Unpacking the opportunity in developed market equities
While over the past decade developed market equities have overwhelmingly lagged behind their U.S. counterparts, the case for international markets still exists, with Japan and Europe offering attractive investment opportunities. On this episode, David Lebovitz is joined by Tim Woodhouse, a Portfolio Manager in our International Equity Group, to discuss cross-border investing, valuations, sector themes, corporate governance and more.
CIE Podcast Transcript
Recorded 11.07.2023
Air Date: 11.20.2023
00;05;58;13 - 00;06;00;30
Speaker 1
Welcome to the Center for Investment Excellence.
00;06;00;45 - 00;06;01;26
Speaker 2
Thank you for having me.
00;06;01;44 - 00;06;22;17
Speaker 1
Well, I'm looking forward to a two hour conversation today. And obviously, we're going to be focused on, you know, what's going on in in markets outside of the U.S. and any potential opportunity.
00;06;22;41 - 00;06;50;37
Speaker 1
China has been under pressure. PMI kind of teetering around that key 50 level. Europe, obviously, the PMI's have moved down below 50, signaling fairly weak growth. The U.K., you know, stuck in stagflation, arguably the worst case scenario if you're an economy, but an even worst case scenario if you're a central banker. But, you know, when you talk to other investors, there's still an element of enthusiasm and excitement about markets outside of the U.S..
00;06;50;37 - 00;07;14;23
Speaker 1
And, you know, my first question to you would be let's just start with the 20,000 foot view. Over the past decade plus, developed markets outside of the United States have lagged the U.S. equity market market horribly. Right. And a lot of people have left international for dead. They're leaning heavily into the U.S. The U.S., I'm not saying is without its own problems, but again, looking relatively good, particularly from a growth perspective.
00;07;14;24 - 00;07;20;21
Speaker 1
So can you talk a little bit about in this environment the macro case for developed markets outside of the U.S.?
00;07;20;59 - 00;07;38;09
Speaker 2
Valuations are are an important part of this this whole debate. Let's let's think about what's changed over the past decade where, as you said, the outperformance has been monumental.
00;07;39;14 - 00;08;12;41
Speaker 2
We had a fantastic tailwind for valuations from falling rates and I think most people, myself included, would say that that's unlikely to continue or certainly won't be repeated in the same way nearly half of U.S. returns over the past decade came from a valuation tailwind that came from a rerating. That number is not as high outside the U.S. and if you don't think you have that tailwind going forwards, I think it really does come back to growth and where expectations are and how that's priced in this thing for a second about the highest growth companies, where, of course, the U.S. is innovating better than anybody else.
00;08;12;41 - 00;08;34;36
Speaker 2
There is no denying that. You look at the what's happening in Silicon Valley, you look at the companies that are listed in recent years. Absolutely. There is faster growth. And you look at how they're being valued, though, you're still seeing a significant premium for each point of revenue growth compared to the last 40 years. When you think about where yields are today, that seems even more out of step with where it should be.
00;08;34;54 - 00;09;03;08
Speaker 2
So that high valuation starting point, I think you do have to consider. Now, of course, Europe's in a tougher economic situation, of course, and we're seeing that. We're seeing that the mismatch with the transmission mechanism for interest rate rises is is really starting to have an impact in the U.S.. When I bought my apartment in 2021, I locked in a 30 year mortgage rate to 75, and now I'm getting 5% plus on my my cash in the U.K., the average mortgage has been a five year mortgage.
00;09;03;10 - 00;09;24;55
Speaker 2
Right. So we're rolling through that now. And you can see the pain that's being felt in the U.K., But it's starting to roll across Europe and the rest of the world. It doesn't mean no, the expectations are incredibly low. So I think valuations has to be an important part of why actually, for the first time in probably a decade of doing this job, I think this might now be the moment where you start to see the balance shift in favor of international.
00;09;25;20 - 00;09;43;34
Speaker 1
And it's really interesting that you that you hone in on valuation, because one of the things that we've been spending quite a bit of time talking about is you look at where valuations are today, you think about the risks that may or may not exist on the horizon. Right. You know, kind of soft landing, hard landing. We can debate that until we're purple in the face.
00;09;43;55 - 00;10;03;22
Speaker 1
The question is what's been priced in. Right. And it feels to me and I think that you would agree something very different and arguably more pessimistic has been priced into markets outside of the U.S. And this comes at a really interesting time because I would argue that from more of a fundamental perspective, the tide is beginning to turn, particularly in places like Europe.
00;10;03;22 - 00;10;26;36
Speaker 1
You know, you've basically seen fiscal austerity get thrown to the wind, the sector mix from a market perspective is very different today than it was prior to the financial crisis, when obviously European markets were primarily dominated by by banks. And, you know, frankly, I think that higher interest rates having a cost of capital means that it's not necessarily just a U.S. story.
