Global Perspectives: For equity investing, a global rebalancing

Adam Hetts: Welcome back to Global Perspectives. I’m your host, Adam Hetts, and today we’ve got a much-needed update on international equities. To help me with that, I’m happy to have George Maris and Julian McManus with me. George is a Portfolio Manager and Janus Henderson’s Head of Americas Equities. And Julian McManus works with George in equities as a Portfolio Manager and Research Analyst. First, we’ll cover what international sentiment is feeling like to our portfolio managers at the moment, and then we’re going to dig into some of the shocks we’ve been dealt over the last year or so, with banking stress and inflation and energy shortages.

So, George, Julian, thanks for joining, and let’s just start at the highest level. Since COVID hit, we’ve been living through these historic bouts of volatility, both good and bad. As global equity portfolio managers, what’s the sentiment like right now for you and your peers?

George Maris: I sense an overwhelming negativity on the environment. I think there’s a lot of caution. We’ve got geopolitical uncertainty with respect to the Russian/Ukrainian conflict in Europe. You have political uncertainty everywhere you look. You still have Brexit, which is a significant deal, and never mind the political uncertainty in the United States and across much of the rest of the world. So that’s out there. You still have the notion of central banks tightening money supply almost everywhere you look. And so, you have all these factors that are negative overhangs. You have a slowing of the economy. And so, there’s a real bearishness that pervades everything; it’s hard to feel really bullish.

Yet, with that backdrop, markets have been incredibly resilient. Equity markets, in particular, the last several months belie the general feeling in the space, and that feeling in the space is noted by, if you look at net ratios by hedge funds, they’re very conservative. Cash positioning in mutual funds is at near-historical highs. There’s a lot of bearishness that’s out there, yet markets [are] trading near all-time highs. So, there’s this overall bearishness that’s being offset by near-term market dynamics.

Julian McManus: Yes, and I’ll just build on that idea that, because of the negativity that you see out there, I think there’s a tendency for a lot of managers to take the negative interpretation. And so, we saw that when CSFB [Credit Suisse] had to be rescued, I think there was a widespread, very rapid conclusion that many managers jumped to that we were going into 2008 again. That was very much the case of fighting the last battle; I think we’re in a very different world. The banking system is regulated in a very different way and capitalized very differently now. But nevertheless, you’re seeing, as a result of that negativity, people assume the worst in areas like banks. And in addition to that, a very truncated time horizon when the markets are looking at really attractive free cash flows that are on the horizon, maybe two, three, four years out. But those are beyond the time horizon that the market is currently prepared to adopt.

Hetts: Okay, thanks. We just have to go straight to the elephant in the room here and, going as far back as the 2008 crisis, more or less, Europe just hasn’t kept up with U.S. equities. So, is there something unique about this year or this part of the cycle that makes you guys think the regime could finally switch and Europe can actually lead the U.S. in equity returns?

Maris: I do. And so, one of the reasons that Europe – I’m going to include the UK in the continent – we talk about Europe has underperformed the U.S. There’s been, frankly, a relative lack of, I’d say, business dynamism that you would have seen in the U.S. relative to Europe. The U.S. has had incredible innovations, whether it’s in technology, communications, healthcare … it’s fed into other industries. It’s no accident that the world’s largest companies – the giga-caps – that have emerged over the last decade, are in the U.S. I was going to say primarily in the U.S., but all of them are in the U.S. And that’s been a massive factor in the U.S. outperforming.

I’m not calling for that dynamism to fade going forward, it’s just that the relative difference between that growth is converging. We’re seeing a convergence of growth for the first time in a long time. I think part of that is just that a lot of the innovation that’s occurred and sparked growth – so, SAAS [software as a service] and the cloud and things like that – I’m not saying that they’re not growing, but they’re in a more mature phase than they’ve been in the past. For sure, AI [artificial intelligence] is a great next development, but right now it’s still open to see who’s going to benefit, who’s not, how that’s all going to play out. But one of the areas where it’s going to play out really well is in robotics. It’s an area of strength of companies outside the U.S., not in the U.S. And so, if we’re thinking about the next evolution of where technological dynamism is going to occur, it’s going to feel a little bit more balanced than it’s been in the past.

And then, also, I think if we think about some of the macrostructure that has really allowed the U.S. to outperform, and that is, we’ve seen, essentially, very easy monetary policy for over a decade in the U.S., really as a function of the [Global] Financial Crisis (GFC). That easy-money policy, when it’s applied globally, has kept rates low. That’s favored long-duration growth stocks. Those long-duration growth stocks were more often than not domiciled in the U.S. and benefited that market more than it’s benefited other markets.

