East vs West in global equity allocations

Go West

Manuela D’Onofrio, Head of global investment strategy at UniCredit Private Banking

In the past I often had clients asking me why our equity portfolios had so much exposure to non euro markets and almost zero exposure to the Italian equity market. I used to reply to them with a very short sentence: “It’s because of globalisation.”

As consumers of a globalised world, we like the feeling of being able to choose from goods produced in a range of countries, with very different characteristics and therefore different prices attached. Likewise, as an investor, I like the feeling of being unconstrained in the selection process of the country, the sector and the company which offers the best risk-return profile.

Based on my experience, I believe that a sound investment process has to rely first on a deep understanding of how the economy of a country works in terms of labour and production dynamics, of how the country’s public balance sheet is managed and finally of how the country’s central bank manages monetary policy. Countries, like human beings, differ from one another. Some countries are very business oriented and favour conditions conducive to individual wealth creation, while others are more focused on social issues; some countries react quickly to crises implementing necessary changes, others need to see the finish line before getting their act together.

And so I come to the point of why, in early 2009, my equity and bond teams both agreed that US equities deserved to have the largest exposure in our equity portfolios. The Federal Reserve was committed, with quantitative easing, to rescue the banking system and to provide unlimited support to the economy, while the political authorities were willing to accept higher deficits in order to provide some sort of relief to both US households and companies.

After almost four years, the Fed is still committed to a stimulative monetary policy as long as the unemployment rate is above 6.5 per cent.

Although fiscal policy is not as accommodative as it was until last year, the economy appears to be strong enough to be able to absorb the higher tax rate without sustaining too much damage, while the US public deficit should start declining in a meaningful way thanks to higher tax revenues.

So we still have US equities as the largest holding in our equity portfolio. Last September, after the ECB announced the OMT (Outright Monetary Transactions) programme, we felt markets were still assigning too much probability to the euro break-up scenario, and therefore the European equity market seemed to offer a very high risk premium due to a systemic risk we deemed to be much smaller.

Although we did not expect any positive surprise from the eurozone economy, and we still don’t, we decided to assign the second largest position in our equity portfolio to the European equity market on the basis of its relatively cheap valuations.

The third call we made was on Japanese equities last March, on the back of Bank of Japan’s announcement of the largest quantitative easing programme an investor could hope for. As a consequence of these three big bets on the US, European and Japanese equity markets, we decided to reduce both emerging countries and Asian equities.

The main reason behind this relative value choice is that most of these fast growing economies are experiencing wage inflation, which translates into decreasing profits if companies fail to invest adequately in order to increase productivity. Moreover, the massive co-ordinated quantitative easing programmes are putting fast growing countries’ central banks in front of the binary decision of either letting the currency appreciate or taking the risk of some sort of inflation.

So the conclusion for us is that the Asian and emerging market equities could well continue to underperform developed equity markets, at least until the Federal Reserve starts to slow down its bond-buying binge. 

Go East 

Lim Say Boon, CIO for DBS Group Wealth Management and Private Bank

Lim Say Boon, DBS Group Wealth Management

Wealth has been and will continue to be created more rapidly in Asia ex-Japan than in the developed economies. And the logic of net present value/discounted cash flow would argue for long-term overweight positions in allocations to those parts of the world that are capable of generating superior future streams of income and cash.

It is important to be clear about timeframes. Some might argue that developed market equities generally outperformed Asia ex-Japan for the year to date. But that would be selective. They might also mention those same equities underperformed in the second half of last year. And that the MSCI Asia ex-Japan decisively outperformed the global benchmark from 2002 to 2007, accompanied by stronger currencies against the US dollar. 

Yes, there are positive things happening in the US, Europe and Japan – the shale energy revolution in the US; the narrowing of fiscal deficits in parts of the euro area; the impact of ‘Abenomics’ in stimulating the Japanese economy. But these economies will continue to struggle with the problems of debt and deficit for at least another decade. And even if policy intervention prevents a meltdown, the twin problems will likely limit growth.

There are trends and there are cycles. Even the fastest growing economies of Asia are not exempt from economic and market cycles. But while most of the developed world struggles with interest rates at the ‘zero bound’ and debt limitations to fiscal stimulus, much of Asia ex-Japan has considerably more policy ammunition to manage those cycles. Beyond that, those economies will see rising income trends much steeper than those in the developed world.

At the current trajectory, Asia ex-Japan is likely to overtake the US in sheer economic size in constant US dollar terms in three to four years from now. The region’s population will hit 3.3bn by 2020 – a rise of almost 300m from 2010.

Literacy rates are already high by international levels with educational standards rising. Dependency ratios are much lower than those in the G3 (the US, Europe and Japan)
and will push even lower in some emerging Asian economies.

Where you have young, educated populations with access to capital and technology, it is difficult to not see rapid growth. The so-called ‘middle income trap’ makes a nice headline but per capita incomes in the largest Asian ex-Japan economies are still 30 to 50 years behind the US. Meanwhile, rapid catch-up means huge growth in business and investment opportunities.

With rising incomes, consumption in Asia ex-Japan should grow to 80 per cent of that in the US by 2020 – creating opportunities in everything from food production to retailing to luxury goods. And fragmentation in market shares in industries catering to Asian consumption will generate merger and acquisition interest, creating even more investment opportunities. Per capita healthcare expenditure in the region should double from 2010 to 2020. The growth of mega-cities will drive robust demand for housing, mortgages, transportation, energy, and environmental solutions.

Beyond mean-variance optimisation and the efficient frontier, diversification and asset allocation can ultimately be explained in simple layman’s terms as investing in the ‘wealth’ of the global economy.  And the greatest amount of wealth will likely continue to be created in the fastest growing economies in the world – in Asia ex-Japan.