Trade wars pose threat to global supply chains, said Lucy Macdonald, Allianz Global Investors, and added that the biggest geopolitical issue was trade because that has the biggest impact on the overall global gross domestic product.
"There are big long supply chains, which go across the world and can be affected by the trade issues," she said.
"So, one will have to watch if there is any real disruption in trade and how that escalates between China and the US, and how other companies get hit by that in the meantime," she added.
Macdonald said in the technology sector, there is a strong domestic and international growth potential and they would be interested in companies which can compete on a global stage.
Watch: Trade wars pose threat to global supply chains, says Allianz Global Investors Edited Excerpt: Q: How comfortable you are feeling about equities generally after what has been a fairly volatile start to the year? A: We are expecting flatter returns from markets and more volatility and that is after a period of very strong returns and very low volatility for the last five years.
Now we think we are in a period where we are going to get just more difficulty in getting those returns because we think we are at a peak liquidity as far as the quantitative easing is concerned.
We think that corporate profits are now very strong and unlikely to be growing quickly next year particularly because we are not going to get repeat of the US tax benefit and from where we are starting, the valuations are quite high. So it is difficult to see a real revaluation upwards for all equities. All of that together suggest to us that returns are going to be flatter and we think there will be more volatility, a lot of that due to geopolitics.
Q: You alluded to almost three peaks out there. Does it mean that the markets and generally economic conditions are beginning to level off or even slide off a bit from here? A: As far as the corporate profit, which is most important thing for the equity market, yes, we do think that we will get a deceleration into next year because of that factor in particular of not repeating that the US tax reform. However, we are also at a quite at a high level of margins particularly in the US as well.
So it is difficult to see that you can get much more margin upside and at a time where you are beginning to see some deceleration in topline. So overall it does suggest that we are seeing a peak in corporate growth at the moment.
Q: But you are not ready to call it the end of the cycle as such in developed markets yet? A: It’s closer to the end than the beginning but what we think is still going to be a support and why think it is not going to be any worse than flat is that the monetary environment we think will still be supportive, and the reduction in liquidity that we are going to see is going to be taken very carefully by the central banks.
They will take their time in raising the interest rate and removing the liquidity from the system because they are still very-very aware of the risks to the system and they do not want to repeat the global financial crisis and there is still a lot of debt in the system, actually more debt in the system than there was pre-financial crisis and so it is still a very fragile environment and all of the central banks really understand that.
Q: The volatility which is crept in this year, do you think it is a function of the issues that you spoke about or is it to do with some fear of external risks which seem to be rising around the market? A: I think there are three real reasons for the volatility that we have seen. One is the geopolitical and particularly trade tension and that really come this year and can probably been slightly forgotten towards the end of last year and that is real concern.
Second, there is slight inflation; upwards surprise that came into the market in February and that was a result of the higher than expected wages in the US and that was a real concern and a little bit of a surprise. It was looking for some wage pressure. No one seen it for years and suddenly that appeared to be coming through. Now whether that is sustained. We do not know yet, but that was another reason. Third, a feeling of higher rates and removal of liquidity and these are all reasons why we think there will continue to be a bit more volatility in the market now than it has been over the last few years.
However, for active investors like us, we do not think that is a bad thing; actually it is healthier having, more normal levels of volatility in the market as it is having normal level of interest rate. We have been living in an environment which has been very abnormal and volatility, you could argue, being too low and that risk is not been priced properly. So going into a more normal environment, I think it is probably healthier for all concerned but it is more challenging and certainly it is more challenging to deliver the sort of returns that been delivered in the last few years.
Q: You mentioned active investing and there is been a big debate going on whether active investment actually can deliver alpha over passive investing. Where does the debate stand in the West right now with regard to that? A: It depends and it depends on the asset class that you are looking at, it depends on the environment that you are looking at and from my perspective as a global investor, it is clear that it is possible for the average investor to add value in global equities. Median investor outperforms the index over time. So it is an area where there is a possibility of adding and you cannot say the same in all parts of the market and particularly in US largecaps. It’s difficult to make that case. However, in the last year it did better as a whole.
Globally it is certainly possible and that is because there is still anomalies around the world and not all investors are equal in this. So it’s indeed possible to do that. However, you can also say it is more challenging than it used to be because there is more competition and the output generated as a whole is lower than it has been historically. A part of that we think is also to do with the fact that volatility has been lower and so that seems to be correlated with this lower over generation. However, it is still possible and certainly we think we are going in an environment where active investor should be able to do better for two reasons.
