Goldman Sachs Asset Management senior portfolio strategist Katie Koch tells Business Spectator's Alan Kohler, Stephen Bartholomeusz and Robert Gottliebsen:
Alan Kohler: OK Katie Koch, the world has perhaps more clearly been divided between the developing old economies and the new economies because of the way that Europe and America are slowing and then such trouble with the debt and I guess the emerging economies are still growing. So, how do you see that from your position as a portfolio strategist? Do you basically have to divide your portfolios between the two or just focus on emerging economies?
Katie Koch: Right . So, I think I’d start by saying that I agree absolutely with the premise of the question, which is that world growth is increasingly shifting to a part of the world that we actually call growth markets. So, the first thing I would say is that we no longer call them emerging markets, some of the most big important ones, because we think they’ve evolved and emerged already. And because they are having such a dramatically positive impact on global growth that they need to be thought of in a new paradigm and the way that we call them now, growth markets, we think is a better recognition of the impact those countries can have. And to quantify that for you, we actually think that eight countries that we call growth markets are going to drive 60 per cent of global growth over the next decade. In fact, if you were to look at the top ten contributors to global growth over the next ten years, we think eight out of ten of them are going to be the growth markets.
AK: Which are those eight markets? Do you want to just run through them?
KK: Sure. It’s all the BRIC countries, so Brazil, Russia, India and China and then four growth markets after the BRICs are Mexico, Indonesia, South Korea and Turkey. And those together again are going to be the engines of global growth, so to get to the point of your question, we absolutely think that these countries need to be a very core part of client portfolios, both in the equity part of their portfolio as well as the fixed income part of their portfolio. There’s obviously still a place for developed market exposure. You know clearly very well in this market that there are developed market listed companies that can benefit from the dynamics in these economies, but increasingly we think that there is a very strong investment case to be invested directly into these countries.
Stephen Bartholomeusz: These growth economies, how dependent are they on the developed world?
KK: I would say that going forward we actually think they’re going to be less dependent and the reason for that is that we think domestic consumption is going to be a much bigger driver of growth within these countries, so maybe can take China as an example. Over the last ten years China is obviously very dependent on developed markets because their growth model was about exporting, particularly in the light manufacturing sector, to the rest of the world. In the next ten years China is going to grow slower than it did in the last ten, so maybe that’s the bad news and we saw some of that come out last Friday where they printed growth at about 7.6 per cent, slightly below consensus and obviously below the trend growth over the last decade. But there is good news in that which is that the next ten years are going to be in our view a period of higher quality growth because it’s going to be internally generated growth and increasingly they’re going to be dependent on their own citizens and domestic consumption for driving growth going forward. And if I could broaden that out to the other countries that we talked about, the growth markets, a pretty remarkable fact about those countries is that we think two billion people are going to enter the middle class across the growth market countries in the next two decades and so that just gives you a sense that there is going to be increasingly a domestic driver of growth within those countries. The last point I just want to make there is that in our actively managed portfolios, you know, we obviously recognise that growth is slowing in Europe as well as in the US and so we overweight this theme of domestic consumption and hopefully that gives our portfolios some insulation from the woes in developed markets.
Robert Gottliebsen: The international portfolios in Australia have a very big skew towards developed countries who have been… mainly America but also Europe. Would you say that we need to readjust our superannuation portfolios so that most of the international sector of those portfolios is in these growth countries?
KK: Sure. I would say that we just take equity markets.
KK: We think that an allocation of 25 per cent of global equity exposure directly into growth and emerging markets is a prudent allocation for investors. So we certainly aren’t suggesting that investors should sell all their developed exposure. That’s not the case. We think they need to have a balance of both and our recommendation right now is to have 25 per cent of equity exposure directly into growth in emerging markets.
RG: Are the stocks in those markets overvalued? When you look at a Chinese stock it always seems to be incredibly expensive and ditto for some of the other countries.
KK: So, I think that’s a great question because I think everyone needs to remember that valuation for equities is basically a primary driver of returns. So, we can sit here and talk about this really exciting growth story, but we’re asking people to buy a derivative of that growth or get exposure to a derivative of that growth which is equity markets. And in order for a GDP to translate into investment returns, you have to access it at a good valuation and so to get to the harder question: are valuations attractive? I would say absolutely for growth in emerging markets it is attractive. If we just take the BRICs for example, right now they have a valuation of about eight times on a twelve month forward priced earnings metric. That is at a discount relative to their long term history and it’s also at a discount relative to developed markets despite superior growth prospects and some would argue superior quality on the sum of balance sheets of those countries. So, I think what’s pretty exciting about this point in time for Australian investors that might be underweight this opportunity is that you have a great secular story of strong growth dynamics and also a very compelling interesting cyclical entry point.
