Credit: Shutterstock photoOver the next decade, the one part of an investor’s portfolio that is likely to change the most is international equities, particularly with the availability of targeted country and strategy ETFs. In order to better understand this trend, I reached out to John Lunt, CEO of Lunt Capital and a board trustee for 13 years with the $20B Utah retirement pension system. In addition to his many years of investing experience, John and his colleagues are close to completing an intensive 3-month investment trek of 25 countries across the world, where they conducted in-depth meetings with senior central bankers, asset managers and analysts.
Below are edited excerpts from our conversation.
Before we talk about specific countries, let’s start with overarching themes. What do you think has changed the most in the way an international equity portfolio is constructed compared to 10 or 15 years ago?
John Lunt: Traditionally, investors and financial advisors defined their international exposure very broadly by developed equity (EFA) or emerging markets. A lot of countries were mixed in there, and typically they were all market cap weighted. The key change is that ETFs now provide the ability to get much more granular in international equities – by country, currency, sector and weighting scheme. Also, we are in a time where central banks rule the world, so monetary policy and incentives are likely to create a divergence in performance across countries.
With this ability to get much more granular in country or sector exposure, does the traditional distinction between developed and emerging markets still matter?
John: It's not such a helpful distinction anymore. For example, one of the debates in international investing is whether South Korea should be classified in developed or emerging markets. The right question is do we want to own Korea or not, and what are the dominant sector exposures in Korea that would make you want to own it. If we take a global view, the US is always going to be the core of the US investor’s portfolio, but it's going to decline as a percentage of theglobal marketcap, and getting more targeted in the other portions of the portfolio is important.
As we use ETF data and analytics to get granular exposure in international equities, there are two ways to view the space: By country or by sector. Do you think one view is more important than the other or is a combination of sector & country analysis required?
John: This is an important question. In practice, both country and sectors can have really powerful effects. One the one hand, companies in these different countries have a lot of global exposure, not just to their home countries. However, they are also impacted by currency, policy and regulatory exposure in their home countries. So the sector and country factors are going to be linked, and the key is to know when one is a little more dominant than the other, and to run rotation strategies accordingly.
Are you more optimistic about certain regions? The accepted wisdom is that the 21st century belongs to Asia. Do you see a shift away from a Western-centric model towards a more Asian model or do you think there are growth opportunities everywhere?
John: I really see opportunities everywhere, though Asia is clearly top of mind due to the demographics and country-specific growth factors. Asia is an under-exposed area for many investment portfolios. But even today, if you were to list attributes that you would want in a country that you were going to invest in, the US has more of those attributes than anywhere else. The idea that the US is going to be relegated to insignificance isn't true. The US is going to continue to be an engine of growth, it's just that other opportunities are also emerging. Of all the countries I visited recently, I think India may offer the most interesting risk-return opportunities in the next decade. There are interesting pockets in other areas, for example, Turkey looked really interesting in many ways.
Let's dive into some specific countries. Let's start with Japan, since this is the most optimistic that investors have been about the country in many years, largely due to its monetary policy. What changes do you see today compared to 5-10 years ago?
John: For the last two decades Japan has really been in the grips of a deflationary environment, and nominal GDP has even declined. Now for the first time in many years, the elected officials and the Bank of Japan have been in sync when it comes to monetary accommodation. They are using multiple tools including interest rates and the purchase of ETFs and REITs to create a wealth effect. They now have a mindset that they are going to use monetary policy as a tool, in a way that hasn’t happened for the past two decades. Japanese corporations and the markets have responded, and are effectively factoring in the shift from deflation to re-inflation. Time will tell if they succeed, but I think these are the best underlying conditions we’ve seen in Japan in twenty years.
Do this go beyond being a monetary policy play? Is there a fundamental shift in Japanese corporate profitability and competitiveness?
John: The weaker Yen has been a significant positive factor, but even if it weakens at a more modest pace, corporate profitability and competitiveness is likely to keep improving. A lot of that is due to corporate governance. In my discussions with the Tokyo Stock Exchange, they highlighted the new JPX-Nikkei 400 Index that's going to include governance and fundamental factors. This Index is being used by the Bank of Japan and the government pension investment fund as a benchmark. There is a much more renewed focus now on corporate governance, and shining a light on the traditional interlocking relationships that have existed among Japanese corporations, which will help competitiveness. It’s been a business culture traditionally resistant to change, but we finally see a willingness for corporations to become more profit minded. Also, from the US investor’s point of view, you can hedge that declining Yen exposure with ETFs like DXJ, HEWJ, or DBJP, so you can actually get that the local currency move in Japanese corporations.
What about immigration in Japan? They have the most adverse demographic challenge among developed countries, which immigration could potentially alleviate, but we have not seen any moves in addressing this.
