European equities: which style has been in vogue this year?

European shares made a strong advance in the first half of 2019, but the gains were not evenly spread across the market, shows Simon Corcoran, Investment Specialist, UK & European Equities, at Schroders.

Given the headlines over the past six months, it feels a little odd to realise that European equities are up 16% in the same timeframe. From trade wars to slowing economic growth to Brexit, there are plenty of reasons why the market shouldn’t have rallied. But the gains perhaps look less surprising when we dig into the detail behind them.

We looked at the return for the overall index - MSCI Europe – and then for four style factors within this index: growth, quality, high dividend yield and value.

Style factor definitions:

  • Growth companies may currently be growing at a faster rate than the overall market, and/or have higher potential for future growth.
  • Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance.
  • Dividend yield is calculated by dividing the dividend per share by the price per share; a high dividend yield could be a sign a stock is underpriced, or it could be that the stock is under pressure and future dividends may not be so high.
  • Value refers to those stocks that have low prices relative to their fundamental value. This is commonly tracked by metrics such as price to earnings (a company’s share price divided by its profits).

As the table below shows, growth and quality have been the factors in greatest demand in the past six months. Returns from these parts of the market have significantly outpaced returns from value and high dividend yield stocks.

index-style-ytd-return.jpgPast Performance is not a guide to future performance and may not be repeated. 

The uncertain economic backdrop may be one reason why investors have favoured stocks with these growth and quality attributes. After all, this economic cycle has been very long. As we move towards the end of a cycle, investors often look for those businesses with reliable, predictable earnings that can potentially fare better than the rest of the market in a slowdown or recession.

The MSCI Europe Quality and Growth indices have outperformed the Value index by over 10%. Sectors such as industrials, technology, luxury goods and food products form a large weighting within these indices and have led the gains.    

There is considerable overlap between the MSCI Europe Quality and Growth indices. The table below shows eight stocks that are among the top ten constituents by size in both indices, and the returns posted by these stocks in the six months to the end of June. Only AstraZeneca has failed to outperform the broader MSCI Europe index. 

stock-ytd-return-valuation.jpgAny reference to securities are for illustrative purposes only and not a recommendation to buy/and or sell.

As well as offering quality and growth characteristics, large companies such as these are often favoured in times of uncertainty due to their size. Larger companies are often assumed to offer greater stability than small companies, and have usually weathered a number of economic cycles successfully.  

What does this mean for valuations? The chart below shows the forward price-to-earnings ratio for the next 12 months for MSCI Europe Quality relative to MSCI Europe Value. It shows that investors have recently been willing to pay a larger premium than they did previously for quality stocks.

Quality valuations have become elevated


Martin Skanberg, fund manager, says;

“Such a situation can persist for some time, but is unlikely to do so indefinitely. There are signs recently that the quality rally is fading as companies struggle to meet lofty growth expectations. That said, it is impossible to time precisely when the trend might change. As investors, we look for the best trade-off between risk and reward that we can find”.

This information is not an offer, solicitation or recommendation adopt any investment strategy.  If you are unsure as to the suitability of any investment please speak to a independent financial adviser.

For more on the factors driving the market, see why growth stocks look vulnerable.

See our Alpha Equity strategic capability page for further equity insights.

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Bank of Japan officially enters the currency wars

The Bank of Japan’s stance at its July meeting is aimed at stopping the yen appreciating, explains Piya Sachdeva, Economist at Schroders.

The Bank of Japan (BoJ) today signalled readiness to expand stimulus “without hesitation” if downside risks to inflation were to rise.

Until now, the BoJ had acknowledged downside risks to both growth and inflation, but had given little explicit guidance that it would ease policy. It has kept more quiet than the Federal Reserve (Fed) and European Central Bank (ECB).

There were no major changes to the overall monetary policy framework at the BoJ’s July meeting. The short term policy rate was kept on hold at -0.1%, the 10-year government bond yield target kept at “around zero per cent”, alongside an unchanged ¥80tn annual pace of JGB purchases.

In its quarterly Outlook Report that accompanied the announcement, the BoJ yet again revised its inflation forecasts* down to 0.8% year-on-year (y/y) and 1.2% y/y in (fiscal year) 2019 and 2020, respectively. These exclude the effects of the upcoming consumption tax hike.

The growth projection for 2019 was edged down slightly to 0.7% y/y and remain unchanged at 0.9% y/y for 2020.

Ultimately, inflation well below its target is nothing new to the BoJ and its growth projections actually remain fairly healthy by Japanese standards.

Its “ready to act” stance is aimed at stopping the Japanese yen from appreciating against a backdrop of heighted expectations for easing from both the Fed and the ECB. In other words, the BoJ has officially entered the currency wars.

It is well known to investors that the BoJ has little to ease further, given that interest rates are already negative and a full blown asset purchase programme. We believe that the BoJ will be reluctant to ease further, but so far will be quite happy about its ability to keep the yen fairly stable.

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What is “energy transition” and why does it matter to investors?

The switch to renewable energy is gathering pace and is likely to prove hugely disruptive, explains Mark Lacey, Head of Commodities at Schroders.

Renewable energy is well on its way to becoming a core part of our energy mix. In May this year, the UK went a full week without using coal to generate power for the first time since 1882. Clean energy sources are increasingly being used as cost effective and low emission alternatives to coal, oil and gas.

But renewable energy makes up just a small part of the global energy mix at present. This needs to rise substantially if we are to meet climate targets, including the Paris agreement designed to limit temperature rises to 2°C. We therefore need a rapid switch to renewable sources of energy.

There have been two previous transitions to new sources of energy: from traditional biofuels (such as wood) to coal in the late 19th century, and from coal to oil and gas in the mid 20th century. The chart below shows how the global energy mix has changed since 1800.


As the chart shows, renewables are currently just a small part of the picture. But we think they could reach a 30-40% share of the total mix in the next 30 years.

Both of the two previous energy transitions were long-term structural changes that proved hugely disruptive. Use of coal was spurred by the introduction of the steam engine. The transition to oil & gas was driven by the move to the internal combustion engine. These technologies then powered enormous changes in society.

While full adoption of coal took around 70 years and full adoption of oil and gas took around 50 years, we think the full adoption of renewables will take closer to 30 years, essentially happening much more quickly. This is because it will be driven by forced change; the severity of the threat posed by climate change means government policy simply has to support the energy transition to renewables. 

But switching to energy generated by renewables and away from fossil fuels is only one part of the energy transition. Just as crucial is the development of the infrastructure needed to enable the switch. For example, wind and solar farms can generate a huge amount of power when it’s windy or sunny, but this will need to be stored until it’s needed by consumers.

Similarly, there will need to be huge investment in the transmission and distribution networks to support increased demand for electricity rather than other forms of energy. In addition, a significant amount of investment is needed to make the entire system more efficient and this involves a large amount of technology-driven investment. An important part of this demand is the growing popularity of electric vehicles and therefore new, large-scale charging infrastructure for these will be needed.

To sum up, when we talk about energy transition, generating power from renewables is only part of the picture. The mass introduction of electric transport infrastructure, energy storage, improved transmission and distribution networks, coupled with the increased usage of technologies to improve energy efficiency, are all part of the transition too. We expect this to prove hugely disruptive to the energy industry over the next few decades.

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Where next for China A-shares?

by Louisa Lo, Head of Greater China Equities at Schroders.

The rise of China’s A-shares market is a theme that can’t be ignored. Here’s where we’re seeing opportunities in the country.

China’s domestic stock market is on the rise and we think it represents a potentially very attractive long term opportunity for investors.

There is a striking disparity between China’s share of global economic growth and its share of the global stockmarket index. Chinese stocks currently represent just 3.8% of the MSCI All-Country World Index, while China’s share of global GDP is 16%.

With the market opening up to foreign investors, and given MSCI’s recent decision to include China A-shares into its global indices, we expect China’s representation in global portfolios to increase significantly over the coming years..

How investors access Chinese shares

Investors can access Chinese equities through a variety of channels:

  • The companies quoted in Hong Kong (H-shares, red chips and P-chips)
  • The depository receipts quoted on the NASDAQ exchange in the US (these are called American Depositary Receipts and enable access to the likes of tech giants Alibaba or Baidu)
  • The on-shore domestic market (A-shares).

There is still important progress to be made in A-shares, with the on-shore market only recently opening up to international investors through the Shanghai-Hong Kong (2014) and Shenzhen-Hong Kong (2016) Stock Connect programmes.

These programmes allow foreign investors to access domestic Chinese equities (A-shares) through the Hong Kong Stock Exchange. However, only 3% of investors in the domestic market are foreigners.