Now that we’re seeing a reversal in monetary policy – both in terms of where fed funds rates are sitting and other central bank rates are sitting, but also in terms of the reversal of quantitative easing – I think that’s going to be a long-term drain on the money supply globally. Well, all of a sudden, you have to value – or you should value – long-duration growth assets more lowly than you would have otherwise. The discount rate just has a higher impact on that. And so that naturally will benefit companies that have more visible cash flows, putting companies located outside of the U.S. on better footing relative to the U.S.

And moreover, that’s also a sign of inflation. And the companies that are the best placed to do well with inflation are those that are cyclical in nature, that can pass through inflation. In fact, inflation, as long as it’s controlled, is a real benefit to equities. I think that’s one of the things people forget is inflation is, generally speaking, good for equities because you get that benefit on the top line, and even if it’s moving your costs up as well, you generally get the operating leverage in growing earnings, where you weed into more other stable asset classes. Ex-U.S., in particular Europe, has a lot of more of those companies available to it, that are more cyclical in nature. And even if they’re global, they’re more cyclical and will benefit from greater pricing power than they’ve had in the past.

And then the one last thing I would highlight, too, is a lot of the companies that do business in Europe or Japan or are domiciled there have dealt with essentially no growth for over a decade and have become very efficient in terms of how to operate in a really challenging GDP [gross domestic product] type of environment. And so, as we get inflation, as you get growth, it really does benefit those companies more from an operating leverage perspective than it does companies that may not necessarily have had to be as disciplined from an efficiency perspective.

Hetts: So, in a sense, there’s really no competition for a decade or so. We have these U.S. giga-caps, tech companies, long-duration growth, that were essentially funded by rock-bottom interest rates. And that’s just objectively shifted, and driven by inflation, rates have increased, so it starts making me look at equities a little bit differently with that inflation catalyst.

When you think about U.S. vs. European/ex-U.S. inflation, can you guys just talk a little bit about the structure and the sources of inflation – ex-U.S. vs. U.S. – and then how that plays with the structure of the European markets? You mentioned more cyclicality in European markets, but can you tie the nature of inflation over there into the nature of the markets and how that might benefit the companies, specifically, there?

McManus: Sure, I can take a first cut at that, and then, George, please, add on. But I think there are a number of sources, some demographic, some geopolitical. To start with the demographic, China, to begin with, is now seeing a peaking of its population, and in fact its working-age population is now already in decline, and that’s going to continue to accelerate. So, China as an exporter of deflation or low labor costs is leaving the world stage. And in addition to that, you have demographics in the rest of the world where workforces are similarly aging, and you have, likely, an increase in the costs of labor.

And then, layer on top of that, the geopolitical. At the margin, it’s not happening in a monolithic uniform way, but every day it seems a new cycle brings us another example of a company having to move some of its supply chain away from China. And, increasingly, high-end technology exports to China are being restricted. And so, that geopolitical polarization is, by its nature, inflationary because you’re going to get fragmented supply chains. Any time supply chains are more fragmented into smaller clusters, it leads to less efficiency and higher costs. That’s just a bargain or a contract that both suppliers and customers have come to accept.

An example is, in the summer last year, I was meeting with a lot of European CEOs, many of which were discussing just this phenomenon, and the phrase that came up again and again was “building local for local.” Building local capacity to supply local customers, and as that continues, you’re going to see inflationary pressures build.

Hetts: To go back to earlier last year, it was the structural vs. transitory debate on inflation, which ended up feeling silly because everybody said it was obviously structural. But now transitory is coming back to the conversation in the U.S. With all those factors ex-U.S., would you argue it’s a little more structural ex-U.S.?

Maris: I would argue that it’s structural everywhere. The only place you could look near term in terms of where there’s a real difference would be on a demographic side. You’ve got challenging demographics in Europe, in Japan, in China, as well as in the U.S., who are really struggling with that. But the U.S. is starting from a much lower unemployment rate, and so you don’t have the kind of slack in the labor force to offset any wage-push inflation in the U.S. I think that’s really the only difference.

But if we’re thinking the true structural changes, [those] are global in nature. And so, we talked about deglobalization, the localizing of all of manufacturing and supplying. It’s happening wherever you go. In addition, whether it’s environmental or otherwise, we’re seeing regulatory costs go up everywhere. And that may be a societal good, but it definitely makes the same amount of stuff more expensive, and that’s going to be a persistent inflationary trend for a while.