AK: What about the non-BRIC markets that you mentioned minutes ago, Turkey and Indonesia? Are they even cheaper perhaps on a PE basis than the BRICs?
KK: They’re not cheaper. They’re actually marginally more expensive, but one of the reasons for that is the sector composition of different markets. So, when you take the BRICs it’s more commodity heavy and so it tends to trade at a slightly lower valuation. In Mexico, Indonesia, South Korea and Turkey if you aggregate those countries, lower commodity exposure so it trades at a little higher of a valuation. But the point still holds overall: growth markets trading at a discount to history and a discount to developed markets.
AK: And how safe are those markets to invest in?
KK: I would say that in this environment when you look at a portfolio overall, diversification is your friend, right, because you want to be diversified into countries with different and potentially higher growth patterns and diversified into countries whose capital markets may not lower correlations to developed markets. So, when I think about safety I think the primary thing to do there is to diversify one’s portfolio and from that perspective adding, you know, substantial weight to these countries up to 25 per cent of a portfolio, when we take a step back and look at the portfolio overall, I think that can be a very return enhancing but also risk adjusted return enhancing decision. So from that perspective I would say, you know, it can improve portfolio safety.
SB: Katie, since the onset of the financial crisis there’s been enormous volatility in capital flows. People pursue those sorts of risk on, risk off type strategies. Do investments in these growth markets do they come with high volatility and risk?
KK: Yeah. So, you know, a great question and the answer is yeah they do, and it really dovetails on what you were asking as well. Volatility is higher, so if you were to measure volatility as standard deviation of returns, right, it’s higher for growth in emerging markets than it is for developed markets. And this gets at something very important, which is that in these countries, and part of it’s because we need to educate people about improvement, both on sovereign and corporate balance sheets within growth emerging markets, but the reality is there is a disconnect between the fundamentals which we think are very, very sloppy in these countries and sentiment which is weak and because it’s a higher beta asset class and because it has a higher volatility, when risk aversion rises, capital flow can be strong out of these countries. And so what do you do with that information as an investor? You look at valuations. They’re saying that this makes a good entry point, so we think it makes sense for clients to build up positions right now, but we do think they need to leave some money on the side because the volatility is there. If more bad news comes out of Europe, these markets probably will sell off and that will give an opportunity for investors to add more to their exposure.
RG: Do you think there’s a real chance that a European split which will greatly affect the global banking community and therefore share prices? What are your odds on that happening?
KK: So, you know, this is a question obviously that’s been asked to many people over the past four years and I don’t think it’s hugely productive for me to speculate on whether or not the eurozone will break up. But here’s what I’d know if I take a step back as an investor because what we’re really focused on is: what kind of investment opportunities is this throwing up for our clients? One of them is what we just talked about which is diversifying away from issues in Europe as well as the US and to the growth in emerging markets, right, so diversifying into other countries. The other one that is interesting to me though for Europe specifically is that yes the sentiment is very, very bad. That’s obvious, right. Connected to the sentiment being bad about the European macro situation valuations for European equities – incredibly cheap. Valuations for European equity markets even if you normalise earnings are at a 50 per cent discount to their long-term history. And if you were to look at the dividend yield for the European equity market, it’s at about 4 per cent spread to 4.5 per cent spread over German bonds. So, valuations actually look really compelling for European equity. And the last point is that when you look at European listed companies, a phenomenon you guys will be very familiar with, from an Australian perspective, 50 per cent of revenues for European corporates come from outside Europe, right. So the European macro is not actually the European equity market. And if you were to look at the earnings profiles of European companies, it has a very low correlation to European GDP and the markets that they’re selling the growth is increasing mostly in terms of revenues is actually growth in emerging markets. So, there is a compelling opportunity. Yes, it is a lot of bad stuff happening in Europe clearly, but actually if you can take a step back from that and be contrarian long-term, there’s really an opportunity there to step into the equity markets.
AK: So, is your fund a buyer of European equities?
KK: When we look at global equity overall, we are overweight Europe relative to other developed markets and that’s a pretty contrarian position, but it’s for the reasons I highlighted; sentiment is weak, valuations are attractive and revenue has huge amounts of exposure to faster growing parts of the world.
RG: But you’re also saying keep some money back because if it does split – I’ll quote your odds on it – if it does split, you’ll have great disruptions I markets?
KK: Absolutely. So, I think it’s imperative because of Europe and also a lot of other uncertainty out there right now again that clients I think should be comfortable buying into equities at these valuations in Europe as well as growth in emerging markets, but yeah the drumbeat of bad news could certainly continue. There could be a cheaper entry point. For sure, markets could sell off again and give yourself the opportunity to take advantage of that sounds like a very sensible investment strategy.