Retail investor dominance

The A-shares market remains dominated by domestic retail investors who make up 86% of daily trading volume, compared to 35% for the Hong Kong market.

This high proportion of retail investors contributes to the higher volatility of the market relative to more developed exchanges. This is because retail investors typically have shorter investment time horizons and respond more to market events, resulting in more buying and selling of shares and higher market volatility.

That said, the market is attractive for active fund managers who can take advantage of the inefficiencies in the market. Looking across the board, the median China A-shares fund manager has outperformed the MSCI China A Onshore benchmark in four of the last five years.

Market shifts

Over the last few years, investor interest has shifted from "old" China (infrastructure, banks, telecoms) to a greater focus on consumer (staples, food & beverages) and so-called "new economy" stocks (healthcare, consumer discretionary, IT).

This is because the driving force behind Chinese growth is increasingly based on the consumer. We expect this shift to continue.

Another theme we’ve been seeing in China is the push towards automation, given the need for China to improve productivity. This move is also consistent with the need to produce goods with better quality, and to become more self reliant in terms of technological capability.

The A-shares market remains very well balanced in terms of sectors, especially when compared to Hong Kong where technology, banks and commodities still dominate the index. This means it is possible to manage a more diversified portfolio on the A-shares market.

Meanwhile, inflows to the market have been strong since the start of the year, despite constant headlines around US-China trade tensions.

It’s also worth noting that the Chinese market has a low correlation to the other global markets, which can provide diversification benefits. But investors need to remember that this is still an emerging market, with a higher level of volatility.

Which sectors in China A-shares are of interest?

At the moment, we continue to see a number of potentially attractive investment opportunities in the Chinese market.

One of the sectors we are especially interested in is healthcare. There has been a strong trend towards the outsourcing of manufacturing and research & development of drugs by pharmaceutical companies. We expect firms operating in this area to become more prevalent going forward.

Elsewhere, while we remain cautious on real estate companies, insurance companies are of interest to us due to the level of penetration of insurance products in China, which remains low.

Corporate governance catch-up

Finally, from a corporate governance perspective, in many cases companies are still catching up, in terms of the standards generally seen in more developed markets. However, the trend is definitely positive and we think the level of domestic ESG (Environmental Social and Governance) standards will improve going forward, with increased engagement from institutional investors.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

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The case for global small company investing in an era of disruption

The theme of disruption is having a profound effect on how we live and how we invest, explain Matthew Dobbs, Fund Manager, Asian Equities & Head of Global Small Cap, and Kristjan Mee, Strategist, Research and Analytics, both Schroders. There are three factors which we think mean small caps are potentially the best way to tap into the theme.

Smaller companies (small caps) offer the potential for higher returns compared with investing in larger companies, although not without risks. The returns from individual stocks vary a lot and the market is relatively inefficient. This gives active investors greater opportunity to add value.

In addition, investors are increasingly being drawn to the small cap sector due to its ability to profit from the ever-growing theme of disruption.

Over the very long term, US small caps have handsomely outperformed large caps. $100 invested in US small caps in 1966 would be worth $56,232 today compared with $15,576 invested in large caps (Figure 1, left chart). There is also evidence that small caps outperform on a more global basis. Nonetheless, while small caps can outperform over the long run, they can also go through extended periods of underperformance (Figure 1, right chart).

Figure 1: Long-term small-cap performance has been impressive but cyclical

US-small-v-large-cap-disruption-770px.jpgPast performance is not a guide to future performance and may not be repeated.
Source: Credit Suisse, S&P. Data prior to March 2006 is Ibbotson. Data from March 2006 is S&P LargeMidCap vs. SmallCap. Data up to April 1 2019. USD return.

Understandably, such cyclicality might cool investors’ enthusiasm for small-cap investing. However, we believe that there are structural reasons why selective exposure to global smaller companies can potentially yield better returns than a broad market exposure. This belief is based on three key factors: the fundamental attributes of small caps, the relative inefficiency of small-cap equities, and the scale of the opportunity set.

The fundamentals

The fundamental case is based on the fact that small companies have the capacity to grow disproportionately from a relatively low revenue and profits base.

Almost by definition, it is only by investing in small companies that investors can gain effective exposure to a new technology or a market.

They are often the driving force behind disruption, benefiting from this trend rather than being a victim of it. They are less burdened with layers of management and there is less fear of losing sales volume or market share by introducing new products; a major issue for well-established large corporations. Smaller companies who are key players in the fast-growing electric vehicle and artificial intelligence industries are good examples - please see the full paper below for more information and case studies.

The opportunity

The opportunity case is the fact that the small cap market is much larger than the large cap market. For example, there are 6,216 small cap companies in the S&P Developed Benchmark Index, compared with 1,932 large and mid cap companies, according to S&P data as at March 31 2019. Large cap investors are at risk of ignoring the vast majority of the investment universe.

Small caps also tend to be more domestically focused than large caps. This means that, even if the broader global picture is less encouraging, it can be possible to identify companies that are exposed to supportive local growth dynamics. In contrast, large caps are more likely to be buffeted by global trends.

The inefficiency

The inefficiency case rests on the fact that the smaller a company, the less well-followed it is, and therefore the greater likelihood of pricing inefficiencies. This can result in greater opportunities for active managers to add value. Figure 2 illustrates this by showing that the number of broker forecasts declines as companies move further down the size spectrum. This relationship holds across all markets.

Figure 2: Average number of I/B/E/S* estimates per company by size

Company-earnings-estimate-by-size-770px.jpgSource: I/B/E/S, Schroders. Data as at March 31 2019
*Institutional Brokers’ Estimate System – A system that compiles estimates made by analysts on future earnings of publicly traded companies.

The consequence of these inefficiencies is greater opportunity for active small cap managers to outperform. Figure 3 shows the five-year annualized gross and net of fees excess returns of global, US and European active small and large cap funds.

In all regions, the median gross excess return for small caps has been positive, indicating that small cap managers on average do add value. Furthermore, in all regions, small cap funds have performed better than large cap funds.

However, after adjusting for fees, the median net excess returns are negative for global and US small cap funds. Because the cost of small cap funds is generally higher, the excess return must be large enough to cover that cost. Consequently, the fundamental advantages of small-cap stocks and manager skill are two necessary but not sufficient conditions for delivering positive excess returns after fees.

The good news for investors is that the top quartile of small-cap funds have been able to consistently outperform their benchmarks in all regions. This highlights the importance of manager selection to benefit from the inefficiencies in small caps.

Figure 3: Five-year annualized excess returns to end of March 2019

annualised-excess-returns-770px.jpgPast performance is not a guide to future performance and may not be repeated.
Source: Schroders, Morningstar. Data as at March 31 2019.

You can dowload and read the full paper in the link here.

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The downgrade risks facing passive investment grade bondholders

Passive credit investors could be facing significant downgrade losses when the next economic downturn hits. Active managers, however, have the flexibility to manage these risks more efficiently, argues Sean Markowicz, Strategist, Research and Analytics, at Schroders.

Investors have become increasingly worried about the steady increase in the number of lower rated US corporates. The share of BBB-rated bonds, the lowest tier of investment grade (IG) debt, as a proportion of the overall US market has risen to an all-time high of 50% in 2019. In contrast, it stood at only 33% in 2008.

Although, on average, default rates on BBB-rated bonds are very low (0.2% a year1), a more pressing risk for investors is downgrade risk (a deterioration in an issuer’s credit rating). Whenever the next economic downturn arrives, as it inevitably will at some point, corporate fundamentals will weaken. Falling earnings will put pressure on the cushion available to cover interest payments and some measures of leverage will rise.  All else being equal, credit spreads on affected bonds rise and prices fall. Historically, this has also resulted in rating agencies downgrading many borrowers’ credit ratings.

Passive investors risk holding "fallen angels"

BBB-rated bonds are exposed to a particularly acute form of this risk. Because they are on the cusp of IG status, a downgrade would see them relegated to the high yield (HY) market (these are known as fallen angels). This is a problem as, for a variety of reasons, including regulation, many investors are only permitted to hold IG bonds and so would be forced to sell the downgraded bonds.

Additionally, all passive investors would be forced to sell these bonds because they would exit all IG market indices at the next rebalancing date (usually the following month)2. This market segmentation results in a cliff edge in pricing, hanging on whether a bond maintains or loses its IG status. Unfortunately for these investors, the point of downgrade has historically been the worst possible time to sell these bonds.