John: The demographic challenge can be overcome either through immigration or raising the birth rate, but neither of those seem likely to change significantly in the medium term. There have been some suggestions that Japan is going to attempt to address this risk through robotics and automation, and it is likely that Japan will be one of the leaders in the evolution of robotics.
In summary on Japan, would it be fair to say that it's a mature market with upside due to their monetary policy and improved corporate governance, but until they fix immigration, it's never going to be a high growth market. Is that a fair summary or is that being too hard on Japan?
John: I think that's a fair summary. Demographics is destiny and something that definitely weighs over Japan long-term. Japan is a mature market, but I am more enthusiastic about it now than I've been since I started in the business. How far those changes can go long term is going to be muted by the difficulties in demographics.
Let's switch to China. There's been a sharp correction in Chinese A-Shares recently. What's your view on why that happened?
John: It is important to see the big rally and the sharp correction in China in the context of the structural changes in that country, as the economy has grown. Initially as people gained wealth they put it in bank savings. Then they started to put it into property, which resulted in big moves in property prices. Once they saw that property doesn't always go up, they started moving assets into capital markets. Clearly some of the volatility in Chinese A-shares can be traced back to some of these structural shifts in investments patterns. Also, the volatility of the last two months has highlighted the unintended consequences when China tries to direct all things in an economy and market. You create bubbles and inefficiencies that cannot always be controlled.
In the long term however, capital markets are going to reflect the size of the economy, and there is no doubt that Chinese capital markets are going to grow.
This is important not just for the Chinese people, but for everyone, because all the major economies have large and growing economic ties to China.
John: Executives and regulators I met across multiple countries talked about how they were levered to growth in the US and China.
Japan, Korea, India, Europe – everyone is focused on these two countries. That's why a slowdown in China is of such great concern.
Looking ahead, Chinese policy makers want to re-orient their economy to more of a domestic consumption-based economy. That is going to take time, and we will see the growing pains as China evolves. Their markets are going to be volatile, and one of the challenges that Chinese policy makers are going to face is how to allow financial markets to perform their function, without over-regulating. That requires some political and regulatory change, which could be slow to come, and could limit growth.
From your conversations in China, do you get the impression they are now viewing themselves as a 4-5% growth country or is this current slowdown a temporary phase?
John: I think most economists would put them in the 6-7% range but with the idea that growth is moderating and that the law of large numbers is catching up. The economy is restructuring to becoming more consumption based and labor costs have increased, so it is likely that China isn't going to maintain an 8-10% growth rate. But China's economy is now big enough that 6-7% growth would be welcomed. Can China continue to grow at the levels they have while regulating growth in the way they have in the past? The answer is probably no. That's going to be a difficult transition but one that I think collectively as a global economy, we're going to be cheering them on.
On that note, obviously the big conundrum in China is increasing economic opportunity with seemingly less political freedom. If economic growth slows, would the population be less willing to make this bargain, like we saw with Suharto’s regime in Indonesia several years ago? Or do you think the political system is so entrenched that a similar upheaval in China is unlikely?
John: I'm not an expert on China's politics, but it seems to me that the way that we think in the West is that there is an inconsistency in China. How can you have economic freedom without political freedom? It's interesting when you talk to people in China they don't see the same inconsistency. Though I personally believe that it will be difficult for them to make the transition from a middle-income to a high-income country, without meaningful political reform.
This political risk seems like a critical issue, because if we look at the daily ETF holdings in VWO and EEM, Chinese stocks already make up 25% of exposure. Once A-Shares are added, that will go up to 30% and maybe even 40% in the longer term. This political risk could cap how much investors want to allocate to China in their portfolios.
John: One of the challenges of China that is different from other countries, is that we can limit our actual exposure to Chinese equities but everyone will have a lot of exposure to the Chinese economy, even through their other holdings. That goes back to your theme of looking at sectors, so that's why China becomes so material. Recently, Greece got all the headlines, but it's really China that we all need to better understand. It's going to be so relevant to portfolios and growth, whether you're investing directly in China or investing in China as a secondary derivative.
Switching topics to India, which is relevant since India and China sometimes get compared, although China is far ahead economically. The positives in India are the demographics and political stability with the new Modi government. What do you see as the risk factors for India?
John: Clearly India is starting at a different level than where China is today, but the opportunities are tremendous. I think one of the historical challenges when it comes to India has been the central bank (the Reserve Bank of India or RBI) and inflation. I think you've had a high inflationary environment in India that for years has negatively impacted investing and capital markets. I think Governor Rajan’s inflation targeting could be a game changer when it comes to investing in India. If he is successful, and you see that the Ministry of Finance and the RBI came to an agreement to target inflation of 6% by 2016 and then target this 2-6% range thereafter. If they are successful in that, it totally changes everything in my view, when it comes to India.
The challenge is whether policy makers will give the central bank true independence. You've seen in the recent weeks, the dispute around the make up in the monetary policy committee. How this plays out and how that goes into effect is going to be material. I think the single most important game changing element in the next decade for India is the central bank independence and the ability to bring down and maintain a lower level of inflation. It could just unleash efficiency and investment for a place like India.
