What is your investment outlook for global equities in 2018?
My outlook for 2018 remains positive with a hint of caution.
We’ve been witnessing a synchronised global economic recovery and markets have been robust with one of the strongest bull markets since the 1970s. Equities do appear toppy on an absolute basis, with valuations near all-time highs however fundamentals look fine and we’re now seeing earnings growth coming through.
Volatility in equity markets remains low. This is a function of extremely low (in some cases negative) real rates and low volatility around economic growth, and ignores the volatility that we see on the global geopolitical stage. In my view, interest rates are too low in an environment where economies are moving positively in a synchronised global fashion. Central banks after all can only raise rates (from these unprecedented low levels) in a positive economic environment and it would be nice for policymakers to have some fire power for the next economic downturn. Acknowledging that falling rates have been a significant factor in taking market levels to where they are, I would expect volatility in equity markets to rise as a result.
Increased volatility is theoretically great for stock pickers, but one needs to be prepared to deal with the potential drawdowns that may occur. With little margin of safety present in valuations, a focus on capital preservation would serve well here.
What do you think could most surprise investors next year?
When considering what might cause surprise for investors in 2018, I think it’s prudent to look more closely at factors that are not currently causing concern. Inflation is low as oil prices are stable at low levels. In addition, there are no expectations of wage inflation as markets believe that technology will leave labour forces with little pricing power - artificial intelligence will take the white-collar jobs and automation/robotics the blue-collar jobs. However, this is where we think things might be changing at the margin.
Talking to management teams around the world, we get a sense that companies are finding it difficult to hire: Japan is challenged by demographics and ageing, Brexit is already creating a shortage of immigrant labour in the UK, Europe construction projects are being delayed due to short supply of labour and Mexican/Latino labour is in short supply in the US. Furthermore, while overall average wage statistics have not moved, millennial wages have been rising smartly with companies having to raise wages to attract labour.
In our view, it’s only a matter of time until these trends make it into the headline economic statistics. This would lead a data dependent Federal Reserve to push policy rates higher. And I believe there is a risk that this causes interest rates to increase faster and further than the market expects.
How do you plan to capture the best opportunities and add value for investors?
As a stock picker first and foremost, my focus remains on finding companies that are investing for future growth. I like companies with smart management teams, who use technology, innovation and disruption to their advantage by understanding the long-term trends of their industries.
I maintain that the best way to invest in this environment is to follow a simple toolkit:
- Understand and analyse the impact of long term trends, such as demographics, and technologies, like artificial intelligence, on changing industry structures and profit pools.
- Find and back the smartest management teams, who can use these trends to their advantage to protect and grow their economic moats - managing disruption smartly is where pricing power will lie.
- Industry analysis needs to be global rather than local. Whether I am analysing Westfield, Coles or Woolworths, the impact of Amazon is important to consider. Having corporate relationships and research on a global basis is no longer a good to have, it’s a must have.
- In a market which is absolutely expensive, valuations are my North Star. This is the one area where I believe active management can continue to protect client capital. My key focus here is on that one variable which is always important – cash. Ultimately the value of a stock is the sum of the cash flows that accrue over time to us as shareholders. Cash is generally free from most accounting jugglery. I give a high weight to cash flow metrics, seeking to determine what the free cash flow to shareholders is, how much cash is returned to shareholders as dividends and how much cash is really reinvested back for growth at similar or higher rates of returns.