Given the current large size of the BBB segment, this risk is especially elevated. Fallen angel volumes could be higher than in previous credit cycles and this could weaken portfolio returns. Passive strategies are particularly exposed to this risk, not least because of the sheer increase in passive bond products. Around 28% of all US bond assets under management are now owned by passive index funds, up from 9% in 20083.

Although the exact timing and volume of downgrades from the IG market is hard to predict, we can estimate their potential impact on IG index returns using historical experience. For example, based on the Moody’s 1920-2018 credit migration matrix, 3.2% of the IG market has been on average downgraded to HY each year. If this happened today, $211 billion of bonds would be affected. However, downgrades are typically well above average during economic downturns and this figure could rise to between $275 billion and $557 billion, if the last three downturns are used as a guide. At the overall index level, this could result in a mark-to-market loss of up to 3.5%, or roughly $230 billion in monetary terms.


Being flexible can mitigate against downgrade losses

Whichever scenario occurs, the market is likely to move before the rating agencies act.

Historically, spreads of fallen angels have widened by around 300 basis points, or 3%, ahead of a downgrade to HY. Although they have continued to rise by around another 50 basis points, on average, in the immediate aftermath, most of the pain has already been felt.

In addition, prices tend to partially recover in the months that follow. Selling at the point of downgrade would have been suboptimal, locking in close to the maximum potential loss. Either the ability to sell before a downgrade or hold onto a fallen angel and sell later on, would have generated a better outcome. Neither option is fully open to passive investors. In contrast, active managers have the flexibility to manage fallen angel risk more efficiently because they are not forced sellers and can also discriminate between healthy issuers and those that are more vulnerable.


1) Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2018
2) Most passive investors trade throughout the month as opposed to rebalancing on a single day at month end. This means that they can technically sell bonds before/after a downgrade. However, doing so would increase the tracking error of the index fund so there is an inherent trade-off between tracking the performance of an index and avoiding bonds that may harm the fund’s performance. Seeing as the objective of a passive fund is to track an index, passive investors have very limited, if any, flexibility to manage fallen angel risk.
3) Morningstar Direct Fund Flows Commentary 2018 Global Report

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Are profits no longer required?

The number of loss-making US companies listing on the stock market is close to a record high. Two Schroders experts explain the implications for investors.

The number of loss-making companies listing on the US stock exchange is approaching a 30-year high, according to new research.

Indeed, the average company going through an IPO is now making a loss (IPO stands for initial public offering, the term used when a private company goes public by listing on the stock market).

Perhaps most surprisingly, loss-making companies have beaten the market by around 9% year-to-date, even though historically they have typically underperformed by a similar amount, on average.

Does this paradox mean that profitable companies no longer make for good investments?

Fund manager Frank Thormann doesn’t believe recent performance diminishes the importance of a company’s fundamental strength. However, he does recognise that a new breed of company has changed the way investors think about the stocks they choose.

“I am a strong believer in free cash flow generation as a sign of a strong business model and competitive advantage. There is strong evidence that over a longer horizon, these companies outperform.

“I am not willing to concede that things have changed forever. I consider this current environment as anomalous, and the market has gravitated towards a different kind of company. At the same time, investors should remember that mean reversion is a powerful force. Sentiment could change quickly in favour of profitable and cash-generative companies.”

Percentage of IPOs with negative earnings
1990 until the end of Q1 2019

Percentage_loss_making_companiesSource: Empirical Research Partners Analysis

Operating profits 1991 to end Q1 2019

Operating_profit_marginSource: Empirical Research Partners Analysis

Private equity specialist Schroder Adveq has been involved in IPOs since 1997, and Chief Investment Officer Nils Rode believes that there is a lot of capital chasing these late stage/pre-IPO deals.

Late stage deals are when part of an IPO is placed with private investors (such as private equity or hedge funds) just before the IPO enters the public market.

Investor enthusiasm for such deals has led to a sharp increase in late stage valuations over the past few years. Rode thinks many companies deserve such high valuations, but not all.

“For some of the fastest-growing companies it is normal to be cash flow negative for two reasons:

“Highly successful companies with great upside potential have no problem in raising large amounts of capital that cover their negative cash flows (losses). Companies like this should grow as fast as possible, to lock in market share across regions and across related product categories. This fends off competitors, but requires investment into growth instead of focusing on profitability.

“For some business models, reaching large scale can be a key success factor and requires strong growth, even if this means to be loss-making for some time.

“Nevertheless, it is always possible that some companies burn through too much capital, especially in industries where a significant share of the investor capital goes into marketing or advertising, or even into subsidising product prices.”

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Why growth stocks look vulnerable

The divergence between growth and value parts of the market has been extreme and could be due a turnaround, argues Rory Bateman, Head of Equities at Schroders.

The outperformance of “growth” and “quality” style stocks versus “value” has been a defining feature of markets in recent years. This outperformance was very marked in 2018 and at the start of 2019. In many ways this is to be expected as we move towards the end of this economic cycle.

Value stocks tend to be more tied to the economic cycle and so their earnings are less predictable, especially as the world economy slows. By contrast, growth stocks generally have more visible earnings and the market so far has still been willing to pay up for this in the form of ever-higher share prices.

Given how long this economic cycle has been going on for, growth’s continued outperformance is perhaps unsurprising, as investors wonder if the economy is due a turn for the worse.


However, we think there are other factors at play too. Equity (stock) markets have seen huge inflows of passive money over the last few years. This passive money is essentially forming what is known as a “momentum trade”, meaning the money goes towards those companies that have already performed well and so form a larger weighting of a given index. This momentum trade could become quite worrying in the medium term as money continues to flow into stocks with little regard to their underlying fundamentals.

Despite their more volatile earnings profile, we may be close to the point where value stocks are simply so cheap that they can no longer be ignored. When we reach that point, value should start to perform better.

What value stocks need is for investors to look through the end of this economic cycle. Once we’ve seen clear evidence of slowdown in the underlying economy, investors will start to look towards the next earnings recovery. That’s when the value element of the stock market could really start to recover.

This divergence of value compared to growth and quality is significant in every market in the world, although it’s most acute in Europe. Globally, quality has outperformed value by nearly 5% p.a. over the last five years, so we are at extreme levels in terms of the valuation differential.

This extreme outperformance means growth stocks could look very vulnerable if we were to see a “risk-off” environment. This is where nervy investors shy away from higher risk assets such as equities and move instead towards the relative safety of bonds, for example. We think this risk-off trade would likely be most evident in these highly-rated quality and growth stocks, particularly if these companies were to start missing their earnings forecasts.

Such a risk-off environment would clearly be negative for the overall equity market. But we think the elevated valuations of quality and growth mean these areas could be the most negatively affected, and value could perform better on a relative basis.

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Why ESG matters in value investing

It’s not just the E of ESG that matters – for value investors the S and G are vitally important, explains Kevin Murphy, Fund Manager, Equity Value, at Schroders.

As value investors, we have long taken environmental, social and governance (ESG) considerations into account when investing in stocks. After all, it is our job to weigh up risk and reward and we can only do this competently if we consider all of the potential risks around any investment we might make. ESG has clearly become a hot topic in finance at the moment but there are different ways of looking at it.

For example, lots of people tend to focus predominantly on the E, or environmental side, of ESG. When thinking about that, people tend to be drawn to businesses like wind farms or start-ups offering new battery technology.

The problem with this focus on the environmental side is that it often leads you towards small, microcap, new technology businesses. This can introduce some significant, and unwanted, style biases into your portfolios. Instead, we believe it's worthwhile thinking about the whole of ESG in its totality. The E for environment is important, but so is the social (S) and the governance (G) side.

In the social aspect, we think of the stakeholders. These would be the suppliers to the business, the customers, all the staff, and the regulators it deals with. It's every relationship that a company will have with the entire value chain.

These relationships are of crucial importance when thinking about the sustainability of a company’s profit margins, for example. If a business is paying too low a tax rate, or underpaying its staff, or squeezing its suppliers, then fundamental economics suggests that the associated risks increase. So to us, the stakeholders/social part of ESG is an extraordinarily important and all-encompassing risk to consider when thinking about companies to invest in.

The governance side is equally important because it examines how a company is managed. Questions we ask here would be: are there appropriate staff on the board? Are there appropriate checks and balances? Is there an appropriate incentive structure? Ultimately, we need to consider whether the management team is capable of running the business in the best interest of shareholders.

Of course, as active shareholders, these governance questions are an extraordinarily important part of an investment case for us. If we do not believe a company is acting in the interests of long-term shareholders, we will do all we can to actively engage company management to protect and grow our investment.

