate earnings growth. UK profits rose 6% a year on average, against over 8% in the US and between 11% and 12% in Japan and Europe. In the next 12 months, if the consensus is correct, UK profits growth of 8% should be exceeded by the US (10%), Japan (10%) and Europe (9%). UK investors should, however, be aware that they may need to pay a slightly higher price for this sort of earnings exposure. Equity valuations, based on 2007 expected earnings growth excluding goodwill write-offs suggests a consensus PE on UK equities of 11.3x. This is a modest premium to Europe exUK PE on 11.1x, but a discount to the US PE which is 12.9x. Investors are pricing Japan on 15.5x using 2007 earnings including goodwill.
Bond investors have had the benefits of lower inflation in Japan and Europe over the last 10 years and a consensus prediction of a better inflation performance than the UK for 2006 and 2007. While the US inflation situation is likely to get worse before it gets better, the yield on 10 year bonds, at 4.5% at the time of writing, offers value when compared to underlying growth inflation expectations.
Equity sector exposures compared
While the top down macro environment looks favourable towards overseas assets, one question for equity investors is what sort of sector exposure do the UK and overseas markets offer? An examination of equity exposures at the sector level for the UK market compared to the World exUK stock market highlights striking differences in four key areas. The UK has a higher weighting in commodity stocks; the oil and gas plus basic resources sector is around 22%, compared to just 12% in the rest of the world. The UK also has a higher banks weighting - 17% vs. 14%. Other sectors which are also more prominent in the UK include food and healthcare. Looking at the exposure to growth sectors, the UK comes out with less than a 1% weight in the technology sector compared to 8.6% for the rest of the world. The industrial goods and services sector is just 6.6% of the UK compared to 10.4% for the rest of the world.
These differences are important, as investors in the UK enjoy a more defensive sector exposure with a high resources element. To compensate them for this lower exposure to cyclical areas the UK had a dividend yield over the last 12 months of 3.0% compared to overseas equities which had a dividend yield of just 2.0%.
Currency conundrum
While the investment rationale for investing in overseas equity and bond markets looks interesting to a UK based investor, the issue of whether to hedge currency exposures back into sterling needs to be addressed. Sterling in trade weighted terms has been volatile in recent years. For example, sterling fell 10% through 2002 into 2003 as the UK economy slowed, only to rally back to where it started as the economy picked up and interest rates, and interest rate expectations, rose into 2004. Since then the economy has oscillated around trend growth rates and interest rate expectations have moved frequently, with the Bank of England finally moving rates in recent quarters. Consequently, over the last year, sterling started to move up out of its recent range, mainly due to US dollar weakness.
Our analysis suggests for a typical UK pension fund portfolio that there is a non-linear relationship between the benefits of hedging a portfolio bets and suggest that the most optimal solution on a risk reward basis is a 50% partial hedging of excess overseas asset bets relative to a benchmark.
Overall Conclusions
The global economy has become more integrated over a number of decades as trade and investment links between countries have deepened. This has implications for the investment decision-making process of both UK and overseas based investors, as the stronger correlation between economies and assets prices around the world may mean greater risks ensue. An economic model of the world economy shows the likely reaction of other economies to a moderate US consumer slowdown. This suggests that despite the interlinking between global economies, even a material slowdown in US consumer spending would have a reasonably limited impact on world economies and export growth, especially outside of Asia. Despite the globalisation of economies, individual equity markets overseas sales exposure is still limited, especially in Japan and the US, making these markets attractive diversification for UK based investors. In addition, overseas assets are forecast to have a better fundamental outlook and sector make-up potential offering UK investors' superior returns going forwards.
While the investment rationale for investing in overseas equity and bond markets compared to the UK looks worthy of consideration, the thorny issue of whether to hedge currency exposures back into sterling needs to be addressed. UK based investors need to negotiate a number of issues including: a volatile currency, the cost and range of hedging. Our analysis suggests partial hedging is the most appropriate for excess overseas asset bets.
Richard Batty, Global Investment Strategist, Standard Life Investments
First published in Investment Adviser on 29 January 2007.
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