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Q U A R T E R LY R E P O R T
20.01.2017
MANAGEMENT REPORT – 4TH QUARTER 2016
Q4 2016
20.01.2017
A crucial development from the standpoint of our investment strategy
is that fiscal policies are becoming more expansive at the same time
that inflation is staging a moderate comeback. This cyclical shift marks
the end of a lengthy period during which central banks had the ability
to turn any macroeconomic bad news into good news for financial
markets.
The global outlook
In our two preceding reports, we predicted a regime change in terms of economic
and financial policy with greater emphasis on fiscal stimulus, after a decade of
unprecedented central-bank interventionism. We anticipated such a shift for political
rather than economic reasons, given that popular pressure in favour of a new policy
approach was palpable, and still is. “In light of Brexit, support for Donald Trump, ‘no’
campaigners’ lead in opinion polls for Italy’s constitutional referendum, and the
increasing popularity of extremist votes in Europe, a return of these expansionist
fiscal policies seems likely,” we wrote.
In the intervening time, Donald Trump has ridden to power on a platform and political
narrative calling for higher fiscal spending to boost domestic growth. The Italians,
meanwhile, have voted down a proposal to modernise their political institutions that
might have helped the country’s economy operate more efficiently, but through the
kind of belt-tightening likely to depress the business cycle.
Election after election reveals mounting dissatisfaction with an economic and
political system that has left the middle class increasingly vulnerable, just when
inflation is picking up in the United States (+2.1%) and even in Germany (+1.6%).
The stage is therefore set for a cyclical upturn. Moreover, in this expansionary phase,
growth will be less hampered by a massive global debt overhang and, as deflationary
pressures subside, central banks will feel less compelled to take action at the
slightest sign of a faltering economy. This cyclical shift marks the end of a lengthy
period during which central banks had the ability to turn any macroeconomic bad
news into good news for financial markets.
A crucial development from the standpoint of our investment strategy is that fiscal
policies are becoming more expansive at the same time that inflation is staging a
moderate comeback. Rising bond yields – something we correctly predicted –
coupled with a sector rotation into cyclical industries and markets – a trend we
should have done more to leverage in our equity portfolios – and a stronger US dollar
– which we failed in part to cash in on just after the November elections – all bear
witness to the sea change taking place. The question at this stage is what
investment opportunities and what financial-market risks that sea change will
generate.
United States
Today as much as ever, the United States is the epicentre of the cyclical upswing.
How should we interpret Trump’s promises – which may or may not be kept – to use
fiscal policy to spur economic growth at a time when a return of inflation looks
probable?
Infinitely more important than his pledge to spend heavily on infrastructure is his
proposal to cut the corporate tax rate, possibly from 35% to 20%. Such a policy
could lead to a cyclical turnaround in profit margins, which have historically been a
key determinant of the business cycle. Since the Lehman Brothers meltdown,
corporate revenues have fallen faster than costs, with the result that profit margins
have tended to shrink. That decline has been a major obstacle to capital expenditure
in recent years – even with rock-bottom lending rates. Companies with heftier
margins will be more inclined to invest, and thus better able to respond to the uptick
in consumer demand that Trump’s victory at the polls has served to strengthen.
Source: Carmignac, CEIC, 30/12/2016
The year-on-year growth rate in durable goods orders climbed from 0% to 1.8% in
November, while the Consumer Expectations Index has hit a thirteen-year high. This
renewed consumer confidence should be strong enough to offset slower growth in
real disposable income, which at +2.3% year-on-year represents a thirty-three month
low. But what these figures show above all is how high hopes in the US currently
are. High hopes, however, have a way of being disappointed.
Source: Carmignac, CEIC, 30/12/2016
If the new US President’s economic programme fails to go through, or goes through
too slowly, a rebound in capital expenditure will become a more iffy bet. And that
would also be true if companies chose to use the prospective tax cuts to engage in
financial engineering. But these possible let-downs are not our baseline scenario. We
anticipate more vigorous growth accompanied by mounting inflationary pressure.
