Darren Read is the new head of global equity strategy at UBS. With a global view of markets, Mr Read answers your questions on how investors can exploit this theme, the outlook for both developed and emerging markets, what sectors are most attractive, the outlook for interest rates and the subsequent impact on shares and how investors should position themselves to exploit other themes. More background.
(UBS may have positions in markets discussed)
I am a private investor who, over time, have followed small caps. You mentioned above smallcaps are trading on a 20 per cent premium over bigger pears. However, the P/E of TRowePrice New Horizons fund-some say a bellweather small caps- closed Sep 2006 at approximately 19 while the S&P 500 P/E was aprox 1,15X the P/E of NewHorizons. I read in James Broadfoot investing in emerging growthstocks that this 1,15X multiple has typically indicated a good time to invest in small-caps as a relative multiple closer to 01 (rather than 02. What might be going on? Is the P/E of New Horizons not a good bellweather for small-caps?
Sergio Carpenter, Rio de Janeiro, Brazil
Darren Read: Hi Sergio, On a sector adjusted basis the discount is somewhat less -although still meaningful. Our forecasts show the US quartile of largestcompanies to be trading on a discount to the smallest. I think from your data that you may be looking at trailing data for the S&P, and also that an actively managed fund will have different characteristics to a small cap index.
At which economic growth rate should markets regard the US economy in the soft-landing process? Also assuming that the consumer spending gains momentum in Asia, partly offsetting the slowdown in the US economy, how do you think the global financial markets respond?
Tolga Kotan, Istanbul
Darren Read: We are looking for GDP growth of 2 per cent out of the US for the next two quarters, and a reacceleration after that. A soft landing implies a growth rate below trend, but above recession. There is no formal definition of a soft landing but I would expect the cut off to be at maybe 2 per cent growth for the year. We do look for Asia to continue to grow rapidly, but so not think this is going to accelerate further - indeed we are looking for a deceleration in growth.
Asia will not substitute for slower US growth, but can help through the transition. Corporate capital investment is likely to remain strong globally, given high capacity utilisation rates, and high levels of profitability. Capital markets today are very integrated, and corporates are very multinational. As such the potential for decoupled returns is relatively low.
It appears investors are 100 per cent sure the US is heading to a soft landing. Markets are showing an upward trend on the back of that. What could possibly go wrong? How does GEM market fit in?
Alvaro Maia, Brazil
Darren Read: Hi Alvaro. The risk short term is that we have indeed again priced in an element of Goldilocks. Together with this we have seen implied vols across a number of asset classes fall. Risk appetite is again high, and so anything reversing this will hurt. Which means that the acceptable band of economic data is fairly narrow - too hot or too cold are likely to upset the markets. I do think seasonal factors are also in play here - many investors have not had a great year, and so risk appetite has moved up to look for some returns. Emerging markets remain a high beta play, with a bit too much cyclicality, but some genuine growth opportunities. A few years ago emerging markets were priced for a poor case scenario; today that is not the case - although valuations are still at a discount to the rest of the world.
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In the face of expected global economic slowdown that most analysts and strategists anticipate - what are your favourite regional equity markets going forward for the next 12-18 months and your least favourite ones?
Niraj Shah, London, UK
Darren Read: Of the major markets we continue to prefer the US market, and remain most cautious of Japan. Elsewhere I would again highlight that I expect Thailand, Malaysia, the Philippines, and domestic Russia to do well over this period. Medium term concerns remain in those countries with macroeconomic imbalances, such as Turkey and Hungary.
What are the implications of a flat yield curve for equity investors?
Jeffrey Palma, Stamford, CT
Darren Read: Our global asset allocation team did some interesting work on this subject. Their conclusion is that a flat or even inverted yield does not necessarily mean a recession - although it has usually in the past. In addition to considering the term structure of the yield curve, you must also look at the real rates - and today these rates remain low. For equity investors the yield curve is normally a pretty good indicator of earnings growth. A flat curve indicates slower earnings growth - with which we agree. It also suggests that profitability should stay structurally high as it is now. All in all, it pints to a mid cycle slow down in economic activity.
Where should one invest in large caps - US or in Europe?
Darren Read: I do not think there is a huge amount of difference between the US and European large caps. Over recent years US markets have underperformed markedly against Europe. However they then traded at a significant post 1999 valuation premium, which has been eroded. Today the US is trading on a modest premium to Europe of only 4 per cent or so on a sector adjusted basis - which is probably justified on the basis of lower risk, and deeper markets.