Thinking about ESG is fundamentally important to all of our investment decisions and it is a theme that fits in with the value style of investing. Ethical investing is often about trying to achieve long-term change. This chimes with our approach, as investors need to take a long-term view in order to access the best possible returns from a value investment style.

Ultimately, value investing is about buying cheap stocks where we think the potential reward is greater than the risks. In analysing the risk part of that trade-off, we will take into account anything that helps us reach the most considered conclusions and ESG is a crucial part of that.

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How different assets perform in an economic slowdown

It appears that the US is entering the slowdown phase of the economic cycle, argues Martin Arnold, Economist at Schroders. But what might that mean for returns across asset classes? And can a recession be avoided?

For the first time in two years the Schroders US output gap model is signalling a change in the US business cycle. It suggests the economy is moving from “expansion” to “slowdown” (the other two stages in the cycle being “recession” and “recovery”).

The last slowdown period occurred during the Global Financial Crisis and so this should be seen as a warning sign to US policymakers that a recession could be on the horizon.

Is a recession in the offing?

The Schroders output gap model is a way to estimate the difference between the actual and potential output of the economy (GDP). It uses unemployment and capacity utilisation as variables.

Since the model was launched in 1978, there have been six separate instances when it has indicated the US economy was in slowdown mode. Of these six phases, four have been followed by a recession. The two periods of slowdown that did not result in recession and reverted to expansion, occurred in early 1990 (when the slowdown was a false signal) and in the final months of 1998 (when it was a slowdown in the middle – not the end – of the cycle).

In our view, US growth has been supported by accommodative central bank policy and we expect that slowing US growth will force the Federal Reserve’s (Fed) hand in cutting rates in 2020 to bolster activity. Although we feel that the slowdown phase will be prolonged and not end in recession, the balance of our scenario risks indicates that recession is a possibility, especially if policymakers don’t respond to the threat.

What might a slowdown mean for multi-asset performance?

Recession prospects aside, the slowdown phase of the economic cycle has historically had considerable implications for the performance of various asset classes. Of course, past performance is no guide to what will happen in the future and may not be repeated.

The table below shows the average performance of US equities, government bonds, high yield (HY), investment grade bonds (IG) and commodities, over the various stages of the cycle, since February 1978.


During a slowdown phase in the output gap model, equity markets not only perform the worst compared to other phases of the business cycle but exhibit greater volatility. During the slowdown phase, US equities have returned on average less than 5% on an annual basis, with volatility of more than 15%.

Periods of slowdown are historically the only phase when sovereign bonds outperform equities.

Also during slowdowns, sovereign bonds have outperformed investment grade corporate bonds, which in turn have outperformed high yield credit, by around 2% and 4.5%, respectively, on an annual basis. During a recession, performance tends to reverse: high yield credit has outperformed both investment grade and sovereign bonds, by around 2% and 5%, respectively, on average.

This time could be different

The current slowdown phase could be different. The recovery from the Global Financial Crisis was the longest and shallowest in history. With monetary policy remaining accommodative, there is the potential for the Fed to engineer a slowdown phase that is longer than average and which doesn’t end in recession – a period of so called “secular stagnation”.

On the surface, such a period of weak growth appears bad. But arguably, if it doesn’t end in a recession, central bank policy may have finally delivered on an objective it has been trying to achieve for decades: smoothing growth and avoiding the boom and bust cycle of the economy. Indeed, the Fed states that monetary policy works “by spurring or restraining growth of overall demand for goods and services”. In this way, it can “stabilise the economy” and “guide economic activity…to more sustainable levels”.

Time will tell and investors will likely keep their fingers crossed.

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Three reasons why the UK stock market looks compelling

UK equities are unloved, undervalued and high yielding; an ideal scenario for stock pickers, argues Sue Noffke, Head of UK Equities at Schroders.

Whatever the opposite of a sweet spot is, many investors think UK equities are currently in one. With Brexit still unresolved, some have put the market in the “too difficult” basket. While it is understandable to fear uncertainty, as stock pickers we embrace the mis-priced opportunities created by it.

The global nature of the market means that international developments often set the tone for UK equities, and following the trough in the wake of the global financial crisis (GFC) of 2007/08 they’ve had a good run, as have equities generally. However, Brexit has still loomed large and been a drag on returns.

UK equities have underperformed global equities since the EU referendum. As a consequence, relative to global equities they are now the most lowly valued for decades. The market also looks very attractive in absolute terms: its current dividend yield is significantly in excess of the long-term average yield.

1. Unloved

The negativity of international investors towards UK equities is entrenched – global fund managers have been “underweight” the UK for three years, according to the Bank of America Merrill Lynch’s global fund manager survey (see chart, below). Investors are said to be underweight an asset class when they are allocating less capital to it than would normally be the case.


As patient investors, we are often interested in how corporate investors are behaving since we share their long-term mentality. Overseas companies (and private equity) buyers are capitalising on the relative valuation opportunity of UK equities, and sterling weakness.

To cite two recent examples, Coca Cola has acquired the Costa Coffee chain from FTSE 100 group Whitbread, while shareholders in mid-cap speciality pharmaceutical company BTG have approved a bid from Boston Scientific.

Costa Coffee generates the bulk of its profits from the UK, although it has a fast growing international franchise business. In contrast, 90% of BTG’s revenues derive from customers based in the US1. To our minds the bids for these assets underline the indiscriminate negativity towards UK equities – many investors have sold ALL UK equities, both their domestically and internationally focused ones. Remember the UK equity market derives more than two thirds of its revenues from overseas.

Share buybacks2 by companies are another interesting theme. It is, perhaps, no coincidence that Whitbread has proceeded to use the larger part of the the Costa sale proceeds to repurchase stock.

Whitbread has joined a number of other UK quoted companies which have either recently initiated, or extended share buyback programmes, including Standard Chartered and UK-focused peer Lloyds Banking.

It seems to us that many UK corporates see their own shares as undervalued, so are sending another valuable signal.

2. Undervalued

Indeed, valuations reflect the degree to which investors have shunned UK equities. The chart below tracks the market’s valuation discount versus global equities based on the average of three metrics. The metrics used are the price-to-book value (PBV) ratio and price-to-earnings (PE) and price-to-dividends (PD) ratios.

All valuation metrics have their strengths and weaknesses, so combining three reduces the risk of distortions (see the end of the article for a description of these metrics).


Based on this analysis, UK equities are trading at a 30% valuation discount to global peers, close to their 30-year lows. While it is likely to persist until there is some form of clarity over the terms of any Brexit deal, the valuation gap provides an attractive entry point for investors with long time horizons.

Please be aware the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

The valuation of domestically-focused equities is particularly attractive, and consequently we have been increasing exposures to this area of the market. The uncertainty created by Brexit has driven a slowdown in the UK economy since the EU referendum (albeit, by less than feared), while the global economy has held up well.

Associated UK political uncertainty is further weighing on valuations, and might continue to do so given the relatively high probability of either a leadership election or a UK general election in 2019.

3. Attractive yield

Over the past 30 years the dividend yield of the UK equity market, relative to the rest of the world has only been higher during the 1991 recession and at the peak of the technology media and telecoms (TMT) bubble (see chart, below).

CS11445_Equities_chart_v1_UK_dividend_V2.jpgPast performance is not a guide to future performance and may not be repeated.

In absolute terms, the UK equity market is currently yielding c. 4.5% (MSCI UK index), which compares very favourably to the average dividend yield over the past 30 years of 3.5%. For yields to revert back to their long-term average, either the market has to rise or bad news needs to arrive soon and companies cut payments. They would need to cut by a good margin more than they did following the GFC and ensuing global recession – is this likely?

Following the GFC, UK dividends fell by 15% over two years on a cumulative basis, and that includes the effect of BP suspending its dividend following the Deepwater Horizon disaster in the Gulf of Mexico. We don’t believe we are on the cusp of a recession like the one which followed the GFC. Despite some recent high profile and material dividend cuts from Vodafone and Marks & Spencer, overall we still believe that the market’s dividend payment will continue to rise.

If we do experience a recession in the near term, we would expect it to be local to the UK (possibly the result of  a disordely Brexit) rather than a global one, although we are in the latter stages of the economic cycle. This gives us a degree of comfort that the UK equity market’s yield is sustainable as the large majority of UK stock market dividends derive from overseas.

The charts and data highlighted help put the opportunities within UK equities into a broader context. In light of these conditions it is perhaps unsurprising that our allocation to overseas equities is currently at the lower end of its historical range.