00;10;26;36 - 00;10;35;41
Speaker 1
Right. There are good companies elsewhere which may be viewed differently now that there's actually differentiation between winners and losers. And so talk to me a little bit about Europe and the opportunities out there.
00;10;35;57 - 00;11;00;35
Speaker 2
Without that sector. Competition point is a great place to start because if you look back at the start of 2008, the top three sectors never saw Europe where energy and mining 19%, banks 15% and telecoms at 7%. You look today 14% is farmer and biotech, 12% is cap goods and 8% is food and beverage. So within all of those sectors, I would argue they are higher.
00;11;00;35 - 00;11;26;00
Speaker 2
Are we businesses, more stable businesses? And I think that's what makes the fact that Europe is trading at really close to all time low versus the rest of the world. Particularly interesting because it is a structurally better market. That's true. Even if you look out that longer term piece. And the reason that's important is when you look at our long term growth forecast for Europe versus the U.S., we're forecasting 9.2% long term earnings growth for the U.S. and five and a half for Europe.
00;11;26;33 - 00;11;50;08
Speaker 2
So going further out with your peers does matter when you're trying to measure what the true valuation is even on long term peers. Europe looks very, very cheap today. And I think that that gives us some comfort that that overweight is to the to the region are actually going to be quite beneficial. Bridgewater interestingly, last week came out with a piece that highlighted that even if European earnings fell modestly for the next decade, investors are still on a breakeven equity risk premium.
00;11;50;08 - 00;11;57;59
Speaker 2
So essentially normal compensation for taking equity risk.
00;11;58;30 - 00;12;20;17
Speaker 1
And I think that there's there's another angle to that story as well, which is, you know, socialization, globalization on shoring. However, however you want to phrase it, countries are going to trade with their friends more going forward. And there are a lot of very, very, very solid businesses in places like Europe that are now setting up operations here in the United States.
00;12;20;17 - 00;12;35;16
Speaker 1
And so, you know, arguably there's there's an extension of the story that you were talking about where, you know, some of these businesses are arguably increasing their exposure to an economy with a trend growth rate, which is above that of what we see in the Eurozone and the U.K..
00;12;35;16 - 00;12;52;41
Speaker 2
And that's an important point because I think people do still perceive Europe as being European exposure and very cyclical. And like I said, the largest sector in Europe is far from biotech. They don't make that money. And in Europe they make their money in in the U.S. And we all know the reasons for that. And I but I think that's particularly important.
00;12;52;41 - 00;13;08;44
Speaker 2
We think about the stability of the returns that you can make in Europe. You look at the high quality nature of some of the companies that we've been been buying, whether it's in ASML or in LVMH, who clearly dominate that particular sector. But even you look at a Volvo within trucks, so you look at a kingspan with an insulation.
00;13;08;44 - 00;13;19;49
Speaker 2
These are champions of their particular industries, which happens to be listed in Europe, which happens to mean you can get them at a better valuation. Right now. But it doesn't change the high quality nature of the cash flow generation.
00;13;20;09 - 00;13;38;53
Speaker 1
We're in an environment where rates may go down, but they're not going to go back to zero. And so we need to be sensitive to the prices we're paying today, given that structurally it looks like we're going to be operating and investing in a slightly different type of interest rate environment.
00;13;38;53 - 00;14;00;44
Speaker 1
And speaking of interest rates, I want to move on to what many would consider to be the the elephant in the room. So Japan, you know, you and I have known each other for more than a decade. We've seen plenty of glimmers of light from the Japanese economy, the Japanese markets and it feels like, at least in my experience, that each time it kind of proves to be a bit of a false dawn.
00;14;01;11 - 00;14;23;11
Speaker 1
But you look at what's going on in Japan today and things are going to say different, which I know is a dangerous word in our business. But you know, it's in the midst of a post-COVID rebound, right. Much earlier on in that recovery than the rest of the world, and particularly the developed markets. You're seeing higher interest rates, more inflation, more wage growth.
00;14;23;18 - 00;14;44;11
Speaker 1
You know, we hear that corporate governance is coming into focus and there's going to be more attention paid to making sure that shareholders are compensated for for their equity ownership. And so it feels like structurally things are moving in the right direction in a way that hasn't necessarily been the case in the past, where it's, oh, buy it because it's cheaper.
00;14;44;12 - 00;15;00;15
Speaker 1
Oh, buy it because they're not dealing with the same problems as the rest of the world. It seems like there's actually a positive fundamental story that's beginning to take hold there. So talk to me about Japan. I mean, is this another head fake? Is it another false dawn or is actually an emerging structural opportunity?