One is the fact that you are getting now a more differentiation on balance sheets and so as the liquidity is withdrawn from the market as a whole, those companies which have stronger balance sheets and they are able to finance themselves should perform better and therefore, you should have a bigger differentiation; if a bigger differentiation than active investment tends to do better.
The second reason is that we think that there is huge surge or change going through which is due to technology and that is affecting companies very differently. Some companies are very much ahead of the curve and they are investing in a technology and gaining share within their own industries, others are lagging and that is also giving a bigger differentiation between performance of companies and that again, if you have good research you are able to differentiate between those winners and losers within each industries. So overall those factors we think are leading to a better environment for active investing.
Q: You said that we are probably closer to the end of the cycle in the US but where are we in the cycle with regard to the emerging markets (EMs) because the EM cycle did not quite start when the US cycle started. It maybe just two-two-and-a-half years old. Do you see EMs actually fleshing out their cycle for few more years regardless of whether the US cycle actually ends over the next one or two? A: There is more scope but also there is more structural potential which at the end of the day is more interest in the long-term investors so we can call cycles but really what we are interested to see is where is that good long-term structural growth and that certainly is in the emerging markets.
As long as there is equity investor, you can find companies which are able to benefit from that and that can be companies in those regions or companies based elsewhere who are benefiting from that growth and that at the end of the day is more interesting than the short-term cyclical changes.
Q: How do you look at a market like India in that context? You run a global portfolio and India is just another market for you but since you are a very stock specific in your approach, have you in the past had been able to spot high quality companies with great growth potential which have been realized in a market like India? A: Yes and particularly in the technology sector where there is a very strong domestic and international growth poetical and companies which can compete on a global stage and that for us as global investors is what we are interested in.
We are seeing where these companies are supported and have been able to compete and that is an area where we are still interested. I think what is changing there and for the Indian companies is that the end clients for all of them are demanding higher value added service and they are changing the scale of the projects that they are asking for and that they mean that all companies need to be able to provide a lot broader services that they did in the past, so it is not just a question of outsourcing or even consultancy.
It’s a question of delivering very wide service offerings and digital transformation projects which are taking enterprises and moving them completely into a digital space and that means having capabilities in cloud, in security, in automation, all of these areas which service companies wouldn’t traditionally have but they need to do if they are going to compete on world stage.
Q: The other thing which people in India are very excited about is domestic consumption theme. Do you find good companies there as prospects in your investment basket, Indian consumers? A: Yes, our specialists in area like the jewellery space and that looks to us one which has got quite a good demand growth even some of the areas which have slightly lower growth are seeing slight better prospects now in the rural areas like some of the few companies which have been a little bit depressed but that seems to be picking up now but there is huge potential, structural potential for consumption in India and finding in companies which are both there and externally which are able to benefit from them. Q: I comeback to those external risks that we spoke about. Some global investors have begun to fret over issues like Argentina, Turkey popping up here and there. Do these have the potential to insert far more risk called volatility in the market you think in the foreseeable future? A: Yes. I think the biggest geopolitical issue, as I mentioned, is trade because that is one that can have the biggest impact on overall global GDP. There are many incidents which happen around the world which are very dramatic or it can be very tragic but they cannot necessarily have a big impact on the overall economy and at the end of the day when we are investing that is what we are interested in.
So it is trade and any real disruption in trade which is the big concern at the moment and seeing how that escalates or not between China and the US and how other companies get hit in the meantime by that is something that we are focusing on a lot and one area in particular it focuses is the technology area because there are big long supply chains which go across the world which can be affected by this.
So that’s one area we are looking at. Within that context however, and if that is one of the biggest risk to growth, India looks relatively well placed because it has got such a good domestic focus and that from a global investor’s point of view and emerging markets investor’s point of view means that they will go to India when they are concerned about some of those big worries globally. So in fact India can be a relative beneficiary of some of them.
Q: Let me ask you about the US bond yield because that is consuming a lot of investor attention these days. Do you think most of it is played out in that run up to 3% plus or is that something which can inject a lot of volatility yet by surprising on the upside? A: Our expectation is that the path will be slow of interest rates up from here for the reasons that I said. The inflation picture as far as we can see it is relatively muted in the US and elsewhere. However there is more upside pressure than there has been for a while and that is both in wages, because of the strength of the corporate sector at the moment but it is also oil prices and that shift in oil prices over the years has been quite strong and that is coming through in some way into import prices. So, there is a bit more upward pressure at the moment.