I think one of the other issues that people don’t talk about sufficiently and I think is a concern is, essentially, the end of the post-Cold War paradigm we’ve had since the fall of the Berlin Wall. And what you were allowed to do is witness declining defense spend across the globe. We’re clearly seeing that reverse. Defense spending, by definition, is inflationary, i.e., you spend a ton of money to build something that you hope never gets used. Certainly, a tank doesn’t have productive capacity. And so, by definition, you’re talking about a greater proportion of government spend that’s going toward stuff that isn’t productive, like a bridge or a highway or something of that nature. So, that spend in and of itself is somewhat inflationary, and that’s happened everywhere else, as well. So, I think the world is just going to be living with a greater inflationary backdrop than it has for a long period of time.

I think the other element that is really concerning to me – and this is global again – is the reversal of quantitative easing. That is going to be an impact everywhere we look. We’ve seen – whether it’s the Fed [Federal Reserve], the ECB [European Central Bank], the Bank of England, the Bank of Japan [BOJ] – post-GFC, significantly increase their holdings on their balance sheets via quantitative easing, i.e., throwing money out into the system. That evolution from GFC up until February of ‘20, pre-pandemic, was pretty massive. And then, post-pandemic, it exploded from there. The Fed’s balance sheet post-GFC was around $1.5 trillion. In February of ‘20, it had grown to about, I think, $4 trillion, $4.5 trillion. At the end of ‘22, it was around $8.5 trillion. Same numbers apply to the ECB. The BOJ had a similar rate of growth. That’s going to be liquidity that, I think, has to come out of the system or it’s inflationary tinder.

And so, the transitory vs. structural, you can’t get head-faked by the decline in near-term inflation. You knew you were coming off of massive supply chain dislocations. So, you still had COVID to deal with, and in fact, you had China’s zero-COVID policy to deal with. You had the Ukrainian/Russian conflict, and the issues that it had to deal with. Those were all going to eventually normalize; that’s just how the math works. And we’re starting to see that come through now. What’s going to be very interesting is where this settles out, let’s say, a year from now, and I think that’s when you’re going to see the structural elements in play. I’m not calling for hyperinflation, but require inflation and rates to settle at a much higher equilibrium rate than we’ve witnessed over the last decade. And I think you’ve got to think about what that means for investing on a global perspective.

Hetts: So, you two are experts on global markets, you have been for some time. For other investors, the sentiment’s not great looking at Europe vs. U.S. What are they missing? What’s the single biggest thing that’s given you the optimism about international developed markets?

McManus: I think time horizon again; I come back to that. I think a willingness to look three years or more into the future and have a sharp pencil around what those free cash flows and free-cash-flow growth are worth, is something that time and again we see markets missing. Sometimes it’s because of constraints, such as defense companies in Europe being un-investible because of ESG [environmental, social and governance] considerations or regulation. And sometimes it’s because of behavioral bias or behavioral flaws, where the market’s just not prepared to look out more than a year or so. But we see a lot of examples of inefficiency that is great to take advantage of.

Maris: There’s always home country bias. And we see the bias in the U.S. that all the cool stuff that happens, happens here. By and large, it’s kind of true, but you are missing that there’s a lot of fantastic companies, innovative, competitively advantaged, that are located outside the U.S. And so, I would argue the two most geopolitically important companies in the world are the enablers of the leading edge of IT development. One’s a Dutch company; one’s in Taiwan – it’s not the U.S. If you think about some of the leading pharmaceutical companies in the world, they happen to be in Europe. You’ve got this notion that, well, you’re dealing with an area that doesn’t grow, and it misses the fact that these are global companies operating in a global arena and sell all over the world.

So, there’s a lot of fantastic companies that do business outside the U.S. that are cool, that are competitively advantaged, that are going to grow really, really well for a long period of time. And yet, I think we prejudicially ignore that, and that’s to the investor’s disadvantage.

Hetts: That’s a global phenomenon. The database that we have of our own Janus Henderson client portfolios, the home bias in the U.S. is around, call it, a 20% overweight. In the UK, it’s worse; it’s more like 10 times over overweight on UK equities compared to their market cap globally. Australia’s infamous for huge home bias there, as well.

Maris: The anecdote I have on that, Adam, which I think is such a great point: A few years back, I was speaking to a group of advisors here in Denver on global markets, and as soon as it ended, a bunch of hands shot up and were like, “Why in the world would we ever invest outside the U.S.? All the cool stuff happens here, this is where the growth is.” The same week – it was two days later – I’m in London giving the same speech on global markets. And as soon as I’m done, a bunch of advisors’ hands shoot up – and these were across Europe, UK, and the continent – and [they] were like, “Why in the world would we ever invest in the U.S.? The valuations are nuts, the politics are crazy, this makes no sense.”

