Tail Spin, Fundamentals and Europe

Markets are in a tail spin, emerging markets and Japan have fallen sharply, the US modestly, odd given it was the tapering off of money printing by the Fed that got the bears going. Risk averse investors have been buying dollars, emerging market currencies have fallen. Japanese Government Bonds (JGBs) are volatile, yields have spiked with falling prices spooking the equity markets. Meanwhile fears of a debt bubble in China and the sharp 1994 sell off of government bonds may be repeated, unless of course central banks can control their bond markets. Interesting if scary times for investors. Certainly a good time to bank profits, albeit selectively.

In conclusion like the Emperor the liquidity driven rally has no clothes. Equities have risen but global economic fundamentals remain weak. It is notable disparity but does it matter? Not according to Mark Hargreaves, senior portfolio manager at Axa Framlington. He cites studies that show long term equity returns are not correlated or even are negatively correlated with economic growth. A clear example is China between 1992 and 2012. He cites growth was 10.1% p.a. on average whilst equities returned -2.3% p.a. The point Hargreaves makes is that economic growth may benefit workers, consumers and government coffers but it may not add value for shareholders. This is down to companies’ management of cashflow, (for example avoiding leakage to third parties), return on investment and how shareholder friendly the company is.

So what are the consequences and applications of this assertion? First many fund managers operate a bottom up fund management style. No I don’t mean drinks in City wine bars after a hard day on the trading floor. Bottom up investment means disregarding high level macro-economic factors and hence the domicile of a company – instead there is a focus on company fundamentals, its markets, balance sheet and cashflow. For example a global mega cap domiciled in Europe with a strong balance sheet and cashflows may be delivering sustainable profit and dividend growth and good returns for shareholders. It does not matter to many fund managers that the stock is listed in a low growth European economy especially if most earnings are made overseas. Naturally for economically sensitive cyclical companies with most earnings from domestic sources its domicile does matter. An example here would be the consumer discretionary sector. The commodities and property sectors are also highly economically sensitive.

Hargreaves then argues that Europe is very attractively valued, companies scores high on corporate profitability and cashflow management, and systemic risks in the EuroZone are being addressed. He concludes for long term investors Europe should feature more in asset allocation decisions. I agree. Those investors who dismiss Europe simply because of the dismal economic growth, high debt, deficits and unemployment and EuroZone problems will miss great buying opportunities. I am much more positive on Europe than a year ago but favour smaller companies due to them being under researched, potential mispricing, higher organic growth potential and beneficiaries of mergers and acquisitions.

You should seek advice before making investment decisions.