Download 2017 Investment and risk outlook

Wells Capital Management
2017 Investment and risk outlook
EverKey Global Equity
January 2017
Venkateshwar “Venk” Lal
Director of Investment Risk & Strategy, EverKey Global Equity
Executive summary
We remain excited about the opportunities we are identifying given
extraordinary short-term, medium-term, and long-term cyclical
swings in market assessments of intrinsic value as we approach our
tenth anniversary at EverKey Global shepherding investments across
global public equity markets. Vast divergences in company fortunes,
sector and industry developments, global economies, public policies,
and capital markets provide us a solid foundation to continue delivering differentiated performance by leveraging our core investment
philosophy—a disciplined approach to search for non-consensus
fundamentally under-valued equities with patience and care in the face
of persistent bouts of macroeconomic and political uncertainty.
Last year and this year ahead appear to exemplify the power of cycles
driving market valuations inherent in all asset classes. Investors begin
2017 pointing to a global reflationary window opening—optimism
reinforced by signs of synchronized worldwide recoveries after
almost a decade of healing since the global financial crisis (GFC), the
comforting fading into rear view of early-2016’s disruptive deflationary
scare, and any pernicious prospective inflation still far out of sight. At
the same time, official government policies are pivoting increasingly
towards thrusts from fiscal stimulus and structural reform and away
from reliance on diminishing returns from loose monetary policies.
Expectations for central bank policy rates are now turning positive,
rising from zero, if not negative real rates, and ostensibly onceunfettered mechanics of free-markets are gradually falling under the
influence, or command (but debatable, if actually control), of greater
state capitalism, in developed (DM) and emerging markets (EM) alike.
We look forward to capitalizing on what we expect will be evolving
market volatility to season our portfolios, as stocks which are capable
of normalizing their earnings much higher in coming years are
periodically misjudged by powerful waves of short-term reactive
investor sentiment. No doubt, 2017 will provide its fair share of
market rotations, if not reversals. What began as volatility within the
weakest links in credit markets one decade ago and quickly caught
fire across equity markets during the depths of the GFC unleashed
unprecedented global policy accommodation rescues in the immediately forthcoming years. However, the shifting tectonic plates of
policy divergences from competing economic and political responses
to the crisis since then triggered volatility first across currency and
then commodity markets. Now we believe that cross asset class
volatility has also spread to sovereign interest rate markets, best
evidenced by last quarter’s U.S. Treasury bond sell-off, rising yield
curve, and groundswell of populism polarizing disaffected and
disgruntled electorates worldwide.
Only time will tell if a tipping point has been passed contradicting the
multi-decade asset allocation mantra of bonds out-performing stocks,
or the last 10 years’ investing playbook of U.S. stocks out-running
foreign stocks, or even the post-quantitative easing (QE)-fueled
environment of passive growth and momentum equity investing
out-pacing active value equity investing. Shifting performance since
last summer suggests a long-awaited normalizing reversal may
indeed finally be under way. Nevertheless, we remain disciplined
in exercising our investment and risk management process marrying
fundamental stock and fundamental macro research.
Our positioning favoring individual stocks in Europe and Japan
(as well as in North America and certain EMs) is predicated on what
we believe are the most attractive three to five year total returns with
limited near-term downside—under-valued, under-earning, underappreciated equities benefiting from self-help restructuring, targeted
reform and reflationary public policy backdrop in macro resilient markets.
While we sense improving prospects for a stimulus-enhanced U.S.
recovery, we appreciate that some companies in Europe (Germany,
U.K., Switzerland, Netherlands, as well as Norway, Denmark, Italy,
and France), Japan and select EMs (such as Hong Kong, South Korea,
Russia, Brazil, as opposed to other EM value traps with intractable
imbalances) exhibit greater operational leverage to accelerating U.S.
and global growth given higher fixed costs and sensitivity to revenue
and profitability enhancement. In fact, these international markets,
especially Europe and Japan (1) trade at historically steep valuation
discounts (-20-40% versus the U.S. S&P 500), (2) harness significant
relative earnings power (MSCI World ex-U.S. earnings per share (EPS)
50% below 2007 peak versus MSCI U.S. EPS 20% above 2007 peak)
and (3) benefit from more supportive government policy mixes (active
European Central Bank (ECB) and Bank of Japan (BOJ) easing with
expanding fiscal support and targeted structural reforms versus a
normalizing Federal Reserve); on the other hand, rising domestic
wages, interest rates and exchange rates weigh on U.S. corporate
earnings and stock multiples.