And the right answer is, you’re both right. What you just said is absolutely correct, which is why you want to think about things seamlessly and invest in truly the best companies you can find, irrespective of where they just happen to be domiciled.

Hetts: Julian, going back to the global perspective, you mentioned free-cash-flow investing a little bit earlier. So that’s a lot of hard work, adjusting for accounting irregularities and getting companies to look apples-to-apples from a cash-flow perspective. Is that harder work in the U.S. market or the ex-U.S. market, as far as understanding the different accounting quirks, normalizing for that?

McManus: I think, again, just to echo George’s point, each has its own challenges. In the U.S., you have to do more work adjusting for stock-based comp [compensation] and non-GAAP [generally accepted accounting principles] adjustments that a lot of companies are fond of to flatter their numbers. Conversely, in places like Japan, where managements are relatively insensitive to their own share prices, you have to do the opposite; you actually have to add back things like goodwill, amortization because typically their accounting conventions do a poor job of that and actually understate their true free-cash-flow potential and earnings power. So, both have their needs for adjustment, and it takes a global perspective to be able to grasp each and make a fair comparison.

Hetts: Okay, thanks. So, I think we can round off on a couple of the more specific macro shocks we’ve been dealing with, and we’ll talk about banking stress and energy shortages. So, we can start with banks: Just how are you two looking at European banks in the face of what we’ve seen, that’s been more or less a U.S.-centered banking crisis, if you want to call it that. Obviously, some overflow into Europe already, but what’s your view there?

Maris: I think, certainly, first of all, when Credit Suisse goes under, it shows that Europe’s not immune to the fears in banking. But there’s a couple of key things that separate the European banking industry from the U.S. banking industry, especially when you get outside the G-SIBS [global systemically important banks] in the U.S., the smaller banks. And that is the securities portfolios of these European banks, by regulation, mark to market their portfolios, so you don’t have these big held-to-maturity potential embedded losses that are in there that need the marking. So, the portfolios are marked to a more realistic market perspective, and that provides a lot more comfort.

And even with that, part of the function of a very challenging regulator environment over the last decade for European banks … folks forget that 2012 and 2013 were really tough periods for European banks, given some of the instability in European markets then. These banks have had to have incredibly resilient and strong balance sheets, just forced via regulation. And so, even with the marking to market of the securities portfolios, they have substantially higher capital positions than do the U.S, and frankly most of the rest of the world, and so it puts them in a much more resilient and strong perspective.

Competitively, most European markets are much more concentrated. The U.S. still has well over 5,000 banks. Most European countries have a dozen maybe, and so, the whole continent of Europe probably has 10% of what the U.S. does, or something like that. And so, the competitive situation is better. You’ve got better balance sheets. You’ve got more concentrated, competitive positions. I guess a side benefit of not really having a lot of GDP growth [is] there’s not a lot of places to put bad loans. You don’t have the kind of consumer leverage that you have in the U.S. It’s a much more thrifty culture in Europe than it is in the U.S.

And then, moreover, you don’t have a lot of the leveraged loan activity that you have in the U.S. The innovation sparks some excesses. You don’t have that, as well, so their loan portfolios tend to be a lot cleaner. And yet, these banks trade at, even today, substantial discounts to their U.S. brethren, which to us is very bizarre.

And then, lastly, these banks have had to generate earnings for the last several years in the face of a very hostile yield curve – yield curves that were not only negative in real rates [inflation-adjusted], but negative nominally [not adjusted for inflation]. If you’re a bank and you’re trying to earn carry and the overarching rate is -50 bps [basis points], good luck. That’s changed dramatically. So that uplift of the yield curve is going to benefit Europe net interest income a lot more than it will for U.S. financial institutions.

McManus: Yes, and I think a lot of people also less familiar with European financials probably are unaware that they’ve spent the last 10 years having to contribute to the Resolution Fund, which is a central bank-mandated fund to deal with banks going under. This has been around a 10% drag to their earnings, which effectively goes away from next year. So, there are hidden boosts to profitability that are probably not appreciated by the broader market.

Hetts: That’s right, definitely wasn’t appreciated by me.

So, then another massive stress, particularly in Europe, is the energy shortages and the inflation stemming from the Russia/Ukraine war. Do you see these energy shortages as a major headwind for Europe’s medium-term growth? We had a somewhat warm winter last winter in Europe. Of course, no idea this coming winter, but what are these energy constraints going to do to Europe in the medium run, in your view?