However when it comes down to where we shift the bond yields, it is a combination of that- inflation expectations but it is also supply and demand. So, as we go through the year and we see the increase in the supply of treasuries coming to the market, that will be a big determinant of where the interest rates or the bond yields go.
For the moment we think that, that will be managed and so if there is a big sell-off then that programme will be adjusted.
Q: If had to ask you to guess, how far away are we from the next US recession? A: We do ask ourselves this within our strategy group and at the moment we can't see it in the next 12 months and that is as far as we look when we are doing macro forecasting. So, we can't see it at the moment because you have still got an environment which is supported with monetary policy and you have got a fiscal boost coming through as well. So, we can't see it at the moment. Q: Does the bull market fade into a bear market synchronously with signs of a recession popping up or well before it happens. If you are saying it is 12 months away maybe or more than that, when does the bear market kick in because most investors worry about the first year of the bear market which typically takes away two or three years of gains, you think that would be a couple of years away or it could now start to get priced in slowly? A: The best guess at the moment is that it is really flat rather than either a bull or a bear. So, you can go for an extended period of really not going anywhere but with more volatility. At the moment that looks like our best guess of the environment that we are in. Q: What is easier to pick right now - a US market which is probably past its peak or emerging market adjusted for risk, maybe at a slightly lower end of the growth cycle? In a relative sense what is easier to make an investment call on? A: What we are looking for is growth and valuation. You can find growth in US but it is not cheap and you can find some value elsewhere but you need to make sure you are finding growth as well. At the moment because of the big run up that you have had in all markets, it is difficult to find both of those things in the same place. So, that is really what we have spent all our time looking for. However the valuation angle is definitely more of a challenge now than it was five years ago. Q: At this stage of the cycle do PEs tend to compress or do you get market returns which are more or less in line with the kind of earnings that you are getting? A: It is the latter. At the moment, you would expect just in holding where you are on PEs and that is after a period where you have had some compression particularly because of US tax reforms which is a major boost to earnings this year, you had a 3 point derating in the US market just on the basis of that. So, you have had that sort of compression and from now it looks to us like it is going to be growing in line with those earnings and then as we go forward if we do get more upside on the bond yields then you might see a bit more compression on PEs. Q: Does the political landscape look more challenging to you as an investor or more unpredictable as an investor? A: Yes, I think it certainly does and that is one of the reasons why we think we will get some more volatility. Certainly the advent of Donald Trump as President of US has led to more uncertainty about old policy. So, that is something we can't second guess what he is going to do. So, we need to just look at the portfolios that we have and the stocks we are looking at to see where the relative exposures might be. Q: What would make you relook at your hypothesis that we are now going to amble through maybe a period of subpar returns but it won't be anything drastically bad or neither is it a roaring bull market, when would you sit and reassess saying something new has happened and we need to relook at this hypothesis? A: I think it is trade. If we really do see a big escalation in tit for tat between the US and China, then that would call for reassessment because it could mean a direct negative impact on growth as a whole but on some particular sectors like technology specifically and because that has been such a big driver of markets and still is, that I think would definitely cause us to reconsider. Q: What is your own assessment of whether that risk plays out or not? A: It looks certainly a higher risk now than it was 12 months ago and so it is something that we really do need to be thinking about and taking some action, taking some profits out of some of the high momentum names that we have got which are very exposed to that. So, some of the areas where we have been taking some profits out over the last few months have been areas like semi-conductors which are very much in that sort of line and they have done very well. Q: In a phase like this what is the investment strategy that you have chosen? Have you become more defensive in your portfolio positioning just to ride through this kind of period that you just described?
Although over time you can't prove that having a quality focus is of particular benefit to returns but there are times when it certainly helps you avoid disasters and I think we are going into a time where that quality threshold is going to be more important and would be more beneficial in allowing us to avoid torpedoes.
A: We don't tend to shift the beta of the portfolio around very much. So, we don't tend to take too many directional bets in the portfolio. We are always looking for growth, we are always looking for quality and we are always looking for some valuation upside but in this environment I think the quality threshold which we always have is probably going to be just tweaked up a notch.