Asset allocation – Kinetic vs. potential energy

In our latest Investment Strategy Outlook we discuss kinetic energy vs. potential energy and how the distinction between the two provides a helpful metaphor as we formulate our investment strategy. The following excerpt focuses on our equity strategy.

Using the metaphor of kinetic energy as a tenacious force, we find that most equity markets across the globe were swept up in the first half of the year. Returns on equity investments across the globe — U.S., Europe, emerging markets — were positive. Despite surprisingly weak first quarter growth, overall economic momentum remains steady in the U.S., and our internal research framework continues to point to modest acceleration in growth ahead for the global economy. We continue to focus our return-generating strategies around opportunities in equity markets.

To extend our analogy, we prefer equity opportunities with both a kinetic energy and potential energy advantage. There were a handful of notably weak exceptions to the generally positive first half performance. Japanese, Russian and Chinese equities experienced negative first half returns. It is worth spending some time to review these areas of underperformance in the context of kinetic energy (momentum) and potential energy (valuation and sentiment) to identify those that present attractive investment opportunities looking ahead and those that are likely to continue to underperform.

Exhibit 1 shows that Chinese, Russian and Japanese equities as measured by MSCI indices rank as some of the cheapest across the globe measured by current P/E as a percentage of their 10-year history. From both a valuation perspective and investor sentiment viewpoint, these markets have built up a sizeable reserve of potential energy, which make them candidates for a second half recovery. Japan is one area where we believe the market participants have been exceedingly negative for a long time given its long period of underperformance. Expectations of equity market disappointment are engraved in the investor psyche. Both valuation and our fundamental research point to strong earnings for Japanese companies this year, and we expect the built-up potential energy to provide a tailwind to the region. Similarly, Chinese equities have valuation support but the authorities orchestrate the delicate process of changing their growth model from an over reliance on infrastructure investments to consumption, without a significant hit to the economy. In the second quarter, Chinese equities have kept pace with U.S. stocks and have begun to exhibit positive momentum, which combined with attractive valuations, could be a source of solid equity returns. Russian underperformance on the other hand is a reflection of the geopolitical risks they represent with outcomes nearly impossible to predict.

Exhibit 1: Regional equity valuation as measured by P/Es

Global 12-month forward P/E ratios

Asset allocation

At the beginning of the year, we expected the U.S. to pass the baton of strong positive performance to the international markets, particularly Europe where hopes were high that the economy was finally edging out of recession. Instead, the European economy has continued to show signs of disinflation, prompting the European Central Bank (ECB) to introduce new stimulus measures in June. Analysts have also reduced earnings growth estimates sharply from overly optimistic earnings expectations at the beginning of the year. It remains to be seen whether these new ECB measures will be enough to stimulate lending, but for the moment Europe once again appears vulnerable to shifting sentiment in addition to further downward revisions to profit expectations.