Secular Outlook Series

 

Q: PIMCO sees global growth moderating in the years ahead. Are companies properly positioned for slower growth in both developed and emerging markets?
Gordon: Looking first at emerging markets (EM), which have been strong contributors to global growth, we expect economic expansion to moderate over the next three to five years, although still outpace the trajectory in the developed world. This is likely to happen with a backdrop of labor gaining vs. capital, resulting in upward pressure on labor costs.

The key question coming out of that view is whether companies in a number of cyclically sensitive industries will recognize and treat this shift as a secular one in nature. If we are right about this, a number of companies in parts of EM will temporarily face lower capacity utilization. During this transition, the firms will have to adjust to this new environment in EM of negative operating leverage and higher labor costs.

Lahr: Still, company balance sheets in developed markets are generally in good health and many are well positioned to generate growth even in difficult times. One area that is persistently showing growth both in good times and bad is the technology sector. That is a consequence of a number of factors, including the super-secular trend of just how embedded technology has become in the lives of people everywhere.

We believe the persistence of technology earnings growth is not properly reflected in current valuations, and that is an area where it is fair to say that there are still a lot of ideas to be mined and unearthed to the benefit of investors. 

Q: Europe is the biggest macro and perhaps bottom-up issue facing investors. What does the situation in the eurozone mean for equity markets over the secular horizon?
Lahr: This is a topic that we discuss frequently in the firm's Investment Committee – not just the potential outcomes on fixed income or equities, but also on economies, the global banking system and all markets. Our base case is that the eurozone faces an extended period of subdued growth with periods where it tips into recession. In many ways, the outlook is similar to the lost decade of Japan in the ‘90s.  

There is a bull case here. And that would be the introduction of a broader eurozone bond issuance and tighter integration of fiscal policy along with structural reforms to heal the economy. Of course there is a bear case, and that is the disorderly breakdown of the eurozone. Both scenarios assure investors one thing: volatility. 

Navigating volatility is critical, particularly in an asset class like equities where it can soar and do considerable damage to short- or long-term returns. Investors need to be focused on both mitigating downside exposure and on idiosyncratic opportunities that may expose an investor to upside above and beyond what the base case and the broad markets within Europe might be offering.

Gordon: Europe is one of the world's largest consumers. Lower aggregate demand from Europe places further pressure on export-orientated countries like China to rebalance toward generating higher domestic demand. Such an adjustment process would have negative consequences for certain companies in both emerging and developed markets. In our work, we stress test earnings trajectories against the lower aggregate demand scenario, as well as against the potential seizure of capital markets – a left tail event that is always unexpected. 

Q: How should an equity investor protect against the downside risks from major macro events?
Kinkelaar: Build diversified portfolios that are designed to protect on the downside as well as participate in opportunities for upside.

You do not have to walk into the fire to find opportunities. Focus on finding companies with solid balance sheets and trading at discounts to intrinsic value.

We also believe it is critical for managers of active strategies to actually be active, and not just hug a benchmark. At PIMCO, we seek at least 80% active share (the percentage of a portfolio that differs from its benchmark) in all our equity strategies.

Q: How are all of these issues – slower growth, the crisis in Europe, geopolitical dysfunction – affecting your stock selection?
Lahr: Our processes are firmly developed and do not change. But what changes is the market, and what this market is highlighting is that a focus on quality is invaluable. In our view, quality is the clearest way to position portfolios given the sharp inflection points that we see ahead arising from debt and income imbalances. 

We define quality by clean balance sheets, high operating margins and access to high-growth markets with barriers to entry. High dividend yields, in our view, are an excellent signal of a quality company – a company positioned to stand the test of time and ride out good times and bad.

Short-term swings often drive people out of quality to try to reach for higher beta. But we believe the potential for lower volatility and lower beta that you can get with high quality helps contribute to the type of return profile that does not get dragged down by external events. It provides the opportunity for consistent returns and may actually compound better over time. In Europe, for example, our process is focused on healthier revenue growth generated outside of peripheral Europe and where growth potential is not reflected in the stock price. 

Q: Where are the opportunities for equity investors?
Gordon: In times of higher volatility, correlations tend to converge to one, creating opportunities to buy strong businesses at very attractive prices. These periods of indiscriminate sell-offs provide us with rare opportunities to buy quality at an attractive price. 

Also, a volatile operating environment leads to displacement of weaker industry players. And that provides opportunities for these companies to outperform the market by taking market share or exercising pricing power. So despite the negative headlines, we may actually see earnings upgrades for such industry champions.

Lahr: I’ll add that opportunity is usually found in areas where the fewest people are looking. Many large multinational companies that have access to growth in both developed and emerging markets are trading at valuations that we view as exceedingly attractive, particularly when we think about living in a world where 10-year Treasury yields in the U.S. are below 2%.

And these multinationals have built in diverse engines of growth where not only should an investor benefit from growing dividends, they also ought to benefit from earnings growth potential in the future. To put it simply, a lot of outstanding value and opportunities are hidden in plain sight. 

Kinkelaar: Despite seeing a synchronized global slowdown, we still believe that we are living in a multispeed world. And we can access opportunities where investors can take advantage of the transition of emerging markets to consumer cultures, as they currently have underlevered consumers, companies and governments, as well as in some cases favorable demographics. 

And in many parts of the world there are still significant infrastructure build-outs ahead that require substantial investment. You can position to participate in local companies and multinationals that are benefiting from that infrastructure investment. 

Q: How can equity investors address specific portfolio needs and challenges, such as producing steady income or protecting against inflation?
Kinkelaar: We think one of the most powerful tools for investors is finding an attractive yield that has growth potential over time, especially in today's low-rate environment. Investors may think dividend-paying companies are mostly mature businesses with little room to expand, but we see opportunities from a range of companies, including those with potential to increase earnings and even some cyclical companies. These companies can help position portfolios for income, as we believe a 4% dividend yield that grows over time is significantly more powerful than a 4% fixed coupon over time.

Lahr: Dividends are not only a developed-market phenomenon, and not sequestered to income strategies. Dividends and the ability to grow them are tremendously important for many strategies for what they can signal about a company’s position, management quality and so many other important factors. And the whole notion of getting that capital back is something that all good investors ought to focus on.

Q: Additional thoughts?
Lahr: At PIMCO, we feel the most important thing an equity investor can do is stay the course, and by that we mean investors need to have a plan for equity allocation and stick to it. They should not let the volatility of equities scare them into something off the plan. 

The long-term potential of equities to grow earnings and dividends is clearly valuable in a world of financial repression. In exchange for some volatility, equity investors can find opportunities to earn a premium in terms of return.