As stock pickers we see plenty of opportunities within the UK – across all parts of the market, large as well as small and mid-sized companies – which could help build portfolios capable of generating superior long-term returns.

Investments concentrated in a limited number of geographical regions can be subjected to  large changes in value which may adversely impact the performance of the fund.

Equity [company] prices fluctuate daily, based on many factors including general, economic, industry or company news.

Please be aware the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

1) See page 124 of BTG’s 2018 annual report and accounts, at:
2) Share buybacks are where a company repurchases its own shares in the open market. Similar to dividends, it is a way for companies to return cash to shareholders.

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Sink or swim – how less liquid assets could buoy portfolio returns

With public equity markets trading close to all-time highs and low yields available from bonds, interest in private assets like infrastructure and private equity has risen, argues Tim Boole, Head of Product Management at Schroder Adveq Group.

In a climate of lower expected returns, both retail and institutional investors are asking where they can generate the performance needed from their portfolios.

With public equity markets trading close to all-time highs and low yields available from bonds, many are exploring less liquid alternatives to get the returns they require. Consequently, investments such as infrastructure or private equity have all seen strong growth in interest.

Yet even in private assets, a record year for fund raising in 2017 has led to questions on whether historic returns are sustainable.

Tim Boole, Head of Product Management at Schroder Adveq, advises that investors worried about this should remember the differences between public and private markets.

“Investors must keep uppermost in their minds that private assets are long-term commitments, meaning they are almost certain to experience at least one complete business cycle. Investment decisions should be considered with due care. Selecting investments that align with long-term trends in the economy are usually best performing.”

Why diversification is key in private assets

Despite the appeal of private assets though, there are also difficulties and challenges to investing in the asset class, not to mention significant risks. There is a lot of dispersion in private markets. While the best managers do very well, the worst can provide investors with quite a dismal experience.

Heeding this warning, what should investors avoid doing and where within private assets offers the best returns going forward? The key, according to Tim, is to avoid following the herd and instead look for where the future opportunities are.

“For those investors who are relatively new to private asset investing, another important lesson is to target portfolio diversification, both in the traditional sense - such as by sector and region - but also by vintage. The latter is a particular characteristic of closed ended funds whereby investments at a different period of the investment cycle are included in the portfolio. This helps combine investments that are already cash flow positive into a fund that is in its launch phase. Investments at a later point in their investment cycle also tend to be more stable. 

“Within private equity there are some areas that have attracted huge amounts of capital and other areas where the growth has hardly changed. For example, huge amounts have been going into the large and mega buy out funds and late stage venture capital finance, whereas capital into small and medium buy-out funds and early stage venture capital has changed much less in the past 20 years1.

Time is on your side

Tim believes that patience and attention to detail are often overlooked in the rush to commit capital to markets. Given the longer market tenure of private assets, investors can afford to dig deeper into new opportunities.

“Investors want to put a lot of money to work and as a result are chasing the big opportunities. But if you are nimble and can work with those who specialise in smaller buy-outs or in venture capital, the returns may be more attractive. This is because the gap between the valuations of buy-outs at the larger end and those at the smaller end have never been as wide as they are today.

“Given that the main access route to investing in private assets is currently via limited partnership structures or closed-ended funds, at present it is a challenge for intermediaries to get easy access to the asset class.

“One of the things we expect to see a lot over the next five to 10 years are intermediary investors being offered more options for private asset investing. This is a particular focus of Schroders and described as the “democratisation of private assets”. One of the things Schroders is working on this year is creating new products for the intermediary market, which are open-ended with periodic liquidity to provide underlying exposure to the underlying private assets.”

A broad offering

The complexity of the numerous instruments within private assets, as well as the extended time commitment, can make choosing a partner for the investment journey a challenging task. Tim suggests that when selecting a manager for the job, investors consider the length and breadth of their experience before taking the plunge.

“Schroders is more often associated with public market investing but has a far more extensive history and platform for private market investing than many realise. In 1971 it set up a real estate business, which at the end of June 2018 housed just under $20 billion of assets. In 2017 it acquired the Swiss private equity business Adveq which in itself has over 20 years of private equity investing experience and today runs close to $10 billion. Schroders Infrastructure Finance team have executed on 46 transactions in just three years. Schroders Insurance Linked Business (“ILS”) is run by Dirk Lohmann, an early pioneer in the field of insurance securitisation, who placed the world’s first non-life insurance securitization (KOVER) in 1993/94.

“With these capabilities, Schroders is well placed to deliver within all areas in private assets. It has a very broad offering, meaning there is a good perspective on where the opportunities are and can act accordingly. It is specialists in all areas, applying the same levels of thought, care and diligence to our private asset products as we do to our public equity offerings.

Given that investments into private assets are often a 10 to 15 year commitment, investors also need to know their manager will be around for that amount of time. Schroders has been around for 200 years, has the backing of the Schroder family and adopts a long-term time horizon.”

1. Source: Preqin, Pitchbook, Zero2IPO, Schroder Adveq 2018. Late stage/growth capital includes 50% of SoftBank Vision Fund and includes investment activity from non-traditional sources of capital (e.g. corporate investors).

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Why a pick-up in UK growth may prove deceptive

Recent economic data from the UK has improved but signs are that this is due to stockpiling ahead of worries over potential Brexit disruption, argues Azad Zangana, Senior European Economist and Strategist at Schroders.

Brexit continues to dominate news and politics in the UK. Even lowly economists pray for a break from the mundane gridlock and circular arguments. Now that the Brexit deadline has been extended to October (see Is the UK stuck in Brexit limbo), a little breathing room has been created to allow other topics to enter the fray.

The medium to long-term outlook for the economy will be heavily influenced by Brexit. The Bank of England had downgraded its growth forecast for the coming quarters, citing a more negative impact from Brexit uncertainty than it had previously anticipated.

However, recent data has been better than expected. The monthly GDP release for January showed a significant improvement, as GDP growth picked up to 0.5% compared to -0.3% in December.

UK growth seems to be improving

UK-growth-GDP.jpgSource: Thomson DataStream, ONS, Schroders Economics Group. 29 April 2019.

The release for February was more subdued, with 0.2% growth, but even if the economy stalls in March, the quarterly GDP estimate for the first quarter of 2019 would be 0.5%. We suspect it could be even higher. In any case, it will probably prompt many economists to revise up their estimates for 2019. The data is due on Friday 10 May.

An analysis of the contributions to GDP shows that a resurgence in manufacturing has played an important role in the pick-up in activity. This is reflected by recent readings from the Markit purchasing managers' indices (PMI) – a set of private sector surveys that gauge the level of activity in the economy. A balance above 50 implies expansion; below 50 implies contraction. The March UK manufacturing PMI showed activity at 55.1, its highest level since February 2018. This has since slipped to 53.1 in April but it remains substantially above the services level (50.4 in April).

UK manufacturing and services PMI

PMI-manufacturing-services.jpgSource: Markit, Schroders Economics Group, 7 May 2019.

The weakness in services is a concern for the coming months given how much larger the service sector is in terms of its share of the economy.

Delving into the details of the manufacturing PMI survey, we discover a worrying development. The questions that ask about the degree to which companies are building inventories show stocks of both finished goods and of purchases (parts or raw materials) are both are record highs.

UK inventories hit record high ahead of Brexit

Inventories.jpgSource: Thomson DataStream, Markit, Schroders Economics Group, 29 April 2019.

The unusual boost from Brexit

In the run-up to the original 31 March Brexit deadline, there were a number of anecdotal stories of both companies and government entities stockpiling supplies, for example, of medicines by hospitals and pharmacies.

While the manufacturing PMI survey only covers private manufacturers, we suspect it is a good indication of widespread stockpiling. Stockpiling inevitably leads to a slowdown in production at a later point in time. Typically, a large build-up of inventories is involuntary. Companies are usually producing output at a normal pace, when a fall in demand and sales leads to unsold stocks building up.

This time is different as companies are hoarding ahead of possible disruption to output and the ability to import. Regardless of the cause, a slowdown in growth is likely, whether that disruption hits or not.

Once stockpiling ends, GDP growth is likely to slow

For manufacturing activity to continue to enjoy above normal production, further stockpiling would need to occur. Reports of shortages of warehouse space suggest that this is unlikely to continue for much longer. Production levels would have to be wound down to stop any further build-up of inventories.

If demand then disappoints, or if imports are not as restricted as feared in a worst-case scenario, then excess inventories would have to be discounted or destroyed at a cost to producers and retailers.