00;15;01;40 - 00;15;24;19
Speaker 2
Look, I think there are there are elements of good things going on in Japan, but there's there's still an element of some things never change. Or if it does change, it takes a very long time. So, absolutely, the rebound post-COVID has helped the domestic economy this year. And with the dramatically aging workforce, the labor market is tight. I know we talk about this all the time here in the U.S., but it is absolutely true in Japan.
00;15;24;19 - 00;15;48;11
Speaker 2
And you think about with 20% of the workforce retiring over the next 20 is just how much more impactful wage inflation could be. All of that then leads, of course, to yield curve control, being hard to maintain and has interesting implications for the domestic economy, particularly banks and also, of course, the yen, which for U.S. dollar investors is critical, too.
00;15;48;59 - 00;16;19;52
Speaker 2
But that aging population is not unequivocally positive. There are various studies on what retiring in Japan means to consumption, and they range from neutral to slightly negative. So I think there's there's a risk there that actually we're still overestimating what Japan domestic growth will be. And of course, it's low quality companies we can see in low with lower approaches in Japan versus Europe or the U.S., not just because of poor capital allocation, but because of lower net interest, sorry, lower net profit margins.
00;16;20;57 - 00;16;44;10
Speaker 2
That's something which is much more fundamentally difficult to solve. And that's where it really does come down to in some ways. Do we believe in the corporate governance improvement? Yeah, because if you believe that if we take the margin point for for a second, if you believe that Japan will no longer focus on trying to employ as many people as possible and keeping businesses running, even if they're multi loss making simply because they don't want to fire people.
00;16;44;34 - 00;17;03;48
Speaker 2
If you believe that their cultural aversion to M&A means that so many of these businesses, which quite frankly in the U.S. wouldn't exist today that have been swallowed up and seen dramatic cost cuts, if you believe all of that changes, then there's some potential for margins to rise, not to the levels that you see in in the U.S., of course, but some potential.
00;17;04;28 - 00;17;31;57
Speaker 2
And then you have to believe that the net cash on the balance sheets gets spent. Maybe it's dividends, maybe it's buybacks, maybe it's for the first time in a long time investing in innovation. But I have to confess some I'm skeptical. I think that even the more optimistic people on corporate governance reform in Japan right now would say would point to slightly higher net dividend to my bank yields, I would point to the fact that they're actually not that much higher than other moments we've seen in the past.
00;17;31;57 - 00;18;05;39
Speaker 2
We've seen different reforms from Japan to intended to drive corporate governance change, and we still haven't seen that. And people have got very excited this year about the Tokyo Stock Exchange threat to delist companies that continue to trade low book value. You've got to remember that the majority of companies that trade below book value on the topics are actually tiny, tiny companies which you could delist and no one would know if you think that delisting a Honda because they're trading at below book value, then unfortunately you're very much mistaken.
00;18;06;11 - 00;18;27;58
Speaker 2
So forgive me for the skepticism, but when it comes to corporate governance reform in Japan, I need to see the proof before I believe it. And even then, even when you look at the auto companies, the banks in Japan, the governance improvements they could make the better allocation of capital. They still don't generate returns which are good enough to justify meaningfully high valuations.
00;18;28;22 - 00;18;48;35
Speaker 2
And I say all of this in the backdrop of Japan has been the best performing equity market. And look at currency this year, right? So expectations have have risen quite dramatically, too. And ultimately for me, I think there is a short term opportunity. I do think if if rates rise, then certainly domestic focused businesses can do well. The depreciation of the yen so far has helped margins and exporters.
00;18;48;35 - 00;19;03;59
Speaker 2
But of course, for everyone arguing that the yen is cheap, they have to remember that that hits the earnings of Japan's best companies if if the yen which rally. So all in all pick your opportunities carefully but I think a structural overweight to Japan at this point is it's far from proven.
00;19;04;54 - 00;19;22;33
Speaker 1
What I'm hearing you say is that it's really about the lack of dynamism. Right. And that's best reflected through the margin and the profitability. Like if the companies looked more like some of the big tech names in the U.S. or some of the names that you mentioned out of Europe, maybe there would be a reason to be more excited from an investment perspective.
00;19;22;33 - 00;19;26;50
Speaker 1
But if I'm hearing you correctly, this is more of a trade than anything else in your in your view.
00;19;26;50 - 00;19;51;07
Speaker 2
In my view, it's more of a trade. And when you think about that innovation, that dynamism, of course, that manifests itself in in top line growth and you look at our long term capital market assumptions, Japan's top line growth lags the U.S. It lags Europe. It's quite frankly not very compelling. And it's because the biggest part of Japan's equity indices are autos, where Toyota used to be seen as the darling of the sector because they had hybrids.