Several points lead us to believe that inflation will rise faster than the consensus
currently assumes. To start with, manufacturers of non-discretionary goods have got
into the habit of raising their selling prices in order to offset the downward pressure
on profit margins. The same goes for the owners of buy-to-let properties. To make
up for low returns on their financial assets, they have hiked rents for the part of the
population that can’t afford home ownership. In addition, a steady appreciation in
energy prices can soon be expected to lift overall inflation. Finally, after eight years
of unprecedented wage moderation, an upward drift is now observable (particularly
for managers), with hourly compensation increasing 2.9% over the past year.
This shows that US inflation is by no means a temporary phenomenon caused by
rising energy prices, but reflects prices across the underlying economy. And upward
wage pressure is starting to feed into it. Even if the expected pick-up in economic
growth doesn’t materialise, we believe the inflationary momentum will be strong
enough to deter the Federal Reserve from transitioning to a more accommodating
monetary policy stance. What we are describing here is merely the standard
workings of the business cycle, whose key drivers have clearly swung into action in
the United States. Their upside potential is visible today, as is the basis for a
subsequent trend reversal.
Given the debt overhang left by a string of crises in preceding years, the Fed is
initially likely to take a hands-off approach to inflation in order to facilitate
deleveraging. This policy should result in real interest rates staying as low as
possible and a steepening yield curve as the economy starts humming in earnest.
Further on, after inflation picks up steam due to a lack of intervention during the
expansionary phase, it will lead to higher long-term yields and cyclical contraction. In
other words, the good old economy is back in town.
Europe
Although the upturn in Europe is nowhere near as strong as in the United States,
two recent developments suggest that GDP growth on the other side of the pond is
still having a knock-on effect here. First, German factory orders have reached a thirtymonth high, and they are being driven by exports. This means that growth abroad
will spread to Europe via Germany.
Second, the latest German inflation readings point to an unusually sharp rebound,
with food, energy and rent prices as the biggest contributors. While prices in the rest
of the eurozone have yet to pick up to the same extent, the experience of previous
cycles leads us to view widespread spillover from Germany as a very likely scenario.
As in the United States, a good many political platforms in Europe call for greater
public spending. That has long been true in France, but the same may now be said of
Italy and Spain as well. This suggests that we may be seeing business cycle
synchronisation between the US and Europe, with the usual delay. At a time of
resurgent inflation, the ECB will be unable to go on expanding its balance sheet
indefinitely through massive bond purchases.
Source: Carmignac, CEIC, 30/12/2016
Emerging markets
Though the emerging world seems to be sharply divided into commodity-exporting
countries and the others, Donald Trump’s victory at the polls and his protectionist
agenda area causing fear in both groups. Mexico is a case in point: the peso has lost
18% of its value since the US elections in November. In contrast, Brazil, a country
grappling with a highly unsettled domestic environment, has seen its currency
bounce back to its pre-election level. The Russian rouble has likewise gained 6%.
The equity markets in both countries have held up rather well, buoyed by stronger
GDP growth. Brazil, for example, has gone from a 6% contraction in output to nearly
flat growth in the space of a year.
China is still the country with the greatest potential to derail the entire emerging
world. Its huge stock of corporate debt has resulted in a systemically fragile
economy that is nothing less than a time bomb. Just how worrying that bomb is can
be gauged from the capital flight it triggers at increasingly regular intervals. Even so,
the economy is recovering and the latest statistics, such as electric power
production, are reassuring enough to keep China’s systemic risk from materialising in
the near term.
Meanwhile, the newly-developed countries seem fairly well-equipped to deal with
further dollar appreciation and rising US bond yields, thanks to a secular
improvement in economic fundamentals – first and foremost their declining
dependence on foreign capital.
Japan
Japan is sticking doggedly to its policy of keeping nominal ten-year government bond
yields close to zero. The result has been to drive the yen way down (by -16% against
the dollar) by encouraging Japanese savers to invest abroad. At the same time,
economic activity has continued to recover. Manufacturing output growth surged
from 0.2% to 2.9% in November, with all industries contributing to the increase.
