The quarter offered a series of vignettes relevant to the longer-term macro discourse, including:
- An emerging “cold war” like stand-off between China and the U.S. over the management of North Korea’s nuclear arms ambitions, with South Korea and Japan somewhat caught in the middle
- The growing unpredictability of Western electoral outcomes most intensely felt in ongoing questions regarding the future of the Eurozone
- Related to this, the difficulty leaders, such as Trump, face in enacting change, e.g. the Republican failure to reach a consensus on the roll-back of Obamacare, which in turn feeds greater electoral polarisation
Accordingly, over the quarter, European domestic equities reacted negatively to a widening of Peripheral sovereign bond spreads (where the Periphery now seems to include France) and U.S. domestic equities sold off on concerns regarding the delay of tax reforms. Ironically, amidst this uncertainty, China appears to be relatively stable, a stark contrast to how markets were positioned just over 12 months ago when China was arguably priced for a hard landing. Since this time, Chinese growth sensitive equities such as Commodities and Emerging Markets have strongly outperformed, a prescient reminder that, as investors, a discussion regarding any of these matters is only meaningful if it includes some reference to how risk is priced.
Table 3, Figure 1, Charts 1 and 2 apply our proprietary quantitative tools to determine the broad geographic sector and factor exposures that are most or least prospective for future returns. We use these as a contextual framework (or peripheral vision) rather than a deterministic tool for allocating team resource. Furthermore, if valuation dispersion is high across sectors or factors, as it is today, a competent stock picker will find attractive investment opportunities regardless as to whether the broader group appears expensive. Above all, the analyst will have the benefit of the broader contextual thinking of the CAPE analysis, sector/factor heat-maps and industry/company level screening before commencing any deep dive analysis.
To the extent that we describe a sector or factor as cheap/attractive or expensive/unattractive we’re referring to a historical mean reversion relationship. Clearly, there are limitations to such a framework, i.e. this is not a statement regarding absolute value as this can only be made after performing our industry/stock level analysis. However, at a large sample size and in the right hands, such a framework still has merit.
Geographic Sector Valuations
See Glossary for CAPE, EMR and Sector definitions. Source: Antipodes Partners
In terms of the broader outlook for equity markets, we find it useful to examine the long-term empirical data in terms of what starting multiples imply for expected future returns. Given broad differences in the timing of earnings cycles across both regions and sectors, we prefer to measure broader expectations for future returns based on “Cyclically Adjusted PE” (CAPE) based valuations. On this basis, the more attractive broad sectors are Developed Asia Global Cyclicals, European Domestics and Financials in all markets outside of North America. The least attractive areas are dominated by the very large Global Defensive sector (28% of global market capitalisation) and North American Domestics (be they Defensives or Cyclicals, in total, another 16% of global market capitalisation).
Our Region-Sector Heat-map (Figure 1) further extends this analysis and we broadly observe:
- Consumer Staples enamored for their perceived Profitability and Growth characteristics (Chart 1), though having significantly underperformed over the past 12 months, still remain one of the most expensive Developed Market sectors
- Healthcare has underperformed to the point now that relative value has appeared
- Interestingly, in a market paying-up for yield (Chart 2) and Global Defensive exposures, Domestic Defensives including traditional yield sectors such as Utilities and Telecommunications have become very cheap, coinciding with the apparent value of Good Yield (funded through cash-flow); within the Global Funds we have taken advantage of this primarily within our European Recovery exposure
- Financials though having significantly outperformed over the past 12 months remain one of the cheapest sectors globally with sentiment and profitability expectations weighed down by macro-concerns, low rates and yield curve compression
- As the broad relief rally in China growth sensitive equities has played out over the past 12 months, Materials have significantly outperformed, though Energy has lagged and remains one of the cheapest sectors globally
Most quantitative strategies would measure the attraction of a certain “factor” exposure on the basis of its price momentum. These same systematic strategies see Value as a separate factor, by which they mean low multiple stocks, but will only buy Value if it exhibits momentum. At Antipodes Partners, we worry that factors favoured by systematic strategies will eventually become overvalued (a symptom of crowding), offering little margin of safety at the stock level and exposure to “regime change” style draw-down risk at the portfolio level. Hence, we value a range of factors (e.g. Profitability, Growth, Multiple Dispersion, Yield, Good Yield, Momentum, etc., Charts 1 & 2) rather than Value in isolation (we prefer to label Value as Multiple Dispersion to make a clear statement that the starting multiple is meaningless without the context of growth).