00;19;51;18 - 00;20;12;27
Speaker 2
Right. Well, now they're lagging far behind the Chinese on on electric vehicles. You think about the bank wet even if they were to to get higher rates, you're still not going to get very good returns from them. And you think about the core shadow shareholdings that they have. There's just too much that has Japan getting in its own way and not enough that really leads to growing markets.
00;20;12;27 - 00;20;15;19
Speaker 2
And without growth, you can't cut your way to nothing. Yep.
00;20;15;36 - 00;20;32;05
Speaker 1
And I mean, there's also an angle where that economy has had a foundation of zero rates for how many decades? I mean, what do we really know about the other side of the mountain if they are able to break away from a zero rate and a yield curve control environment, I imagine it could be a little bit bumpy on the on the way back down.
00;20;32;05 - 00;20;56;39
Speaker 2
I would think so. And that's the Sony dynamics, too, that you think about if there is inflation. Well, Japan's pension system is designed to give pensioners less of a step up in their pension than than inflation. So that will be challenging if you think to ultimately about what higher rates would mean for the government debt. If rates in Japan went to 2%, then suddenly government debt payments are 6% of GDP.
00;20;56;39 - 00;21;04;49
Speaker 2
That's a huge number and that's a problem. I just think it's it's too premature to get excited about Japan, particularly given valuations just aren't that cheap anymore.
00;21;05;02 - 00;21;27;21
Speaker 1
Yep. No, all very good points. And so I want to bring what has been an excellent conversation kind of to a close. You you kind of gave both the bull and the barricades for Japan. I want to circle back to Europe for a second. You certainly painted Europe and the UK in a relatively positive light. What would make you less constructive on the opportunity set across the pond?
00;21;27;45 - 00;21;57;28
Speaker 2
But the challenge Europe has always had is, is it is less self self sufficient from an energy perspective. It has a more nuanced shall we say, government structure. It tends to overregulate itself and really get in its own way. And those things haven't changed. And at certain moments they really they're their heads. If we do have escalation of the the awful issues going on in in Israel, in the Middle East, then what does that mean for energy policy?
00;21;57;28 - 00;22;22;57
Speaker 2
We saw what happened with Russia and Ukraine and how disruptive that was. Well, there are there are risks there. I do think, though, despite these risks, valuations are telling you that the market understands that. And I think just to finish on a positive note for for Europe versus versus the U.S., we talked about higher cost of capital. But there's one dynamic of that I don't think we have touched on, which is I mentioned the U.S. We see earnings growth of over 9%.
00;22;22;57 - 00;22;52;48
Speaker 2
Europe is about five and a half. I don't know that anyone fully understands yet in a high cost of capital world what that means for top line growth. The U.S., of course, is growing significantly faster. But how much of that was an era of free money? Right. It's not all that. Of course not. But if you see a narrowing of that growth gap between the U.S. and Europe at a point where European valuations are just so low, I think that that is a really compelling argument to, I would argue, be overweight.
00;22;53;08 - 00;22;56;21
Speaker 2
Europe at the very least. Make sure you have some exposure.
00;22;56;56 - 00;23;09;21
Speaker 1
Well, as always, it sounds like we should we should focus on the fundamentals. So, Tim, this has been fantastic. Thank you for joining me for the first video edition of Center for Investment Excellence. And more than anything, I'm looking forward to having you back sometime soon.
00;23;09;36 - 00;23;21;12
Speaker 2
Thank you very much.
00;23;21;12 - 00;23;26;51
Speaker 3
Yep.
00;23;26;51 - 00;23;27;36
Speaker 1
All right. I'm ready.
00;23;28;48 - 00;23;29;29
Speaker 3
By the count.
00;23;29;49 - 00;23;30;06
Speaker 1
Yep.
00;23;30;52 - 00;23;37;33
Speaker 3
So four, three, two.
00;23;37;33 - 00;24;02;08
Speaker 1
Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on unpacking the opportunity in developed market equities. I'm David Lebowitz, global market strategist in our Multiasset Solutions business and host of the Center for Investment Excellence.
00;24;02;30 - 00;24;29;07
Speaker 1
With me today is Tim Woodhouse, portfolio manager in the International Equity Group. Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts on our website and on our JPMorgan Morgan Asset Management YouTube channel recorded on November 7th, 2023.
00;24;29;07 - 00;24;30;49
Speaker 3
Good review.
00;24;31;40 - 00;24;34;14
Speaker 1
I thought that was. I thought it was good. So yeah, we're.
00;24;34;14 - 00;24;35;01
Speaker 2
All set from my side.
00;24;35;10 - 00;24;36;15
Speaker 1
Awesome. Thank you. Thank you.