McManus: I think Europe has generally learned to deal with the problem. Germany moved incredibly fast to put in place alternative suppliers of natural gas. It built receiving terminals on its relatively small coastline in record time. In normal times, you could never have got these things permitted. And they’ve effectively repositioned all of the floating re-gas units available globally off the German coast. In addition to that, I think a lot of demand has learned to live with less energy supply. And so, barring an extremely cold winter next year – obviously, we can’t predict the weather – I think Europe’s in much better shape than was feared late last year.

Maris: I do think Europe’s energy policy leaves a lot to be desired. I do think that’s an area of emerging risk that we’re paying attention to, and it’s also a source of potential U.S. manufacturing competitive advantage – just a lot cheaper feedstock that the U.S. has relative to its international peers, and so I do think that’s an area that bears watching. I think a warm winter bailed Europe out this year. I do think it allows them more time to continue to build more resilient supply going into the winter of ’23, and it needs to be there, so we’ll see what happens.

Maybe my concerns are a little bit higher than Julian’s, but I do think, in the back of my mind, if something could go wrong, a disastrous energy policy would be what leads to it. And truly, it’s hard to overcome a decade’s-plus worth of really short-term policy overnight.

McManus: Yes, it’s fair to say, definitely … to tie those two lines of thought together, the U.S. is going to be massively advantaged in terms of downstream chemicals, for example. No one today is going to build a downstream chemical plant in Europe when you can build it on the Gulf Coast [of Mexico] with advantaged feedstock. But that said, I think Europe has done a really good job of navigating the challenges, and I think we’re through the worst of it.

Hetts: Okay, I think we checked off everything I was hoping to hit with you guys. Anything I’m missing, or should we call it a wrap?

Maris: I think the one thing that I’d want to maybe highlight, as well – and we’re talking about the relative attractiveness of Europe and, frankly, ex-U.S. vs. the U.S. – is that the valuations of ex-U.S. stocks relative to the U.S. have probably never been as attractive. They’re attractive in both a relative but also absolute sense. At these levels, they are priced so low that you can make money even in the face of a tougher environment. And there’s a fair rejoinder, and I agree with it, that the U.S. should be more expensive just because the U.S. is over-levered to growthier industries and sectors. So, for example, technology and healthcare make up a greater proportion of the S&P 500 than they do, let’s say, in the FTSE or the European indices or the ACWI ex-U.S. But what’s interesting is that, historically, those sectors… so, if you’re investing in technology outside the U.S., you’ve actually paid more than you would in the U.S. because of scarcity value. But what’s interesting now is tech stocks outside of Europe – or, outside of the U.S. excuse me – are now cheaper than they are in the U.S. Same thing for healthcare, same thing across all sectors. So, all sectors are now cheaper than they are in the U.S. And not only is the aggregate market cheaper, but each of the subcomponents are cheaper.

It just makes it even that much more compelling to allocate capital to companies that are domiciled outside the U.S. And I do think that the recent dynamics, year-to-date, mask a much weaker set of internals in the U.S. than you have elsewhere. And so, again, I do think that the relative opportunity, and absolute opportunity, to make money outside the U.S. is as attractive as it’s been in a while.

Hetts: I think that’s a good point. It’s one thing when Europe was a lot cheaper in the midst of a bull market for a decade, but in the midst of what seems like a more challenging slowdown kind of environment, we’re going to have some earnings weakness. That below-average multiple ex-U.S. actually means the markets can absorb some of that earnings weakness. And that’s a different benefit of a lower multiple in this kind of tougher environment than what it was when the U.S. was just going straight up.

Maris: I think that’s right. Now, I think if you’re talking about the next year or two, earnings estimates outside the U.S. seem a lot more well-triangulated to the environment than they do in the U.S. So, I think in the U.S., revisions have been slow to react to the environment. And so, I think that earnings revision resilience is greater outside the U.S. than it is in the U.S. right now.

McManus: I think, just to add onto that – it’s less earnings sensitivity, but the leading indicator that many in the market used to use in Japan was machine tool orders. Those have rolled over, and yet the markets remain remarkably resilient in the face of that, and I think a lot of that is down to very low valuations as a starting point. So, that’s just one more reflection of what George was talking about.

Hetts: Okay, George and Julian, thanks again for the big update on international equities. And thanks to our listeners for joining. If you haven’t already, you can find more Global Perspectives on Spotify or iTunes or wherever you listen. And of course, check out the Insights section of the Janus Henderson website for more of our views.

Thanks again. See you next time.