Keeping with our philosophy of finding investments with multiple ways of winning, another way we can win is by gaining:
- Cheap exposure to an expensive factor, e.g. Cisco Systems, a very cheap “Profitability” exposure at a PE of 13x where an equivalent exposure would cost on average +20x PE
- An exposure to an out of favour factor based on the view that the market view may change, e.g. “Good Yield” (cash-flow funded) is offered cheaply by many Utility and Telecommunication stocks, as opposed to the expensive “Bad Yield” (capital market funded) offered by many Infrastructure stocks
Accordingly, Charts 1 and 2 apply our proprietary quantitative tools to determine how expensive various factors have become relative to the last 30 years (expressed as a Z-Score) by comparing the valuation of the MOST PROFITABLE (HIGHEST GROWTH/MOMENTUM or LOWEST MULTIPLE) stocks to the LEAST PROFITABLE (LOWEST GROWTH/ MOMENTUM or HIGHEST MULTIPLE) stocks.
See Glossary for factor definitions. Source: Antipodes Partners
See Glossary for factor definitions. Source: Antipodes Partners
With reference to Charts 1 and 2 we note:
- The market is celebrating stocks that display high Profitability, Growth and Momentum independently of starting multiple. Further, it’s noteworthy that the market’s willingness to pay-up for Growth, Profitability and Momentum is approaching the heady days of the late 1990’s tech bubble. One can also observe the subsequent derating that occurred as high Growth and Profitability attracted competition and these stocks lost their allure, a clear example of how a high starting multiple was predictive of future sub-par returns.
- Momentum is simply the outcome of the market’s obsession with an ever narrowing group of stocks selected on a systematic preference for high Growth and Profitability. Whilst clearly Growth and Profitability matter, for Antipodes Partners these descriptors only offer real meaning in the context of valuation rather than momentum.
- A global preference for small-mid caps over large caps, especially in North America, with Asia Ex-Japan the major exception; in many ways an extrapolation of the valuation dispersion observed between hyper and mature growth businesses.
- Extreme thirst for equities with bond like characteristics, i.e. Yield and Low Volatility, without concern as to the inherent risk equities represent. Interestingly, the market fails to pay a premium for Good Yield over Bad Yield.
- Encouragingly, Multiple Dispersion is evident across all regions
More specifically, extreme policy settings in Europe/Developed Asia have led to severe investor herding, evidenced by the extreme overvaluation of Profitability and Growth in these regions. Ironically, investors have the cheapest opportunity to buy balance sheet Resilience and cash covered dividends (Good Yield), even though macro concerns are heightened!
Let’s step-back though and consider the broader question of bond versus equity returns, after-all, equities don’t exist in a vacuum. This is a multi-faceted question and here we will only consider the relative merits of various exposures. Generational low interest rates have been symptomatic of lower growth and inflation, made acute by central banks reacting to structural factors such as aging populations, integration of savings rich economies into the world economy, offshoring and more recently deleveraging and excess export capacity.
See Glossary for CAPE definition. Source: Antipodes Partners
In our last quarterly report, we made a simple observation that considering how investors were positioned and the extremity of valuations (Table 3, Chart 3), U.S. domestically orientated sectors (Retail, Services, Communications and Infrastructure) were increasingly vulnerable to a set-back given the uncertainty that Trump represents. Whilst we’ve seen a small reset, our CAPE analysis (Table 3) highlights that this remains one of the least attractive parts of the global equity market for prospective returns. That is, U.S. Domestic Equities are priced as if Trump’s agenda is signed, sealed and delivered.
