10/06/06
The Benefits of Overseas Investing
In recent years, the coordinated expansion in many of the world's major economies and China's emergence as an industrial super-power have been powerful drivers of a pick-up in world trade growth. Recently, these links have been reflected in investors' perceptions that the world economy is starting to enter a slower growth period as the effects of tighter monetary conditions start to bite. One obvious concern for UK investors is how exposed they would be to this sort of slowdown, either from investments in overseas shares or holdings of UK companies with strong overseas sales.
As an example, chart 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 has a 'soft landing'. Here, spending would slow 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. The models suggest that despite the increased trend towards a more co-ordinated business cycle, a material slowdown in US consumer spending would only have a limited impact on world economic and export growth.
To some extent, UK investors in equity markets are already exposed to the world economy, without needing to invest in overseas assets. For example, chart 2 shows the breakdown of the major stock markets split by domestic and overseas sales. Here, 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 – a benefit to the resource rich UK equity market. Although the European and Japanese stock markets 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 consequently supported their equity markets.
As well as accessing international sales exposure, UK investors may be tempted to invest in overseas equity markets in order to enhance portfolio performance. The consensus view suggests that UK profits growth of 10% in 2007 should be matched by Japan's, but exceeded by Europe's (11%) and the US (12%). UK investors may need to pay a slightly higher price for this sort of earnings exposure. Equity valuations based on 2007 expected earnings growth show UK equities on a PE of 11.3x. This is a modest premium to the Europe ex UK PE at 11.1x, but a discount to the US PE of 12.9x and Japan on 15.5x.
Overseas bonds may also benefit relative to UK gilts as a better overseas inflation performance is likely in 2006 and 2007. While the US inflation situation is likely to get worse before it gets better, the yield on 10 year bonds, at 5.2% at the time of writing, offers a higher premium than the 4.7% available on gilts, when compared to underlying inflation expectations.
With the top down macroeconomic environment looking favourable towards overseas assets, one question for equity investors is what sort of sector exposure does the UK and overseas equity markets offer? The UK has a higher weighting in commodity stocks; the oil and gas plus basic resources sector is 22.5% of the market, compared to just 12.3% in the rest of the world. The UK also has a higher weighting in higher yielding sectors such as banks, food and health care, but a low weighting to growth and cyclical sectors such as technology and industrial goods and services. To compensate investors for this lower exposure to cyclical and growth areas, the UK produced a dividend yield of 3.2% compared to just 2.2% for overseas equities over the last 12 months.
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. UK based investors need to negotiate a number of issues not least the volatility of the currency and the cost and range of the hedging methods used. A case study we have undertaken for a typical UK pension fund portfolio suggests that there is a non-linear relationship between the benefits of hedging portfolio bets, with the most optimal solution on a risk reward basis being a 50% partial hedging of excess overseas asset bets relative to a benchmark.
In conclusion, we can say that while we expect returns from UK equities to be attractive over the medium term, it would be expecting a lot for them to exceed the returns of delivered over the last three years. 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 likely from the UK. Multi-asset investors, however, should be mindful how they manage their currency exposure.
Richard Batty, Global Investment Strategist, Standard Life Investments
First published in Fund Strategy on 10 July 2006
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