Imminent rate rise seems unlikely

The Bank of England has stated its ambition to raise interest rates back to more "normal" levels, but we think it is unlikely to follow through given the poor quality of growth the UK is experiencing, set against a backdrop of ongoing Brexit uncertainty.

The government should also take note. Celebrating the forthcoming pick-up in GDP growth for the first quarter could prove to be premature. Indeed, Chancellor Philip Hammond has indicated that he may need to delay the next comprehensive spending review due to the delay in Brexit. Committing to a multi-year spending programme (which is likely to be stimulative) at a time of great uncertainty would be a big gamble.

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Eurozone growth rebounds as temporary headwinds fade

The latest GDP figures show that domestic demand has remained resilient, shows Azad Zangana, Senior European Economist and Strategist at Schroders.

The early estimate for first quarter eurozone GDP growth showed a pick-up to 0.4% quarter-on-quarter (q/q) from 0.1% in the previous quarter – beating consensus expectations of 0.3% growth.

The latest data release suggests that the monetary union has largely sailed through most of the temporary headwinds that it faced in the second half of 2018. Gilets jaunes protests, new car emissions tests, and low water levels of the river Rhine all disrupted activity last year and caused growth to slow sharply.

While there are some residual effects remaining, the latest figures should also put to bed speculation that the eurozone was in recession, and supports the strong performance of European equities so far this year.

Within the member states that have reported so far, France saw activity remaining steady at 0.3% q/q, although it reported better domestic demand growth thanks to a pick-up in household spending. Spain recorded another impressive quarter, as GDP growth picked up from 0.6% to 0.7%, also marginally better than consensus expectations. Finally, Italy saw a moderate rebound, as growth picked up from -0.1% at the end of last year to 0.2% in the first quarter, also beating consensus expectations.  

Overall, we believe these are a good set of growth figures given recent events. External demand is likely to have remained weak as the fallout from the US-China trade war continues. European political uncertainty in the form of the Spanish elections, Brexit and European parliamentary elections probably had a small negative impact, but domestic demand has remained resilient throughout this period.

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Which stock markets look ‘cheap’ after strong performances in the first quarter of 2019?

Following a dramatic rebound for stock markets in the first quarter of 2019, Duncan Lamont, Head of Research and Analytics at Schroders, assesses how market valuations have been affected.

Those who were brave enough to fight the emotional urge to sell during the carnage in markets which brought 2018 to a close have been richly rewarded in the first few months of 2019.

Of the five markets in our regular analysis, even the worst of the bunch (Japan) returned almost 8% so far this year (as of 12 April).

The US was the best with a 13.9% gain, an almost mirror image of the 13.7% it lost in the fourth quarter of 2018 (although this also provides a useful reminder that, because of the way returns compound from one period to the next, a given gain will not be enough to offset a loss of the same magnitude – the return over this six month period was -1.7%). The UK, Europe and emerging markets have all risen close to 10% this year.

Valuations are one of the most powerful indicators of long term returns. Buy when markets are “cheap” and the odds are stacked in your favour. Buy when they are expensive and, although you won’t necessarily lose money, more things have to come right for you to come out on top.

We highlighted in our January update that a combination of robust earnings growth and falling markets had brought stock market valuations around the world close to their cheapest level for several years. Although short term risks were elevated, the longer term case had improved notably.

Although valuations are usually a poor guide to short term performance, markets have clearly rallied sharply from that nadir. However, the strength of performance in the early stages of 2019 means that returns, which were expected to have been earned over the medium to long term, have instead been harvested in barely three months.

This leaves less on the table for the future and the valuation case is now a lot more subdued. Simple models of expected returns linked to either dividend yields or earnings yields suggest that long term expected returns are around 0.3-0.4% lower in all markets than they were at the start of the year.

This more downbeat picture can be seen in our usual valuations table, which has more of a red hue than in January. However, a closer look at the numbers suggests a more nuanced stance is appropriate.

For non-US markets, those valuation indicators which are in expensive territory are pretty close to historic averages, with the exception of cyclically adjusted price to earnings (CAPE). A cautionary note but not something which should keep long term investors awake at night.

Bad performance could of course happen (a restarting of interest rate hikes in the US would be one possible driver) but valuations are unlikely to be the source of the problem. The US continues to be out on a limb. But betting against it has been a fool’s game for years and investors would be wise to maintain a balanced exposure to global stock markets.

Past Performance is not a guide to future performance and may not be repeated.


The pros and cons of stock market valuation measures

When considering stock market valuations, there are many different measures that investors can turn to. Each tells a different story. They all have their benefits and shortcomings so a rounded approach which takes into account their often-conflicting messages is the most likely to bear fruit.

Forward P/E

A common valuation measure is the forward price-to-earnings multiple or forward P/E. We divide a stock market’s value or price by the earnings per share of all the companies over the next 12 months. A low number represents better value.

An obvious drawback of this measure is that it is based on forecasts and no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong, largely overestimating and making shares seem cheaper than they really are.

Trailing P/E

This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E this involves no forecasting. However, the past 12 months may also give a misleading picture.


The cyclically-adjusted price to earnings multiple is another key indicator followed by market watchers, and increasingly so in recent years. It is commonly known as CAPE for short or the Shiller P/E, in deference to the academic who first popularised it, Professor Robert Shiller.

This attempts to overcome the sensitivity that the trailing P/E has to the last 12 months' earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings.

When the Shiller P/E is high, subsequent long term returns are typically poor. One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive. 


The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

A low value suggests that the market is valuing it at little more (or possibly even less, if the number is below one) than its accounting value. This link with the underlying asset value of the business is one reason why this approach has been popular with investors most focused on valuation, known as value investors.

However, for technology companies or companies in the services sector, which have little in the way of physical assets, it is largely meaningless. Also, differences in accounting standards can lead to significant variations around the world. 

Dividend yield

The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.

However, while this measure still has some use, it has come unstuck over recent decades.

One reason is that “share buybacks” have become an increasingly popular means for companies to return cash to shareholders, as opposed to paying dividends (buying back shares helps push up the share price).

This trend has been most obvious in the US but has also been seen elsewhere. In addition, it fails to account for the large number of high-growth companies that either pay no dividend or a low dividend, instead preferring to re-invest surplus cash in the business to finance future growth.

A few general rules

Investors should beware the temptation to simply compare a valuation metric for one region with that of another. Differences in accounting standards and the makeup of different stock markets mean that some always trade on more expensive valuations than others.

For example, technology stocks are more expensive than some other sectors because of their relatively high growth prospects. A market with sizeable exposure to the technology sector, such as the US, will therefore trade on a more expensive valuation than somewhere like Europe. When assessing value across markets, we need to set a level playing field to overcome this issue.

One way to do this is to assess if each market is more expensive or cheaper than it has been historically.

We have done this in the table above for the valuation metrics set out above, however this information is not to be relied upon and should not be taken as a recommendation to buy/and or sell If you are unsure as to your investments speak to a financial adviser.

Finally, investors should always be mindful that past performance and historic market patterns are not a reliable guide to the future and that your money is at risk, as is this case with any investment.

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China defies the gloom

Chinese industrial production has been stronger than expected, though we see a risk that this could reverse next month, explains Craig Botham, Emerging Markets Economist at Schroders.

First quarter GDP surprised to the upside in China, with real GDP growth unchanged from the end of 2018 at 6.4% year-on-year (y/y). Given the weakness in high frequency data for the first two months of 2019, this came as a surprise to most economists, and it looks like the economy was bailed out by a strong turnaround in March.

If we were to sound a note of caution, it would be to note that GDP was supported by an acceleration in the manufacturing sector, which offset slowdowns elsewhere in the economy. There is a risk that this is a frontloading effect triggered by the April tax cuts and so unwinds next month.

Overall though, this month’s data should still serve to ease fears over China’s impact on the global economy, even if imports are still weak.

Industrial strength is encouraging but difficult to explain

GDP was not the only data to surprise this month; industrial production in particular blew expectations out of the water, growing 8.5% y/y compared to 5.3% for the combined January-February period and the strongest since 2014. Fixed investment also accelerated to 6.5% from 6.1% previously – though despite the pick-up in industrial production, manufacturing investment actually slowed.

Retail sales though slowed in real terms, and while exports bounced back in March they were still weaker for the quarter as a whole and imports are yet to return to expansion.

For us the difficulty lies in reconciling weak domestic demand as evidenced by contracting imports with the story told by surging industrial production. Credit data has been strong but it is too soon to expect it to show up in activity data, particularly as lending to the real economy seemed to slow in January and February and only picked up in March.

