July 4, 2014

Changes to Star Ratings 2Q 14: Neutral on US and Europe
We have adjusted our ratings on the equity markets of the US, Europe and the Technology sector in our latest Star Ratings review

by iFAST Research Team

 Fund Managers on Short-Term Funds


At the end of each quarter, we review our calls on the various regional and single-country equity markets under our coverage to assess each market's attractiveness as an investment proposition both on a standalone basis, as well as with respect to other markets. In our quarterly star rating exercise, we look at key valuation metrics like PE and PB ratios, expected earnings growth, as well as excess earnings yield to determine how attractive a particular market is. In addition, we consider the economic outlook utilising both consensus forecasts, as well as our own assessment of longer-term economic prospects. Our methodology not only incorporates both top-down and bottom-up forecasts, but also includes qualitative adjustments where necessary to achieve reasonable estimates of target upside for each market under our coverage over a 3-year horizon.

Why are we lowering our ratings on the US and Europe to “neutral”?

Following the healthy stock market performances for developed markets like the US and Europe in the first half of 2014 (+7% and +6.6% on a total return basis in their respective currencies, as of 26 June 2014), we are turning neutral on the US and Europe equity markets, given their lowered levels of upside potential over the next three years. Strong returns for both markets in recent years has resulted in higher stock market valuations, and in our forecasts (see Chart 1), we are expecting a slight compression in PE ratios (as opposed to higher valuations forecasted for most markets under our coverage), which are expected to be offset by decent rates of earnings growth and dividend yield. In the absence of a positive valuation re-rating, our expected returns of 7.8% and 6.8% (on an annualised basis) by end-2016 represent much more “normalised” rates of stock market return, which warrants alowering of our star rating on both markets to 2.5 stars “neutral”, from 3.0 stars “attractive” previously.

Chart 1: Forecasted Returns by end-2016 (annualised)


Is the Technology sector still attractive?

The global Technology sector still sports some of the strongest earnings growth, driven by a combination of explosive growth in “new-technology” software and services, alongside more modest rates of growth for technology bellwethers which are more leveraged on the general recovery in global IT spending. Earnings momentum has also been strong for the sector, with Technology companies generally reporting better-than-forecasted earnings so far in 2014. We have held a highly-favourable view on the Technology sector for some time, having last adjusted our star rating on the market to 4.0 stars “very attractive” in April 2012. The technology sector has since delivered a hefty 32.5% return (as of 26 June 2014 in USD terms, including dividends), rewarding investors who have kept faith with the sector. Since the 2009 stock market bottom (9 March 2009), the Technology sector’s 24.1% annualised return has also outpaced the global equity market’s 22.1%’s return (as of 26 June 2014).

Chart 2: Actual and Expected returns for the Tech sector (annualised)


In 2013, the Technology sector saw an upward rerating of valuation multiples, mainly attributed to companies in the developed markets (about 80% of the companies in the MSCI AC World IT index are from the developed markets). Consequently, expected returns for the market have fallen to 10.1% (annualised, by end-2016), still representing a decent forecasted return, although not as attractive as before (see Chart 2). We expect investment returns in the strong-growth Technology sector to be driven primarily by earnings growth (see Chart 3) and to a far lesser extent, dividend yield; the market currently trades near our estimate of fair PE, so we do not expect valuation changes to be a key driver of the market’s return. Following the Technology sector’s strong run-up in recent, we are lowering our rating on the market to 3.0 stars “attractive”, in recognition of the lower level of forecasted upside for the sector. 

Chart 3: Forecasted Returns by end-2016 (annualised)


Which are the most attractive markets under our coverage?

In contrast to the loftier valuations for developed market equities, most Emerging Markets still sport low valuations, having been ignored by global investors for some time (see Fund Flows – Which Markets Have Investors Been Ignoring?). As shown in Table 1, our 5 star rated markets all sport significantly strong upside potential (by end-2016), and all currently trade at valuations which are below where we think they should be, which means that the valuation expansion component should be expected to contribute meaningfully to each market’s return over the next few years. At this juncture, we suggest that investors overweight the cheaper markets of Asia ex-Japan and the Emerging Markets vis-à-vis their more expensive developed market counterparts. Table 2 shows a summary of our star ratings on each market, including the latest changes.

Table 1: Forecasted Annualised Returns for selected markets (end-2016)

Market Earnings Growth Valuation Expansion Dividend Yield  Total Return
Star Rating
China 8.90% 14.50% 4.00% 29.60% 5
Hong Kong 7.40% 11.90% 4.00% 25.00% 5
Asia ex-Japan 10.00% 5.50% 2.90% 19.50% 5
Emerging Markets 9.70% 5.00% 3.20% 18.90% 5
South Korea 12.00% 4.30% 1.40% 18.40% 5
Source: Bloomberg, iFAST estimates as of 26 June 2014

Table 2: Summary of our Star Ratings

Market Star Rating
China 5
Hong Kong 5
Asia ex-Japan 5
Emerging Markets 5
South Korea 5
Russia 4
Brazil 4
Taiwan 4
Singapore 3.5
India 3.5
Technology 3.0 (from 4.0)
Indonesia 2.5
Japan 2.5
Europe 2.5 (from 3.0)
Thailand 2.5
Malaysia 2.5
Australia 2.5
US 2.5 (from 3.0)

What should investors do?

Having adjusted our stance on two major portions of the global stock market to “neutral”, how will this affect one’s investments? In a disciplined portfolio allocation process, we maintain that investors should have exposure to all major regional markets for proper diversification, so there is little for most investors to do except to consider switching some of their developed market exposure into Emerging Markets or Asia ex-Japan. What is more important for investors to consider is that even as investor interest gains traction in these markets, the strong performances delivered by US and European equities mean that return expectations in some of these outperforming markets should be tempered going forward (as guided for earlier in our Key Investment Themes and 2014 Outlook) – investors should certainly not look to the 32.4% return delivered by US equities in 2013 as a guide to future returns!

Takeaway for Indian Investors

Although we have lowered our ratings on the US and Europe markets,we continue to maintain a positive stance on funds focusing on these economies.

Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.

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