Japanese policy offers a welcome counterweight to monetary tightening in the US in
that it helps reduce global upward pressure on bond yields.
Source: Carmignac, CEIC, 30/12/2016
Investment strategy
The general view among pundits is that the election of Donald Trump has created
substantial economic and geopolitical uncertainty. Yet financial markets seem to
disagree, judging from their highly positive reaction to the event. Developed-country
equity markets are ahead by 8% on average, while ten-year sovereign bond yields
have gained 65 basis points in the United States and 23 in Germany. The greenback
has appreciated against all other currencies – including by 11% against the yen and
6% against the euro. Visibly wagering that the policy mix shaping up in Washington
will boost output at a time of renewed inflation, investors have accelerated the
sector rotation into the sectors with the greatest sensitivity to changes in GDP
growth and the least vulnerability to inflation.
It’s hard to say right now whether the new US President will end up dashing the
market’s high hopes, or whether his protectionist policies will turn out to be as
drastic as critics fear. Granted, both stocks and bonds already trade at rather lofty
valuations. But with strong global economic growth coming on top of continued
monetary policy accommodation in Europe and Japan, equity markets look set to
scale new heights.
We have accordingly increased our exposure to
e quit y ma r k e t s
to near-maximum level.
Our basic strategy is as follows: The unfolding scenario of less erratic growth,
coupled with a moderate pick-up in inflation, is likely to put commodities – first and
foremost oil, particularly since the recent agreement among OPEC members – at an
advantage over stocks with “good visibility”. Chief among the latter are the stocks of
drug companies, which will remain a favourite target for populist governments. Our
portfolios also include substantial holdings of Japanese financial stocks. They have
shed a great deal of their market value – even as their issuers are getting a boost
from the global upswing and a weaker yen. At the same time, the political and global
economic shifts we discussed above haven’t caused us to lose faith in our tech
names, whose bright prospects become brighter every day.
F ix e d income ma r k e t s
show as much contrast as ever. A number of emerging-market
local currency bonds offer extremely high yields – exceeding 11% in the case of
Brazil. Moreover, the hunt for yield can make this an attractive asset class, although
careful risk analysis is imperative. As credit spreads narrow, corporate issues may
well be buoyed by positive global growth forecasts, but in light of their broadly high
valuations and discontinuous liquidity, we don’t see a great deal of investment
opportunity here at this stage. It should also be mentioned that the outlook for safehaven government bond yields has yet to improve. While it’s too soon to proclaim
that the long-term slide in sovereign yields is over and done with, we do believe that
they still have room to rise further in the near term. We’d like to see ten-year
government paper trade at 3% in the United States and 1% in Germany before we
move away from our current negative modified duration. Although the Fed has been
slow to normalise monetary policy, the change under way may prove to be
surprisingly bold if our analysis of US inflation is correct. At the same time, the uptick
in German inflation (currently +1.6%) can be viewed as a harbinger of things to come
across Europe.
In t he for e ign e x cha nge ma r k e t ,
States
and
Europe,
the growth and inflation differentials between the United
and
the
resulting
monetary
policy
mismatch,
have
understandably created a broad consensus that the dollar will continue to
strengthen. We are wary of this near-unanimous forecast, particularly because it has
led many investors to take massive long positions in the US currency. We will
therefore be keeping our exposure roughly in line with performance indices. As we
argued in our previous report, the outlook for the yen is clearer, given the Bank of
Japan’s policy of deliberately forcing the Japanese currency down. We will seek to
leverage any pronounced reversal of the weakening trend observed in the past few
months by initiating a short position that is positively correlated with risk assets. The
currencies of emerging-market commodity exporters will likely remain a major
allocation in our portfolios, whereas we hold a large short position in the yuan versus
the dollar. We consider this an effective way of hedging all our assets against the
risk that the Chinese time bomb will go off.
Source of data: Carmignac, CEIC, 30/12/2016
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