Source: Factset, Robert Shiller, Eurostat
As we highlight in Chart 4, since the 1970’s there has been a tight relationship between average nominal 10 year U.S. bond yields and average nominal GDP growth, though we caveat this inference – in the 40 years following the Great Depression, U.S. yields failed to keep pace with nominal growth. In a cyclical sense, global growth has been accelerating for most of the year. Whilst we would hesitate to extrapolate a higher structural rate of long-term global growth, the recent move in rates highlights that global long-term bond yields may have been mispriced, i.e. too low, relative to growth and that this mispricing may be most extreme in the Eurozone.
The more granular observation would be that German yields represent the extreme of global bond mispricing only making sense as a safe-haven asset in an extreme event such as an Italian Eurozone exit. However, taking that turn of events to its logical conclusion, if a weak member such as Italy was to leave, the residual membership by definition looks stronger, i.e. the Euro would increasingly look like the old Deutsche Mark. It seems hard, longer term, to sustain a world of super-low German Bund yields and a weak Euro currency when German nominal growth is tracking +3%.
The French Presidential elections (23 April; run-off if need be 7 May) and Legislative elections (11 and 18th June) remain the last of the major Eurozone political events for the year in that the outcome of the German elections (24th September), dare we say, seem far less important given the likely mainstream choices. We don’t believe we can add much value in attempting to predict outcomes other than to observe that the French version of parliamentary democracy seems designed for inertia, even more so than the U.S. version, in that the President has very little real power without the backing of Parliament. Whilst a Le Pen victory would likely trigger a round of Eurozone risk aversion, it should not be equated with a French exit from the Eurozone. That would remain a very complicated and, hence, unlikely outcome regardless of how aggressively markets wish to price this.
Source: OECD, BLS, Antipodes Partners
Source: BIS, Antipodes Partners
On the flipside, absent a negative political surprise, post the French elections, the European Central Bank (ECB) will come under intense political pressure to normalise policy. European economic fundamentals are much stronger than the headlines imply. Based on a workforce participation measure of employment, the Eurozone recovery in employment has been stronger than that in the U.S. (Chart 5). This shouldn’t surprise given the Euro is super-competitive trading close to its lows on a Real Effective Exchange Rate (REER) basis (Chart 6). Further, the data suggest that in the face of uncertainty Europeans have deferred consumption which may ultimately result in a catch-up phase and a much more durable recovery.
Given Europe’s status as a very large exporter of savings to the rest of the world, the knock-on effects of such a potential policy normalisation should not be underestimated (beyond the potential for the Euro to rebound, just a general tightening in global liquidity conditions). Already the ECB is discussing hiking rates even as it keeps up its rate of QE, i.e. reversing the order of tightening that the Federal Reserve adopted. Why would it do this? Primarily to improve the profitability of the European banking sector, encourage lending whilst also keeping a lid on sovereign yield spreads. Ironically, according to our heat-map, the cheapest sector globally is European Financials, the direct beneficiaries of such a policy.
In summary, the Eurozone bond market (and European Domestic facing equities, especially Financials) are discounting a deep deceleration in growth at the same time that North American domestic facing equities are discounting a reacceleration in growth. Without wanting to make a big call either way, we believe it’s highly likely that both markets are mispriced.
At the core of our investment philosophy we seek in our long investments both attractively priced businesses (margin of safety) and investment resilience (characterised by multiple ways of winning), with the opposite logic applying to our shorts, i.e. no margin of safety and multiple ways of losing. Whilst the investment case will always be predicated on idiosyncratic stock factors such as competitive dynamics, product cycles, management and regulatory outcomes, we seek to amplify the investment case by taking advantage of style biases and macroeconomic risks/opportunities.
In our last quarterly we noted that the blind assumption of unending low rates made the market vulnerable to a cyclical back-up in yields. Whilst this thesis initially played out and has partially reversed, we believe the risk is still asymmetrically priced. Accordingly, we are avoiding expensive versions of the bond proxies as long investments, accumulating selective opportunities, especially in Europe, that have suffered the most from yield curve compression whilst increasing our shorts on the beneficiaries of the low rate world, i.e. expensive bond proxies and growth.
In summary, we’re encouraged by the growing valuation dispersion within and across markets (region/sector/factor) as we think this is indicative of broadening pragmatic value opportunities, both long and short.
To find out how Antipodes has positioned itself in global markets, read our March quarterly report.