Another challenge, and certainly a more visible one for visitors, is the need to improve infrastructure.
John: Clearly there's a tremendous need for infrastructure growth in India, and there is recognition of this among policy makers. One of the problems is that some of the corporations that would build the infrastructure are really challenged. The government can say it but do they have the ability to really implement it quickly? It is likely going to take some time.
Typically India gets clubbed in with the other BRIC countries, even though they're all so different. If you had to compare it with opportunities in Brazil, Russia, China, where do you see India?
John: If we look at GDP per capita today, India is the least developed of the BRIC countries; but if you believe in that Wayne Gretzky quote that you “skate towards where the puck is going," you invest in India. Policy in Russia is unattractive and Brazil faces a lot of structural challenges. We have already talked about China, and some of their challenges.
What strikes me about India is that despite a significant portion of the population being in true poverty, there is still a high level of awareness, and a desire to grow. It is important to remember that this has been a predominantly socialist country in several sectors, and is just now starting to fully embrace a market-oriented economy. They have a reform minded government, a young dynamic population and domestic led growth. Success is not guaranteed, and they need to get their monetary policy right. If I was told that I could only invest in one of the countries that I visited and I had to hold the investment for ten years I would pick India. I think a typical US investor is going to be surprised at the growth opportunity in India.
I want to close with Europe, in particularly the Euro zone, given everything that's going on. The first issue is: do you see the Euro zone as one investment area or do you see each country individually?
John: I think that for policy makers and for industry, they would love to start thinking of the Euro zone as one integrated area. The reality is that we're far from that. What they’ve effectively done is taken out the currency factor, which is a very significant factor. The differences remain; not just historical and cultural differences but regulatory and policy differences and differences on a government fiscal level. They’ve taken out monetary policy differences, which is a step towards that. I still think that you've got to look at those countries separately. There's separate opportunities and risk when it comes to the Euro zone.
Given these differences and lack of true fiscal and political integration, has Euro integration suffered a serious setback?
John: What I believe is that, and this isn't a new thought, this is what everyone would tell you: monetary union cannot succeed without political and fiscal union. The hope had been that monetary union would be the first leg and those other unions would follow. The problem I think those policy makers are finding is that public sentiment is going the other way. They recognize that for the Euro zone to succeed and grow they have to have more integration but the populations of European countries want less.
I think that the correct way to view the Eurozone is as a set of creditor and debtor nations. The key issue is how do you balance this lack of competitiveness of some of these countries within the Euro zone? It's incredibly difficult, because the politics overwhelm the economics. If you talk to executives and regulators in Germany or France, their concern is not Greece per se, but the ability to ring fence the contagion from Greece. And this is not financial contagion but political contagion into Spain or Italy that could impact the growth and competitiveness of these bigger economies. Greece is just emblematic of the kind of political risk and mindset that could face some of these bigger Eurozone economies.
Outside of Germany it doesn't sound encouraging. Political will is going the other way and trying to improve competitiveness in countries with rigid labor markets and limited political capital behind a reform agenda, will be difficult.
John: This raises the issue of why Germany is willing to engage in this. To a degree it's because without the Euro, the Deutsche Mark would be so strong it would impact their exports and competitiveness. So they're benefiting from a weaker Euro to a significant degree. Germany has been willing to be pro-Euro because their unemployment is in the 4% range, France is 10% and southern Europe is 20+%. Germany is very competitive within the Euro zone. The sustainability of that divergence of competitiveness is what threatens the Eurozone itself.
I focused on the 4 regions I thought were the most important and topical: Japan, China, India and the Eurozone. Do you have any thoughts on other countries outside of these in regards to constructing an international equity portfolio?
John: As we discussed, earlier, getting targeted and deliberate with country and sector exposures, particularly with ETFs, is key. For example, a place like Israel has a population of only 8-9 million people and its size in the global economy is not near as big as these other countries we've mentioned. However it has a very interesting tech and biotech center focus. You can see it in the performance of the Israel ETFs (EIS and ISRA). Turkey offers a lot of opportunities and risks. Korea is going to be very leveraged to China.
The big regions are going to be the main drivers in the global economy but we can look at some of these smaller countries, and see really interesting company and sector exposures that have the potential to create opportunities for investors.
Aniket Ullal is the founder and CEO of First Bridge Data, a provider of independent ETF data and analytics to institutional clients. First Bridge is not affiliated with any ETF sponsor and does not promote or distribute any ETF products.
This article should not be considered investment advice. Both the author, First Bridge Data LLC and Lunt Capital shall not be liable for any actions or decisions made based on the information provided in this article. First Bridge Data LLC is not a registered investment advisor or broker, and does not recommend specific securities, funds, or investment strategies, nor does it advocate the purchase or sale of any individual investment vehicle.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
