The US stock market has shot the lights out in recent years, but Franklin Templeton Investments’ Peter Wilmshurst says investors shouldn’t expect the outperformance to continue.
For Australia-based investors, a big determinant of returns from global equities markets in 2014 was the weakness of the Australian dollar.
For investors from other countries, the key feature of the year was the strength of the United States’ stockmarket.
Over the 12 months to the end of February, the MSCI USA Index was up by 13 per cent, which is only a little less than the 13.9 per cent annual return over the previous five years.
In short, the United States’ market has hugely outperformed those of other parts of the world.
In US dollar terms, the MSCI Europe Index fell by 5.8 per cent in US dollar terms in the year to the end of February.
Annual returns over the past five years have been 5.2 per cent.
The MSCI Emerging Markets Index is up 2.5 per cent over the past year, which is a little better than the average for the past five years – of 1.1 per cent.
A number of the drivers of the great bull market in the United States are beginning to deteriorate.
One thing that has changed over recent months is that the strength of the US dollar is finally having a clear – and negative – impact on corporate earnings in the United States.
Exporters are just not as competitive as they were one or two years ago, while a stronger dollar leads directly to lower reported earnings for the significant component of US companies’ offshore earnings.
Thanks to the relative strength of the United States’ economy, corporate profit margins are all time highs.
However, investors have already taken account of the good news.
We have found that many of the stocks that we hold in the United States have risen in price to levels where they are no better than fair value. We have started to rotate out of them.
Although there are particular names in the United States which we continue to consider to be attractive and continue to find some new names to purchase, in aggregate, we are significantly underweight to the market as a whole.
The situation outside the United States is very different.
Whichever metric you use – price/normalised earnings, price/trend earnings, price/book, and so on – stocks outside the United States are generally around 30 to 40 per cent cheaper.
Meanwhile, in Europe, many major companies are benefiting from the weakness of the euro.
European economies have also benefited from the fall in the oil price.
This has had a mixed impact on the United States, given the significant expansion in oil production through shale oil in that market, with its commensurate support for capital spending and employment.
All this is in the context of corporate profits in Europe being around half the peak level and bank lending in Europe having been constrained by the ‘stress tests’ of the European Central Bank (ECB).
In other words, 2015 could well be the year in which economic growth – and corporate profits – in Europe start to catch up.
Another big difference between now and a year ago is that the ECB has confirmed that it will undertake a massive quantitative easing exercise, which will include sovereign government bonds.
This should also help perceptions. In other words, a lower euro, lower oil price and a return to normality for the European banking system should all serve to underpin a better profit performance in Europe in the near-term.
Banking on financials
There are two major stockmarket sectors that we consider to be offering attractive value to investors.
One is the broadly-defined financial services sector – although not real estate companies.
In terms of the price/book ratio, financials are not trading at the fire sale levels that prevailed in 2011/12, when the European debt crisis was really at its height.
Nevertheless, we are able to identify a lot of banks – in Europe, Asia and the United States – which are trading at or below book value.
This is in spite of the fact that they typically have strong domestic (and sometimes international) franchises.
Very long-term data from the United States and the UK suggests that such banks generally do not trade for long at a discount to book value.
A further rerating of financials globally could be one of the big stories in stock markets in 2015, assisted by expanding payout ratios in the sector as capital levels reach target levels.
European bank dividends rose by almost one third in 2014.
Hope in healthcare
The other major sector where we are finding good growth opportunities is global healthcare stocks, many of which pay a decent dividend.
The valuations of healthcare companies were much cheaper five years ago when the big pharmaceutical stocks were trading at an average PER of 10 times.
At that time, they were facing a ‘patent cliff’ (ie, a period when the patents of many blockbuster drugs were expiring around the same time).
But we thought the market was dramatically overstating the negative impact it would have on healthcare companies' earnings. Since then, global pharmaceutical stocks have rebounded in price and are now trading at an average PER of 17 times. However, they are still undervalued.
While it is not the same 'slam dunk' valuation it once was, the old drugs will continue to go off-patent, so they need to replace them with newer ones.
When you have no new drugs, that is negative for revenue growth. But now, pharmaceutical companies are delivering new drugs to the market.
The last time the industry had a peak in terms of new drugs being launched was in the late-1990s.
At that time, the healthcare sector was trading at a PER of 35 to 40 times. Then, for 10 years, not a lot of new drugs were delivered to the market.
Now, you are clearly seeing an inflection point for the healthcare sector.
At 17 times earnings, you need growth. The positive thing is that drugs are coming out of the pipeline so value is coming through.
When you have more new drugs coming on, it is positive for the revenue growth of pharmaceutical companies.
Peter Wilmshurst is an executive vice president and portfolio manager with the Templeton Global Equity Group.