Either imports or industrial production must therefore be “wrong” in their signal on domestic demand. For weak imports to be consistent with strong domestic demand this would suggest that China has managed to shift supply chains onshore. While this is an ongoing theme as China moves up the value chain, it seems doubtful that it could prompt such a sudden and dramatic disconnect given that the two were much more closely related until this month.

Brace for whiplash next month

The alternative explanation then is that something is amiss in the industrial production data. It is curious, for example, that industrial production should be so strong and yet manufacturing investment should slow. The implied increase in capacity utilisation would be expected to see capacity expansion under normal circumstances – that it has not suggests manufacturers do not see this as a sustainable increase in production.

Adding to this, we note that the manufacturing purchasing managers’ indices (PMIs) this month pointed to inventory building, with the return to expansion driven by higher stocks of inputs and finished goods. We would suggest two potential triggers for this behaviour; the first is the end of holiday disruptions to production, essentially “catch up” by manufacturers. The 5.3% print for January-February was very weak and so some bounceback seemed inevitable.

The second factor could be the cut to VAT effective at the start of April. This provided manufacturers with an incentive to frontload orders and production, to enable them to offset the older, higher VAT rate as an expense against future profits, taxed at the lower rate.

As may be apparent, we are somewhat sceptical of the sudden spring in China’s step, and see a strong possibility that some of this strength in production is undone next month. All the same, this is a stronger-than-expected GDP print. We still expect the strong credit data to result in a pick-up in growth in the second and third quarters, so there is some upside risk to our expectation of 6.3% growth for 2019.

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The coming squeeze on US profits

We see US profits falling 4% in 2020 as slower growth and higher wage costs hit companies’ profit margins. But we have modelled a range of alternatives - and charted the potential impact, explains Keith Wade, Chief Economist & Strategist at Schroders.

Progress on US-China trade talks has seen investors’ concerns about a trade war fade, and be replaced instead by worries about economic growth and politic risks. The real concern for equity investors, ultimately, is how slower growth will be reflected in company profits.

In 2018 markets were driven by stronger corporate earnings, but share prices still slipped back as interest rate rises caused investors to reappraise valuations. This year looks like being the reverse, as we forecast earnings to slow whilst the central bank stands back.

Lower inflation and rising wages put pressure on profits

One of the key changes in our recent forecasts for slower growth is an update on the inflation outlook. Inflation looks set to be weaker than previously expected and this has fed into a more accommodative monetary policy stance from central banks.

Whilst this can be seen as positive for stock markets (lower interest rates make cash savings relatively less attractive), lower inflation can increase pressure on profit margins. Companies are facing rising wage costs. When higher inflation is accepted, the increased costs of labour can be more easily passed on through higher end prices. When inflation is constrained and producers are unable to pass the additional costs on, then profit margins take the strain. 

One of the key features of the most recent economic expansion has been the elevated level of profit margins enjoyed by companies. For the US market, this is indicated by the high profit share as a percentage of GDP, shown in the chart below.

US profits as a percentage of GDP

us-profits-as-percentage-of-gdp.jpgSource: Thomson Reuters, Schroders, 21 March 2019.
Past performance is not a guide to future performance

The flip side of this of course has been weak wage growth. In many countries, this has translated into dissatisfaction with the economic status quo, stoking the flames of populist politics. Going forward, we think this could change.

US profits set to fall in 2020

We take a top-down approach to forecast the share of profits in GDP via profit margins and capacity utilisation. Capacity utilisation measures the extent to which businesses are using their capacity to produce goods or services. Our forecast for this is driven by GDP growth, while the forecast for profit margins is also affected by growth in labour costs, prices and productivity.

We do not expect a US recession (i.e. two consecutive quarters of negative economic growth) but our forecasting model suggests caution on US earnings would be appropriate. We expect profits to peak in Q3 2019 and to decline in line with a weaker US economy thereafter. Overall, we forecast US profits (excluding financials) to rise by 6% in 2019 but to fall by 4% in 2020.

This is because below-trend economic growth means lower capacity utilisation, putting downward pressure on profits. Moreover, profit margins will be squeezed as labour costs rise, while inflation and productivity decline on the back of weaker growth.

Profits could fall further in alternative scenarios

While the above reflects our base case, we have also modelled a number of alternative scenarios. Unsurprisingly, the share of profits would see a sharper decline should a US recession occur in 2020. In that scenario, profits could fall by 13.5% (see light green line on chart below). When modelling a scenario of a global recession excluding the US, the fall in profits came in at 7.4% in 2020 (dark blue line).

Only two scenarios pointed to profits growth. Either China tries to avert a deeper economic slowdown by stimulating growth and inflation through extra fiscal spending or US growth surprises again through a stronger supply side (purple and red lines).

US economic profits (ex financials) set to peak in Q3 2019

us-profits-in-different-scenarios.jpgSource: Thomson Datastream, Schroders Economics Group. 27 March 2019.

The above is a forecast based on top-down economic factors. Actual profits, or earnings per share (EPS), for the S&P500 (the large cap US equity index) will be more volatile. This is because of the effects of a company’s borrowings and write-offs. However, we would expect the direction of profits to be similar and so we can make an estimate of market EPS.

We estimate that S&P500 operating earnings will rise by 6.8% in 2019, while reported EPS increases by 7.8%. The decline of the profits share in 2020 would reverse these gains; operating earnings would drop by 3.4% and reported EPS by 6.9%.

Operating earnings are profits earned after subtracting from revenues those expenses that are directly associated with operating the business. Reported earnings include non-recurring items (e.g. the one off cost of closing down a factory).

This analysis of profit margins suggests we will see a squeeze on corporate earnings in 2020. Corporate cash flows will come under pressure and this will provoke a reaction. Typically companies would cut jobs and capital spending. The knock-on impact of this could bring the economic cycle to an end, leading to recession. Our model currently puts a 36% probability on a US recession in the next 12 months – the highest probability since 2007.

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The chart that tells the story of value investing’s potential

Value stocks are currently the most out of favour in the history of financial records, explains David Brett, Investment Writer at Schroders. Is now the time for value to make its comeback?

Value stocks are on their longest losing streak versus growth stocks since records began, according to data stretching back to 1936.

Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Basically, buying companies which appear undervalued by investors for no justifiable reason.

Growth investors pay less attention to a stock’s price. Even if a company looks expensive they may believe its above average future growth justifies the expensive price tag.

Value’s longest losing streak in history

There have been three periods of dramatic underperformance by value relative to growth since records began: the tail-end of the Great Depression in the late 1930s, the build up to the bursting of the dotcom bubble in the late 1990s and now.

As the chart below shows, value’s underperformance during the late 1930s and 1990s was sharp but also short, lasting around four years and two years respectively. In comparison the current underperformance which began in 2009 is now nearly a decade old.

The good news for value investors is that in the past, value’s bouncebacks were even more dramatic than the underperformance.

Analysis by academics Eugene Fama and Kenneth French has shown that in the five years following its underperformance trough in 1940 value outperformed growth by 138%. Similarly, when value’s two year underperformance troughed in 1999 it outperformed growth by 107%. The question for value investors now is could history repeat itself?

Of course, past performance is not a guide to future returns.

Rolling 10-year total return difference: Fama-French (value vs growth)

Why now for value?

Nick Kirrage, an equity value fund manager at Schroders, explains why now might be a good time to consider value stocks.

“We know we should buy low and sell high. We are looking for investment strategies that are enduring and we want to buy them when they look cheap and attractive.

“Value has been through one of its worst periods in history. Performance has been weak but we continue to have the conviction that value is an enduring investment style.

“When we look across investments in the market today we see a huge bias in investors’ portfolios towards growth-type investments. That presents an opportunity, to diversify and buy into a strategy that has a great long-term success record.

“So why now? Because, we believe, with value stocks at such attractive levels the opportunity has never been greater.”

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14 years of returns: history’s lesson for investors

The graphic shows the best and worst performing assets each year since 2005. Schroders research illustrates why diversifying your investments matters, explains David Brett, Investment Writer at Schroders.

The temptation among investors is to stick to what you know. That is no bad thing. It is a strategy championed by successful investment pioneers such as Warren Buffett, a famous devotee of stocks.

It can work, when the market is rising and you have picked the right asset. However, it’s also important for investors to consider the merits of diversification.

This table underlines the importance of spreading your money around. It can potentially help reduce risk and maybe even improve the long-term performance of your overall portfolio. It shows the returns achieved by some of the main asset classes in each year.

Of course it’s important to note that past performance is not a guide to future performance and may not be repeated.

