Manager Q&A: What's Up In International Equities? Watch The Trade Rhetoric 

Michael Testorf, Portfolio Manager at ClearBridge Investments 

How are you approaching international equity markets?

We are monitoring the trade rhetoric. If trade rhetoric eases a little bit, the immediate response will be a weaker U.S. dollar. The U.S. dollar has been very strong over the last month. If it gets weaker, emerging markets will move up. International markets then get tailwinds. The deck is pretty clear to look into a second wave of performance for international equities, particularly if the U.S. Administration eases up a bit. I would leave my eyes open and look for the right entry opportunity, in little steps.


What tangible evidence can you provide that the recovery abroad remains intact?

Last year was a phenomenal year for the international market. In 2017 we had tailwinds not only from the local stock markets, but also from many currencies. At the beginning of this year, we were probably a little too complacent. A lot of flows were going into emerging markets, but also into the developed markets. Since then, we have seen major underperformance in emerging markets, but also in the developed international markets. Part of that was reversing some of the 2017 currency gains, and growth slowed down versus expectations.

Investors worry about trade tariffs, renminbi weakness, liquidity and moves by the central banks, but all these are reflected in market positioning. Many investors have taken a slower path into international markets. We are just the opposite of overbought. Fundamentals still look pretty good. We could see positive returns for the international market towards the end of the year.


How do you assess the current state of major consumer indicators?

Consumers have been in good shape in most countries, with higher wages in many because all the trade deals with the unions have done really well. Unemployment is on low levels; balance sheets of consumers have improved materially; and consumer confidence is close to highs.

Unemployment is a lagging indicator, but we could see in Eurozone unemployment in 2020 reaching the 7 percent level. That would be a great achievement, at levels seen the last time before the crisis in 2008. In Japan, unemployment is around 30-year lows. We have the highest applicant ratio ever and employers must draw more women into the workforce to fill jobs.


How well are corporations faring in these countries?

Corporations also are doing fairly well. The manufacturing Purchasing Managers’ Index (PMI) is still around the 54 level. Utilization rates are around 84, levels that normally lead to more capex investments. They must come; it’s more a question of time. Corporate balance sheets in Europe are strong. In Japan, they’re incredibly cash-rich, with cash flows continuing to be strong. Share buybacks have not happened in Europe and Japan to the extent of the U.S.


What do you think will happen to the international central banks?

That’s a big question. Will they still be accommodative, or will they be like the U.S. Federal Reserve when it was strong and provided a little bit of liquidity? For 2018, the European Central Bank for sure would be judged accommodative. In 2019, it will be probably be neutral, and we will see interest rate hikes only in 2020. The Bank of Japan has had interest rates close to zero for the last 10 years. We worried that China’s money supply would be down strongly, but that changed because the Chinese central bank opened up its money supply quite dramatically and is pumping money into the economy. We saw that in July.


What about valuations?

Price/earnings valuations normally do not derate if earnings are growing. Earnings are growing. If you look to the last peak, Europe is still 18 percent below the 2008 earnings level. Southern Europe in particular is lagging. The U.S. is doing very well, with earnings 60 percent ahead of 2008, but that is mainly due to the tech part and the very strong push from tax reform.

If you look further, is there any kind of stress on high yield markets? No. So overall, the market environment fundamentally is not bad. It is more a question of sentiment. Fortunately, we have been good at finding companies which have done well. We have avoided the potholes and our exposure to trade wars, Turkey’s problems and Chinese deleveraging has been limited.

Looking ahead to 2019, international markets should be similar to or slightly better than the U.S. in earnings growth because 2018 was a big winner in the U.S. because of the tax reform. The very strong earnings here sucked money into the U.S. market. In 2019, the Eurozone should be similar with the U.S., and emerging markets slightly better.


How has your team dealt with the growing political risks, and tried to mitigate those risks?

The biggest worries we see for sure right now are trade tariffs; China; and Italy/Turkey.

Starting with trade tariffs, it is very difficult to predict how the whole thing will pan out. We must see what will happen towards the midterm election, and after. Will the trade rhetoric stop? Will certain things be reversed, or eased at least? Trade tariffs are counterproductive, not only for the rest of the world, but also for the U.S. We all pay for higher tariffs. They increase the price for every single piece of goods and services we consume. That means we will have less money to spend, and GDP will come down. That will be not good for the U.S. economy. In the short-term, some steel mills will reopen, but it will not make a big difference to GDP growth.

It is very difficult to change global supply chains quickly, and once that supply chain has changed, is it very difficult to bring back. More companies will start complaining about the trade war and its impacts, as well as the unintended impacts we will see in the U.S.

If prices overall are rising, inflation could also rise. Inflation will lead to slightly higher interest rates, which will come at a time when the U.S. has a maximum amount of debt to be financed. We are talking about a 5 percent trade deficit in 2019 and 2020. There are a lot of unwanted consequences which have to be thought through by rational thinkers. My serious hope is that, after the midterm elections, we will have a more positive environment.


What about the recent deleveraging in China?

China’s deleveraging made almost a U-turn, because the Chinese government wanted to do the right thing. They wanted to restructure the state-owned enterprises (SOEs), reduce overcapacities and focus on profitable enterprises. Then these profitable SOEs would be merged or closed. They also wanted to put a stop on the wealth management products which very often invest in unsustainable companies; once these go bust, investors would get hurt. A new regulator who does the banking and insurance markets has addressed this subject quite dramatically.

China is like a super tanker: to steer it, you need more time. If you put your foot on the brakes, it could slow the whole economy. To restart it, you have to push down on the accelerator, hard. China is on the accelerator again, with countermeasures against the trade war. We saw major improvements in the Chinese money supply in July; the banks just have to follow through and give out more loans. China is less of a worry than before.


What about Italy?

Italy is a bigger potential risk than Brexit. Italy comprises 15 percent of Eurozone GDP and 23 percent of public debt. Greece was only one-eighth of Italy, but most Italians still want the euro and like being part of the EU. Italy has a large economy, and the last in Europe to hop on the growth train of improvement. We may have seen the maximum point, but for political risks, it can be very hard to predict the final outcome.

The banking system was in very bad shape because they had a lot of bad debt. They did not do a restructuring, but that has been resolved to a good part. With good, strong growth in Italy, the last problems could be solved as well. But the election brought a compromised candidate, Prime Minister Giuseppe Conte, and two vice prime ministers who belong to anti-establishment parties.

These political situations create uncertainty for business. They likely will postpone company or consumer spending, so GDP will be lower. We will see new details from the Italian government in the next few weeks. Most likely, it will reverse the very much needed pension reform. It will lower VAT, cut taxes or so on, but that will also mean Italy’s debt level will increase again – and that could bring indirect conflict with the European Union. Italy has to submit their plans by mid-October to the EU, so do not be surprised about the noisy headlines coming from Italy.


Michael Testorf is a Portfolio Manager at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.






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