Secondly the weakness of the dollar against the euro has also been a significant factor - we are now looking for a fairly stable euro dollar exchange rate. At present I prefer US large caps, because in addition that is counter consensus to where clients have been positioned. I think the more interesting question is likely to be large cap v small cap question - where we favour large caps. They are cheaper, less cyclically exposed, and less geared.
Does investment in large cap oil and gas companies not conflict with investment in ever growing and government-backed small cap alternative energy stocks?
Stephen Francavilla, Edinburgh, Scotland
Darren Read: To be honest, they are different sides of the same coin. Energy prices have rallied over recent years, on the back of strong demand growth, and a patchy history of low investment. The end result of high energy prices benefits the large cap plays - and also means that alternative technologies which were previously not cost efficient have become so. This has taken place with a coincident increase in awareness as to the environmental risks and impact. Economics would suggest that the super normal profits being earned by the sector should disappear, as more investment takes place - and this is happening, in part through a higher cost base.
Given the price setting ability of Opec, the outlook for still reasonable economic growth, then there should be room for both large cap and alternative energy stocks. I favour the sector here, and highlight the services companies as interesting.
Which assets would be least risky for a wealthy European investor, who worries about a potential financial crisis in China?
Erik Hrnell, Sweden
Darren Read: In the event of a genuine crisis, then all risk asset classes are going to have a tough time. The knee-jerk reaction will be negative for equities, as an important source of growth is removed. Likewise credit risk would not perform well. Industrial commodities would be particularly hard hit - although gold may rally as a store of value. A flight to safety and slower global growth will benefit developed market fixed income. The bottom line, for a risk averse European investor, would be to hold euro cash and sovereign fixed income.
Of the global markets that tend to run counter cyclical to the US and Europe, do you see any that are especially underpriced at the moment and poised for a possible rebound within the next two to three years?
Graham Moores, Abu Dhabi
Darren Read: Over recent years not only has global economic activity been highly synchronised, but so have equity markets. The glib answer therefore is that there really are no counter cyclical markets out there. However investor interest is never a constant, and medium term opportunities are more likely to exist where investor interest is comparatively low. On that basis, I would highlight some of Asia (Malaysia, Taiwan, Thailand, the Philippines) - and indeed US large caps - as interesting.
Is the next six months a good time to invest in the US equity market?
Pragarson Pather, Durban, South Africa
Darren Read: The most likely outlook for the global economy, and so the US economy, is a mid-cycle slowdown and a soft landing, with a reacceleration of activity in to 2008. Meanwhile valuations are on the whole still undemanding at the index level. As such this is an all right time to invest in the US equity market - in so much as expected returns are likely to be in line with cost of capital, which is about 8 per cent per annum.
Looking at previous US interest cycles, and the behaviour of markets after rates peak, then two highlights are: 1. the US almost always outperforms the world over the following quarters, 2. earnings growth slows down markedly for 12 months, before reaccelerating again, 3. the stock market rerates to a higher PE. This cycle is likely to be similar to the norm.
Given the recent dive in emerging markets’ stock performance, where do you see these kinds of funds going in the next couple of years?
Nolan Soltvedt, Minnesota, US
Darren Read: It’s time to be much more selective in emerging markets, and invest at the country and stock level, rather than just buy the asset class.
When you buy emerging markets, you get exposure to: 1. a play on global cyclicality, when we are now in a much tougher part of the cycle, 2. macroeconomic risk where imbalances exist, following above trend economic growth ion some countries, and 3. last but certainly not least, to faster economic growth than the rest of the world. In principle you want to be buying the last. Where may this exist? I would highlight the financial sector in some markets, such as Russia, Czech, Mexico, Brazil, Philippines and Indonesia. Likewise real estate across much of Asia continues to look interesting.
Darren Read took the role earlier this year after heading up emerging market strategy for UBS in recent years. Before joining “the sell-side” stockbroking world, he spent nearly a decade working in fund management, specialising in running emerging market money.
Mr Read believes that the time is right for investors to go large - to prefer big capitalisation stocks around the globe over smaller-caps. He says the macro backdrop now favours large caps with smaller stocks more vulnerable to slowing global growth and moderating risk appetite. Mr Read adds that after outperformance in recent years, small caps are trading on a big 20 per cent valuation premium on their price-earnings ratios to bigger peers.