00;24;37;16 - 00;24;38;13
Speaker 2
Thank you.
00;24;38;26 - 00;24;41;06
Speaker 1
Thank you. That was fun.
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CIE Podcast Transcript
Recorded 11.07.2023
Air Date: 11.20.2023
00;05;58;13 - 00;06;00;30
Speaker 1
Welcome to the Center for Investment Excellence.
00;06;00;45 - 00;06;01;26
Speaker 2
Thank you for having me.
00;06;01;44 - 00;06;22;17
Speaker 1
Well, I'm looking forward to a two hour conversation today. And obviously, we're going to be focused on, you know, what's going on in in markets outside of the U.S. and any potential opportunity.
00;06;22;41 - 00;06;50;37
Speaker 1
China has been under pressure. PMI kind of teetering around that key 50 level. Europe, obviously, the PMI's have moved down below 50, signaling fairly weak growth. The U.K., you know, stuck in stagflation, arguably the worst case scenario if you're an economy, but an even worst case scenario if you're a central banker. But, you know, when you talk to other investors, there's still an element of enthusiasm and excitement about markets outside of the U.S..
00;06;50;37 - 00;07;14;23
Speaker 1
And, you know, my first question to you would be let's just start with the 20,000 foot view. Over the past decade plus, developed markets outside of the United States have lagged the U.S. equity market market horribly. Right. And a lot of people have left international for dead. They're leaning heavily into the U.S. The U.S., I'm not saying is without its own problems, but again, looking relatively good, particularly from a growth perspective.
00;07;14;24 - 00;07;20;21
Speaker 1
So can you talk a little bit about in this environment the macro case for developed markets outside of the U.S.?
00;07;20;59 - 00;07;38;09
Speaker 2
Valuations are are an important part of this this whole debate. Let's let's think about what's changed over the past decade where, as you said, the outperformance has been monumental.
00;07;39;14 - 00;08;12;41
Speaker 2
We had a fantastic tailwind for valuations from falling rates and I think most people, myself included, would say that that's unlikely to continue or certainly won't be repeated in the same way nearly half of U.S. returns over the past decade came from a valuation tailwind that came from a rerating. That number is not as high outside the U.S. and if you don't think you have that tailwind going forwards, I think it really does come back to growth and where expectations are and how that's priced in this thing for a second about the highest growth companies, where, of course, the U.S. is innovating better than anybody else.
00;08;12;41 - 00;08;34;36
Speaker 2
There is no denying that. You look at the what's happening in Silicon Valley, you look at the companies that are listed in recent years. Absolutely. There is faster growth. And you look at how they're being valued, though, you're still seeing a significant premium for each point of revenue growth compared to the last 40 years. When you think about where yields are today, that seems even more out of step with where it should be.
00;08;34;54 - 00;09;03;08
Speaker 2
So that high valuation starting point, I think you do have to consider. Now, of course, Europe's in a tougher economic situation, of course, and we're seeing that. We're seeing that the mismatch with the transmission mechanism for interest rate rises is is really starting to have an impact in the U.S.. When I bought my apartment in 2021, I locked in a 30 year mortgage rate to 75, and now I'm getting 5% plus on my my cash in the U.K., the average mortgage has been a five year mortgage.
00;09;03;10 - 00;09;24;55
Speaker 2
Right. So we're rolling through that now. And you can see the pain that's being felt in the U.K., But it's starting to roll across Europe and the rest of the world. It doesn't mean no, the expectations are incredibly low. So I think valuations has to be an important part of why actually, for the first time in probably a decade of doing this job, I think this might now be the moment where you start to see the balance shift in favor of international.
00;09;25;20 - 00;09;43;34
Speaker 1
And it's really interesting that you that you hone in on valuation, because one of the things that we've been spending quite a bit of time talking about is you look at where valuations are today, you think about the risks that may or may not exist on the horizon. Right. You know, kind of soft landing, hard landing. We can debate that until we're purple in the face.
00;09;43;55 - 00;10;03;22
Speaker 1
The question is what's been priced in. Right. And it feels to me and I think that you would agree something very different and arguably more pessimistic has been priced into markets outside of the U.S. And this comes at a really interesting time because I would argue that from more of a fundamental perspective, the tide is beginning to turn, particularly in places like Europe.
00;10;03;22 - 00;10;26;36
Speaker 1
You know, you've basically seen fiscal austerity get thrown to the wind, the sector mix from a market perspective is very different today than it was prior to the financial crisis, when obviously European markets were primarily dominated by by banks. And, you know, frankly, I think that higher interest rates having a cost of capital means that it's not necessarily just a U.S. story.