Stock market performance is measured by the MSCI World Total Return index. Investment grade bonds relates to global government and corporate bonds deemed to be at relatively low risk of default. Property relates to the returns from global real estate markets as measured by Thomson Reuters. More detail on the indices used for each asset can be found at the foot of the table.

Asset class performances 2005-2018

14 years of asset returnsPast performance is not a guide to future performance and may not be repeated. Source: Schroders, Refinitiv data correct as of 01 January 2019.  Stock Market: MSCI World Total Return Index, Property: Thomson Reuters Developed Market Real Estate Total Return Index. Cash: IBA US dollar interbank LIBOR 3 month, High Yield Bonds: BofA Merrill Lynch Global High Yield TR Index, Investment Grade Bonds: ICE BofAML Global Corporate Total Return Index, Commods: Bloomberg Commodity Index, Gold: Gold Bullion LBM $/t oz. All show total return in local currency.

What are the benefits of diversification?

The tables reflects how the fortunes of assets often diverge.

Consider the example of gold. It is often described as the ultimate diversifier because it tends to be uncorrelated with the movement of other assets. In particular, it is perceived as being an asset to hold during times of uncertainty. In 2011, stock markets lost 5% amid the uncertainty of the European debt crisis. But investors who held some money in gold will have had their losses eased thanks to an 11% return for that asset.

The benefits of diversification can be described in various ways:

Managing risk: A crucial imperative for investors is not to lose money. There is risk with every investment - the risk that you receive back less than you put in or the probability that it will deliver less than you had expected. This risk varies by the type of investment. Holding different assets mean this risk can be spread. It could also be managed by you or by a professional, such as financial adviser. Specialist fund managers can also allocate money to help manage risks.

Retaining better access to your money: The ease with which you can enter or exit an investment is important. Selling property can take a long time compared with selling equities, for example. Holding different types of investment that vary in terms of "liquidity" (the ease of buying and selling) means you can still sell some of your investments should you suddenly need money. 

Smoothing the ups and downs: The frequency and magnitude by which your investments rise and fall determines your portfolio’s volatility. Diversifying your investments can give you a greater chance of smoothing out those peaks and troughs.

Johanna Kyrklund, Global Head of Multi-Asset Investments at Schroders, said: “For me, the merits of diversification cannot be emphasised strongly enough. I’ve been a multi-asset investor for more than 20 years and have inevitably faced some pretty turbulent spells for markets. Each time, the ability to nimbly move between different types of assets has better equipped me to navigate those periods.

"Diversification, if carefully and constantly managed, can potentially deliver smoother returns; it’s a key tool to help in balancing the returns achieved versus the risks taken.”

Too much diversification?

There is no fixed rule as to how many assets a diversified portfolio should hold: too few can add risk, but so can holding too many.

Hundreds of holdings across many different types of investment can be hard for an individual investor to manage.

What has been the best and worst performing assets since 2005?

Gold was the best performing asset, bolstering its reputation as a safe haven during times of uncertainty. It’s worth noting that much of the gains were made in the early part of that period before the uncertainty of the financial crisis took hold.

Gold’s strong performance is all the more noteworthy when commodities were found to be the worst performing asset over the 14 years. They alone of the six assets would have lost investors money.

In real terms, $1,000 invested in gold in 2005 would now be worth $2,925 – an 8.3% annual return. $1,000 invested in commodities would now be worth $630 – representing a 2.3% annual loss.

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Global economic outlook: slowdown, not recession

We have cut our global GDP growth forecast again for 2019 but have revised up our prediction for 2020 amid greater optimism on the longer-term outlook, explains the Schroders Economics Team.

We have revised down our forecast for global GDP growth in 2019 to 2.8% from 2.9%, but increased our projection for 2020 to 2.7% (from 2.5%). The downgrade for this year (the fourth in consecutive quarters) is driven by cuts to our forecasts for the eurozone, UK and Japan which offset a small increase to our China forecast.

In 2020, the upward revision is across the board with, for example, the US upgraded to 1.6% (previously 1.3%), Japan to 0.4% (previously 0%) and China nudged up to 6.1% from 6%.

Meanwhile, our inflation forecasts have been reduced for this year and next with reductions across all regions except Europe. US inflation is also lower as a result of a smaller rise in core inflation (i.e. excluding food & energy prices) which we expect to peak at a lower level before declining in 2020.

Longer-term picture looks brighter

Underpinning these forecasts are a number of factors which give us reasons to be more cheerful about the longer-term outlook:

  • Firstly, oil prices are lower. While this is a symptom of weak global demand, it is helping to bring down inflation and boost consumers’ spending power.
  • Second, the US and China are moving closer to a trade deal. President Trump extended the deadline for raising tariffs on $200bn of Chinese imports from 10% to 25% beyond 1 March. This means tariff increases will now be more limited, helping to reduce costs, protect profit margins and contain inflation.
  • Thirdly, monetary policy is easier. This is partly a reflection of lower inflation but it also marks a shift in Federal Reserve (Fed) policymaking where the central bank has become more responsive to financial market conditions.

We now expect the Fed to increase interest rates only once more before they start to fall in 2020 as the boost from tax cuts disappears and monetary tightening feeds through. It seems unlikely that additional fiscal stimulus will be passed by the Democrat-controlled House.

While a trade truce between the US and China could help boost external demand later this year, even as the trade war quietens down the tech war will remain in full swing. We would expect the US to continue to challenge China in this area either through sanctions on Chinese companies or preventing its own companies from exporting key technology items.

Temporary factors have weighed on eurozone growth

We have pushed out rate increases in the UK and eurozone. In the case of the UK, this reflects the growing likelihood that a short delay may be required to facilitate Brexit. Conversely, in Europe, temporary factors have held back growth but we expect the effects to begin dissipating in a few more months.

Among these temporary factors, Germany was impacted by changes to car emissions testing which caused sales of new vehicles to slump sharply from September 2018. Sales have begun recovering. Germany’s woes were compounded by a drought that reduced the river Rhine's water levels so significantly that it led to disruption in raw materials shipments.

In the meantime, in Italy political uncertainty caused financing costs to rise across the economy. In the end, the government’s expected spending splurge was far more modest than feared and the 2019 budget was approved, albeit after a very public battle with the European Commission.  

Given the temporary nature of these shocks, we expect to see an improvement in growth by the summer. Fundamentals are sound in Europe with monetary policy still very loose while most countries have completed their austerity programmes. Following the 8 March European Central Bank meeting, we now forecast a rate rise in March 2020.

VAT increase in focus in Japan

In Asia, we expect the Bank of Japan to leave monetary policy unchanged. Energy and one-off factors should drive a further moderation in inflation before a VAT-led spike in October, as the VAT rate rises to 10% from 8%. We expect a subsequent sharp decline in demand and dissipating inflationary stimulus. On the other hand, more infrastructure spending for disaster prevention should support growth at the end of 2019, and more substantially in 2020.

China is expected to ease further through a lower reserve requirement ratio which is now forecast at 10% by end 2020 (previously 11%). The ratio dictates the amount of cash banks have to hold in reserve, so a lower ratio frees up more capacity for lending.

The main changes for emerging markets come from inflation. Crude oil prices have fallen dramatically since we last updated our numbers. Combined with surprisingly low domestic inflation this sees substantial downward revisions to the inflation outlook for all BRIC economies bar Russia, for whom cheaper oil means a weaker currency and hence more imported inflation.

Turning to currencies, the US dollar is expected to remain firm in the near term, but to weaken later in the year as rates peak in the US whilst monetary policy tightens in the eurozone and UK. Sterling is also boosted by our assumption that a Brexit deal is struck and the UK enters a transition period after 29 March, rather than crashing out of the EU.

Alternative scenarios

These forecasts represent our baseline case, to which we attach a 60% probability. We also model a number of alternative scenarios. One of these is “Recession excluding US”, whereby the outlook in China and Europe deteriorates significantly, while another is “US recession 2020”. These two scenarios would both have a deflationary impact on the world economy and we estimate the probability of these at 17%.

We also model three scenarios that would have a stagflationary impact, i.e. causing persistent inflation and stagnant growth. These are “Trade war: US versus Rest of the World”, “Global inflation surge” and “Italian debt crisis”. We attach a 14% probability to these three scenarios.

We see a lower probability for two reflationary scenarios. In the first of these, “China reopens the spigots”, we assume large scale stimulus from Chinese policymakers. In the second, we model a “US supply side surprise” whereby more people enter the US workforce, therefore containing wages and inflation and extending the economic cycle. 

Table of GDP and inflation forecasts

Source data for table

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