AK: What’s your view about the Australian market?
KK: I don’t cover the Australian market very closely from an equity perspective. Where I sit in my team we’re more focused on growth in emerging markets and from a developed perspective – Europe and the US. But what I do think from an Australian investor perspective, listen there are obviously some companies here that we know reasonably well, there are big beneficiaries of the trends that we’ve talked about in the growth markets and we think that those are great companies for Australian clients to own in their portfolio. I do know from speaking to investors here that there is a very strong home market bias in portfolios and back to the question that I was asked earlier, what I think is very important for clients to do again is to diversify and have some more direct investment into these growth market countries. And let me tell you why. Because while all these are great Australian companies to own in one’s portfolio, we’ve said that we think one of the themes that’s going to be most exciting within the growth markets is the rise of the middle class and the domestic consumer and there are not a lot of ways to access that through the Australian equity market, so especially for Australians direct investment into what we call the growth markets and getting access to that consumer I think is going to be paramount to having investment success over the next decade.
SB: Katie, you referred a little bit earlier to the disconnect in Europe between the corporate performance and the gross settings. There’s a similar disconnect, isn’t there, in the States where the corporate profitability has been really strong, but the mood and that sort of risk aversion is a bit strong. How do you see that playing out in the States in the next few years?
KK: You know, it’s a correct observation, but the reality is that when you compare US with Europe investors still have looked at the US as a relatively safe investment destination, so if you look at the world over the past 18 months, European and US equities actually usually perform in line. Right now, over the past year and a half US equities have outperformed European equities by about 30 per cent and actually I gave you that valuation metric earlier, that European equities are trading at a 50 per cent discount to their long-term history. On that metric US equities are actually at a 20 per cent premium. So, I completely agree. Corporate profitability has been strong. One of the reasons is because they’ve been able to keep costs down. The other reason is because they are selling into more dynamic parts of the world, but I think in the case of US that’s more fully reflected in share prices. In Europe I don’t think it’s been appreciated at all and that’s why we think Europe could be a better relative valuation call right now.
SB: If you take a view that it may take the best part of a decade for both Europe and the US if everything goes well to deleverage, particularly public sectors, what does that mean for equity markets?
KK: Well, first of all the US is further down that path, particularly with individual consumers than Europe is. They’ve done a good job of rebuilding those personal balance sheets post the crisis. But there’s no doubt when you take a step back, both Europe and the US from a sovereign perspective clearly need to lower debt burden on balance sheets. I don’t think that there’s going to be a crowding out effect for equity markets again I think because the corporates are very strong from a balance sheet perspective and they have the ability to tap into dynamic parts of the world in terms of growth. I actually think over a kind of a multi-year view the equity market looks extremely attractive. In the US I’d rather be in equities right now than I would be in the fixed income market, not just because I think there’s a real, serious, you know, systemic risk about fixed income in the US market, but if you just look at the 10-year treasury, it’s at a 220-year low, right, so when you look at the relative valuation call there, you know, maybe equity looks more compelling than the US market itself.
RG: If you look at the growth pattern which we're seeing in these countries over the next 10 years, do you think it’s going to be less commodity orientated like it was over the last ten years? In other words, have you got any mineral commodities?
KK: I think a great country to talk about to answer that would be Russia. So Russia has that growth pattern really for several decades has been extremely commodity driven, right. This has been the big driver of growth in this country and that is by the way that Russia had a bad crisis in 2008, right, so growth deteriorated very quickly, you had capital outflow, etcetera, etcetera, but you used a phrase that my boss, Jim O’Neill who’s the chairman of Goldman Sachs Asset Management likes, "never let a crisis go to waste” and I think the Russians really had learned from that 2008 period and they seem extremely committed to diversifying out the economy and to get even drivers of growth for that country going forward. And so I absolutely believe over the next decade that consumer as well as industrial policies, so even exporting things outside of commodities, is going to be more part of the Russian growth trajectory.
RG: I’m thinking of the question slightly differently. Let’s take China. Its growth in the last 10 years has required vast amounts of minerals. Do you think the next 10 years’ growth will require the same amount of minerals or less minerals or the growth will just keep going in mineral demand?
KK: Yeah. So, I actually believe that there’s still going to be demand for commodities across all these countries because they are literally in the process of being built. It’s true of the BRICs. It’s true of all the other growth markets that we talked about. I however do think that some of them are further along in their pattern of building out infrastructure and so yeah as mentioned earlier when you think about the incremental growth drivers going forward, it is going to be more about the consumer than it’s going to be about building stuff on the ground of those countries.