00;10;26;36 - 00;10;35;41
Speaker 1
Right. There are good companies elsewhere which may be viewed differently now that there's actually differentiation between winners and losers. And so talk to me a little bit about Europe and the opportunities out there.
00;10;35;57 - 00;11;00;35
Speaker 2
Without that sector. Competition point is a great place to start because if you look back at the start of 2008, the top three sectors never saw Europe where energy and mining 19%, banks 15% and telecoms at 7%. You look today 14% is farmer and biotech, 12% is cap goods and 8% is food and beverage. So within all of those sectors, I would argue they are higher.
00;11;00;35 - 00;11;26;00
Speaker 2
Are we businesses, more stable businesses? And I think that's what makes the fact that Europe is trading at really close to all time low versus the rest of the world. Particularly interesting because it is a structurally better market. That's true. Even if you look out that longer term piece. And the reason that's important is when you look at our long term growth forecast for Europe versus the U.S., we're forecasting 9.2% long term earnings growth for the U.S. and five and a half for Europe.
00;11;26;33 - 00;11;50;08
Speaker 2
So going further out with your peers does matter when you're trying to measure what the true valuation is even on long term peers. Europe looks very, very cheap today. And I think that that gives us some comfort that that overweight is to the to the region are actually going to be quite beneficial. Bridgewater interestingly, last week came out with a piece that highlighted that even if European earnings fell modestly for the next decade, investors are still on a breakeven equity risk premium.
00;11;50;08 - 00;11;57;59
Speaker 2
So essentially normal compensation for taking equity risk.
00;11;58;30 - 00;12;20;17
Speaker 1
And I think that there's there's another angle to that story as well, which is, you know, socialization, globalization on shoring. However, however you want to phrase it, countries are going to trade with their friends more going forward. And there are a lot of very, very, very solid businesses in places like Europe that are now setting up operations here in the United States.
00;12;20;17 - 00;12;35;16
Speaker 1
And so, you know, arguably there's there's an extension of the story that you were talking about where, you know, some of these businesses are arguably increasing their exposure to an economy with a trend growth rate, which is above that of what we see in the Eurozone and the U.K..
00;12;35;16 - 00;12;52;41
Speaker 2
And that's an important point because I think people do still perceive Europe as being European exposure and very cyclical. And like I said, the largest sector in Europe is far from biotech. They don't make that money. And in Europe they make their money in in the U.S. And we all know the reasons for that. And I but I think that's particularly important.
00;12;52;41 - 00;13;08;44
Speaker 2
We think about the stability of the returns that you can make in Europe. You look at the high quality nature of some of the companies that we've been been buying, whether it's in ASML or in LVMH, who clearly dominate that particular sector. But even you look at a Volvo within trucks, so you look at a kingspan with an insulation.
00;13;08;44 - 00;13;19;49
Speaker 2
These are champions of their particular industries, which happens to be listed in Europe, which happens to mean you can get them at a better valuation. Right now. But it doesn't change the high quality nature of the cash flow generation.
00;13;20;09 - 00;13;38;53
Speaker 1
We're in an environment where rates may go down, but they're not going to go back to zero. And so we need to be sensitive to the prices we're paying today, given that structurally it looks like we're going to be operating and investing in a slightly different type of interest rate environment.
00;13;38;53 - 00;14;00;44
Speaker 1
And speaking of interest rates, I want to move on to what many would consider to be the the elephant in the room. So Japan, you know, you and I have known each other for more than a decade. We've seen plenty of glimmers of light from the Japanese economy, the Japanese markets and it feels like, at least in my experience, that each time it kind of proves to be a bit of a false dawn.
00;14;01;11 - 00;14;23;11
Speaker 1
But you look at what's going on in Japan today and things are going to say different, which I know is a dangerous word in our business. But you know, it's in the midst of a post-COVID rebound, right. Much earlier on in that recovery than the rest of the world, and particularly the developed markets. You're seeing higher interest rates, more inflation, more wage growth.
00;14;23;18 - 00;14;44;11
Speaker 1
You know, we hear that corporate governance is coming into focus and there's going to be more attention paid to making sure that shareholders are compensated for for their equity ownership. And so it feels like structurally things are moving in the right direction in a way that hasn't necessarily been the case in the past, where it's, oh, buy it because it's cheaper.
00;14;44;12 - 00;15;00;15
Speaker 1
Oh, buy it because they're not dealing with the same problems as the rest of the world. It seems like there's actually a positive fundamental story that's beginning to take hold there. So talk to me about Japan. I mean, is this another head fake? Is it another false dawn or is actually an emerging structural opportunity?
00;15;01;40 - 00;15;24;19
Speaker 2
Look, I think there are there are elements of good things going on in Japan, but there's there's still an element of some things never change. Or if it does change, it takes a very long time. So, absolutely, the rebound post-COVID has helped the domestic economy this year. And with the dramatically aging workforce, the labor market is tight. I know we talk about this all the time here in the U.S., but it is absolutely true in Japan.
