Prepare for a new world investment order

PORTFOLIO POINT: The investment winds of change are upon us, and investors will need to make major adjustments to their asset allocations and strategies over the next 10 years.

We are seeing a rally in global stockmarkets, which provides an opportunity for investors to make long-term decisions about their equity exposure and their allocation of funds.

Today I want to share with you the ideas from one the world’s largest broking houses, Goldman Sachs, about what the world is going to look like over the next 10 years and the investment strategies required.

The Goldman view of the world over the next decade might be right or wrong, but the view envisages a world that is very different from any previous decade in the last century. If they are right, it will require significant portfolio adjustments by Australians.

Katie Koch is portfolios strategist for Goldman based in London and she believes that global growth is going to come from Brazil, Russia, India and China (the BRICs), plus Mexico, Indonesia, South Korea and Turkey. She is not the first to say this and it’s hard for individual retail investors to tap these markets without using big institutions to provide spread.

But her views go deeper and she says:

“We think that an allocation of 25% of global equity exposure directly into growth in emerging markets is a prudent allocation for investors. We certainly aren’t suggesting that investors should sell all their developed exposure.”

When it comes to Europe, the Goldman/Koch view is unusual: The European sentiment is “very, very bad” but valuations for European equities are “incredibly cheap”. Earnings are at a 50% discount to their long-term history. The dividend yield for the European equity market is at about 4% to 4.5% spread over German bonds. Valuations actually look “really compelling” for European equity.

Koch says 50% of revenues for European corporates come from outside Europe: “Yes, there is a lot of bad stuff happening in Europe, but actually if you can take a step back from that and be contrary and long term, there’s really an opportunity there to step into the equity markets '¦ we are overweight Europe relative to other developed markets and that’s a pretty contrarian position”.

But Goldman also recommends holding money back in case the European problems become worse. Koch says that if the Euro splits there will be great disruptions and there could be a cheaper entry point. “For sure, markets could sell off again, so give yourself the opportunity to take advantage of that,” she says.

It’s not a bad strategy – take a base position in Europe in case it does sort itself out but be ready to invest more heavily on a sell-off.

What about American equities? Koch says: “When you compare US with Europe, investors have looked at the US as a relatively safe investment destination.

“European and US equities usually perform in line but over the past year and a half US equities have outperformed European equities by about 30% and European equities are trading at a 50% discount to their long-term history. On that metric US equities are actually at a 20% premium”.

Corporate profitability has been strong, partly because they’ve been able to keep costs down, and are selling into more dynamic parts of the world. In the US it’s reflected in share prices but in Europe “I don’t think it’s been appreciated at all”.

The second part of the Goldman strategy is their predictions about the changing nature of the wealth of China. It’s not exactly good news for Australian miners.

This is an edited version of my conversation with Koch on this front:

Gottliebsen: Do you think the next 10 years’ growth will require the same amount of minerals or less minerals or the growth in mineral demand just keep going?

Koch: I 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 and all the other growth markets that we talked about.

However I do think that some of them are further along in their pattern of building out infrastructure, and so 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.

Gottliebsen: So it won’t stop them requiring commodities, but the pattern of development will tend to lower mineral demand and there might be more demand for food.

Koch: High demand for food is going to be true across all these countries, particularly in the higher protein segments of food. I think when you look at demand for minerals,I think people have to have realistic expectations of what that’s going to look like over the next decade versus the last.

These countries are all going to be diversifying out of mineral demand 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 (minerals demand).

Gottliebsen: So, if we push mineral production up too far and too quickly, we could see gluts?

Koch: I think that the supply response will have to be very careful about that. Yet 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?

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, because people have recognised the demand and demand is probably going to be a bit more moderated.

Gottliebsen: So, you can actually see some quite reasonable falls in prices of commodities?

Koch: No, because I think that there’ll be an appropriate supply response. I don’t think you’ll see that level of volatility”.

In my view, the words “supply response” are a euphemism for lower production. If Koch is right, then a significant part of the vast army of new projects coming forward in Australia are not going to be built and the very high mineral prices are a thing of the past. Make sure your portfolio reflects this likelihood.