RG: So, it won’t stop the demand for commodities, but it will tend to lower it and there might be more demand for food.
KK: Yeah. Well, that’s going to be true across all these countries, particularly in the higher protein segments of food, but I think when you look at demand for commodities, I think people have to have realistic expectations of what that’s going to look like over the next decade versus the last and because these countries are all going to be diversifying out and because the consumer is going to be a bigger driver of growth versus fixed asset investment, we may have to moderate expectations on that.
RG: So, we might, if we’re not very careful, get a glut? If we push the production up too far and too quickly, we could get gluts in that situation.
KK: I think that the supply response will have to be very careful about that. And ultimately you ask are we in a super cycle for all these commodities going forward. I mean it’s been a great decade to be in commodities over the past decade. Is that going to continue over the next decade? I guess our view is that we have a more moderate view of what that cycle looks like over the next 10 years because there is more supply capacity now around, right, because people have recognised the demand and we think demand is going to be probably a bit more moderated.
RG: So, you can actually see some quite reasonable falls in prices of commodities?
KK: No, because I think that there’ll be an appropriate supply response. I don’t think you’ll see that level of volatility.
AK: Within the sort of shift that we’re talking about from the developed world to the growth economies, obviously there’s that shift taking place. Do you think the next 10 years’ global growth overall will be the sort of growth that we’ve seen over the past 10 years?
KK: Actually we think the growth for the world over the next decade could be higher than it is over the last decade, so we actually think world growth could exceed four per cent on an annualised basis over the next ten years and that compares with trend growth under 4 per cent over the past two decades. And the reason that we think the world can actually grow faster over the next ten years than it has over the previous couple of decades is because of the rise of these growth market countries and their ability to substantially alter growth trajectory. So, this is a pretty exciting decade.
AK: Which you obviously think will be greater than the drop off in growth in Europe and America?
KK: Yeah. So, their total growth is going to be higher than it is for developed markets, but the other thing is that they’re much bigger now. So, they’re already bigger countries and they’re going to be able to impact global growth trajectory in a more meaningful way.
AK: Because I guess the rise of the middle classes that you talk about, two billion people entering the middle classes will be offset to some extent by people dropping out of the middle class in Europe and the United States.
KK: Well, first of all I don’t actually think that you’re going to see that that will happen from an income perspective. I think what’s more interesting is that in the growth markets themselves you’re going to have people entering the middle class and your people that are now in the middle class that are actually going to enter into levels even above the middle class, right. So I think the overall the power of consumption in those countries is going to be strong and it will be strong enough to offset any weakness that you have in developed markets, but we don’t see tremendous numbers of people falling out of the middle class in developed markets.
SB: Katie , one of the interesting shifts in language at least in China in recent times has been a transition away from Europe and the developed world towards their own neighbours in Southeast Asia in terms of trade. Are there existing linkages and could they develop?
KK: Yeah. I mean China’s biggest and most important trading partners now actually are increasingly within the growth market countries and vice versa. Brazil’s number one trading partner used to be the US and now it’s China. So, I would expect these countries to have even increasing trade linkages. And that’s actually a really good thing for people that are looking to invest into growth markets because the more these countries trade with each other, right, intra-growth market trade which is picking up pretty substantially, then the less dependent they’re going to be on anaemic growth patterns out of the US and Europe and ultimately that will be actually quite a good thing for investors.
RG: Just one final question, I know you’re an expert on Australia. Our portfolios in Australia are domestic portfolios are basically mineral companies and banks that dominate most investment portfolios here. You’d be putting a caution out there, wouldn’t you, because of a growth pattern you see in the next ten years in mineral demand and well banks are banks?
KK: Well, first of all I think you have done a tremendous job in the financial sector in Australia relative to the rest of the developed markets, right, so I actually think the banks here are very high quality. And then from a commodities perspective again it’s much more complicated than just saying we’re not in a super cycle because when you think about investment returns, you have a supply response and you also have to think about what valuation you’re accessing these stories at, so I’m not saying anything negative about the Australian market, but what I am saying is that Australian investors need to diversify their portfolios to have more drivers of growth in their portfolio. And it’s not just about getting other countries in their portfolio which we think is important, especially the fast growing countries, it is also about getting a diversification across sector exposure. So getting things like exposure to post secondary education in Brazil which you can do on a listed exchange, or the story of beer being drunk in Africa in greater quantity, or pizza delivery in India. All of these big kinds of themes that have very little correlation to what’s happening on the ground in Australia would be great things for clients to have exposure to in their portfolios. And again, they can access a lot of this growth and a lot of these themes I’ve just highlighted at pretty compelling valuations.
AK: It’s been great talking to you, Katie. Thanks for joining us.
KK: Thank you.
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