00;15;24;19 - 00;15;48;11
Speaker 2
And you think about with 20% of the workforce retiring over the next 20 is just how much more impactful wage inflation could be. All of that then leads, of course, to yield curve control, being hard to maintain and has interesting implications for the domestic economy, particularly banks and also, of course, the yen, which for U.S. dollar investors is critical, too.
00;15;48;59 - 00;16;19;52
Speaker 2
But that aging population is not unequivocally positive. There are various studies on what retiring in Japan means to consumption, and they range from neutral to slightly negative. So I think there's there's a risk there that actually we're still overestimating what Japan domestic growth will be. And of course, it's low quality companies we can see in low with lower approaches in Japan versus Europe or the U.S., not just because of poor capital allocation, but because of lower net interest, sorry, lower net profit margins.
00;16;20;57 - 00;16;44;10
Speaker 2
That's something which is much more fundamentally difficult to solve. And that's where it really does come down to in some ways. Do we believe in the corporate governance improvement? Yeah, because if you believe that if we take the margin point for for a second, if you believe that Japan will no longer focus on trying to employ as many people as possible and keeping businesses running, even if they're multi loss making simply because they don't want to fire people.
00;16;44;34 - 00;17;03;48
Speaker 2
If you believe that their cultural aversion to M&A means that so many of these businesses, which quite frankly in the U.S. wouldn't exist today that have been swallowed up and seen dramatic cost cuts, if you believe all of that changes, then there's some potential for margins to rise, not to the levels that you see in in the U.S., of course, but some potential.
00;17;04;28 - 00;17;31;57
Speaker 2
And then you have to believe that the net cash on the balance sheets gets spent. Maybe it's dividends, maybe it's buybacks, maybe it's for the first time in a long time investing in innovation. But I have to confess some I'm skeptical. I think that even the more optimistic people on corporate governance reform in Japan right now would say would point to slightly higher net dividend to my bank yields, I would point to the fact that they're actually not that much higher than other moments we've seen in the past.
00;17;31;57 - 00;18;05;39
Speaker 2
We've seen different reforms from Japan to intended to drive corporate governance change, and we still haven't seen that. And people have got very excited this year about the Tokyo Stock Exchange threat to delist companies that continue to trade low book value. You've got to remember that the majority of companies that trade below book value on the topics are actually tiny, tiny companies which you could delist and no one would know if you think that delisting a Honda because they're trading at below book value, then unfortunately you're very much mistaken.
00;18;06;11 - 00;18;27;58
Speaker 2
So forgive me for the skepticism, but when it comes to corporate governance reform in Japan, I need to see the proof before I believe it. And even then, even when you look at the auto companies, the banks in Japan, the governance improvements they could make the better allocation of capital. They still don't generate returns which are good enough to justify meaningfully high valuations.
00;18;28;22 - 00;18;48;35
Speaker 2
And I say all of this in the backdrop of Japan has been the best performing equity market. And look at currency this year, right? So expectations have have risen quite dramatically, too. And ultimately for me, I think there is a short term opportunity. I do think if if rates rise, then certainly domestic focused businesses can do well. The depreciation of the yen so far has helped margins and exporters.
00;18;48;35 - 00;19;03;59
Speaker 2
But of course, for everyone arguing that the yen is cheap, they have to remember that that hits the earnings of Japan's best companies if if the yen which rally. So all in all pick your opportunities carefully but I think a structural overweight to Japan at this point is it's far from proven.
00;19;04;54 - 00;19;22;33
Speaker 1
What I'm hearing you say is that it's really about the lack of dynamism. Right. And that's best reflected through the margin and the profitability. Like if the companies looked more like some of the big tech names in the U.S. or some of the names that you mentioned out of Europe, maybe there would be a reason to be more excited from an investment perspective.
00;19;22;33 - 00;19;26;50
Speaker 1
But if I'm hearing you correctly, this is more of a trade than anything else in your in your view.
00;19;26;50 - 00;19;51;07
Speaker 2
In my view, it's more of a trade. And when you think about that innovation, that dynamism, of course, that manifests itself in in top line growth and you look at our long term capital market assumptions, Japan's top line growth lags the U.S. It lags Europe. It's quite frankly not very compelling. And it's because the biggest part of Japan's equity indices are autos, where Toyota used to be seen as the darling of the sector because they had hybrids.
00;19;51;18 - 00;20;12;27
Speaker 2
Right. Well, now they're lagging far behind the Chinese on on electric vehicles. You think about the bank wet even if they were to to get higher rates, you're still not going to get very good returns from them. And you think about the core shadow shareholdings that they have. There's just too much that has Japan getting in its own way and not enough that really leads to growing markets.
00;20;12;27 - 00;20;15;19
Speaker 2
And without growth, you can't cut your way to nothing. Yep.
00;20;15;36 - 00;20;32;05
Speaker 1
And I mean, there's also an angle where that economy has had a foundation of zero rates for how many decades? I mean, what do we really know about the other side of the mountain if they are able to break away from a zero rate and a yield curve control environment, I imagine it could be a little bit bumpy on the on the way back down.
00;20;32;05 - 00;20;56;39
Speaker 2
I would think so. And that's the Sony dynamics, too, that you think about if there is inflation. Well, Japan's pension system is designed to give pensioners less of a step up in their pension than than inflation. So that will be challenging if you think to ultimately about what higher rates would mean for the government debt. If rates in Japan went to 2%, then suddenly government debt payments are 6% of GDP.
00;20;56;39 - 00;21;04;49
Speaker 2
That's a huge number and that's a problem. I just think it's it's too premature to get excited about Japan, particularly given valuations just aren't that cheap anymore.
00;21;05;02 - 00;21;27;21
Speaker 1
Yep. No, all very good points. And so I want to bring what has been an excellent conversation kind of to a close. You you kind of gave both the bull and the barricades for Japan. I want to circle back to Europe for a second. You certainly painted Europe and the UK in a relatively positive light. What would make you less constructive on the opportunity set across the pond?
00;21;27;45 - 00;21;57;28
Speaker 2
But the challenge Europe has always had is, is it is less self self sufficient from an energy perspective. It has a more nuanced shall we say, government structure. It tends to overregulate itself and really get in its own way. And those things haven't changed. And at certain moments they really they're their heads. If we do have escalation of the the awful issues going on in in Israel, in the Middle East, then what does that mean for energy policy?
00;21;57;28 - 00;22;22;57
Speaker 2
We saw what happened with Russia and Ukraine and how disruptive that was. Well, there are there are risks there. I do think, though, despite these risks, valuations are telling you that the market understands that. And I think just to finish on a positive note for for Europe versus versus the U.S., we talked about higher cost of capital. But there's one dynamic of that I don't think we have touched on, which is I mentioned the U.S. We see earnings growth of over 9%.
00;22;22;57 - 00;22;52;48
Speaker 2
Europe is about five and a half. I don't know that anyone fully understands yet in a high cost of capital world what that means for top line growth. The U.S., of course, is growing significantly faster. But how much of that was an era of free money? Right. It's not all that. Of course not. But if you see a narrowing of that growth gap between the U.S. and Europe at a point where European valuations are just so low, I think that that is a really compelling argument to, I would argue, be overweight.
00;22;53;08 - 00;22;56;21
Speaker 2
Europe at the very least. Make sure you have some exposure.
00;22;56;56 - 00;23;09;21
Speaker 1
Well, as always, it sounds like we should we should focus on the fundamentals. So, Tim, this has been fantastic. Thank you for joining me for the first video edition of Center for Investment Excellence. And more than anything, I'm looking forward to having you back sometime soon.
00;23;09;36 - 00;23;21;12
Speaker 2
Thank you very much.
00;23;21;12 - 00;23;26;51
Speaker 3
Yep.
00;23;26;51 - 00;23;27;36
Speaker 1
All right. I'm ready.
00;23;28;48 - 00;23;29;29
Speaker 3
By the count.
00;23;29;49 - 00;23;30;06
Speaker 1
Yep.
00;23;30;52 - 00;23;37;33
Speaker 3
So four, three, two.
00;23;37;33 - 00;24;02;08
Speaker 1
Welcome to the Center for Investment Excellence, a production of J.P. Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on unpacking the opportunity in developed market equities. I'm David Lebowitz, global market strategist in our Multiasset Solutions business and host of the Center for Investment Excellence.
00;24;02;30 - 00;24;29;07
Speaker 1
With me today is Tim Woodhouse, portfolio manager in the International Equity Group. Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts on our website and on our JPMorgan Morgan Asset Management YouTube channel recorded on November 7th, 2023.
00;24;29;07 - 00;24;30;49
Speaker 3
Good review.
00;24;31;40 - 00;24;34;14
Speaker 1
I thought that was. I thought it was good. So yeah, we're.
00;24;34;14 - 00;24;35;01
Speaker 2
All set from my side.
00;24;35;10 - 00;24;36;15
Speaker 1
Awesome. Thank you. Thank you.
00;24;37;16 - 00;24;38;13
Speaker 2
Thank you.
00;24;38;26 - 00;24;41;06
Speaker 1
Thank you. That was fun.
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