Notable undervalued sector exposures include segments in industrials
(restructuring and portfolio reshaping stories), financials (capital-rich
insurance, brokers and asset managers, as opposed to banks with
capital and regulatory burdens), energy (integrated oils with encouraging commodity supply-demand balances, as opposed to base
and industrial metals) and telecoms (high yield beneficiaries of rising
consumer demand, especially EM), mindful of avoiding popular
“expensive defensive” DM consumer staple equities that we expect
will de-rate as deteriorating fundamentals dampen euphoric aspirations. Given imbalances in anticipated relative sovereign rates, capital
flows, balance of payments and monetary policies, our portfolios are
still currently partially hedged back to the U.S. dollar.
2017 Investment and risk outlook | January 2017
2016: A tale of two halves
2016 exhibited unusual asymmetries, if not contradictions, between
perceived and actual outcomes as markets grappled to understand
potential turning points in what have become long-established
economic and political cycles and underlying presumptions. Last
year was book-ended by sentiment extremes—creating a tale of two
halves, commencing 2016 in a deflationary scare pounding multiple
asset classes during Q1/Q2 and concluding the year with reflationary zeal
picking up speed in Q3/Q4, propelling the MSCI All Country World Index
(ACWI) to register all-time highs in the first days of 2017. Confounding
most market participants, neither advancement in “artificial intelligence”
(however “robo,” big data, or smart sensor-driven) nor proliferation of
“fake news” (however overt, covert, or clandestine) adequately prepared
consensus expectations for 2016’s milestone events.
First half: Deflationary scare
Right out of the gates, 2016 displayed un-nerving confluence of
international cross-asset class volatility last witnessed during the GFC.
Deflationary angst and risk aversion momentum was widespread:
(1) commodity markets started the year with the CRB Index down
25% from 2014 highs (Brent futures marking their bottom in January,
65% off of 2014 highs), (2) China hard landing fears sent the Shanghai
Composite down 30%+ in January (forcing it 50% below its June 2016
A-share peak), (3) credit and solvency fears surrounding European
banks pummeled the Stoxx 600 Bank Index down 35% by the end
of Q2 (with illiquidity and “CoCo” complexity marring bank credit
instrument price discovery), and (4) currency trading was roiled by
concurrent risk-off carry trade unwinds and central bank credibility
assaults (as the yen spiked 20% and the Nikkei sank 20% after the BOJ
faced scrutiny for its controversial adoption of a negative interest
rate policy (NIRP), crimping domestic bank net interest margins and
derailing an Abe-nomics reflation transmission mechanism). Adding
insult to injury, improperly positioned investors were caught off-sides
by the U.K.’s Brexit referendum in late-Q2, sending the EU Stoxx
Index down 15% intra-quarter and the British pound plumbing past
30-year depths. The rush to safety drove 10-year U.S. Treasury yields
to all-time lows during the week of July 4, further fueling investors’
search for yield and lower volatility surrogates. 2016’s EM bond fund
flows were the highest since 2012, allowing EM equities and exchange
rates, especially high yielding ones, to compress risk spreads, starting
to heal from 2015’s strains and delivering the best U.S. dollar performance since 2010.
Second half: Reflationary rebound
Market performance revitalized beginning mid-2016 into year-end: (1)
supportive public policy muscles flexed, stabilizing monetary credibility
(BOJ JGB yield curve control with quantitative and qualitative easing
(QQE) intact diffused earlier NIRP concerns and round-tripped the
yen, and together with ECB QE extensions, offset the Fed’s U.S. rate
normalization stance) and passing the stimulus baton to fiscal authorities (Japan launched its largest fiscal stimulus under Abe-nomics,
China rolled-out infrastructure spend, and the European Union’s (E.U.)
benign neglect let fiscal austerity relax), (2) commodities regained
composure (Brent climbed 60%+ by year-end aided by OPEC’s first
production curtailment since GFC, and CRB reclaimed half of its post2014 drop), and (3) leading economic indicators rebounded globally
(forceful 52-55+ composite Purchasing Managers’ Index (PMI) lift-offs
from the U.S., E.U., Japan, China, and EM, up-ticks in producer/consumer
inflation gauges, and the Global Citi Economic Surprise Index flirted
with 2010’s highs by mid-January).
Ironically, these inflections unfolded during widespread obsession
with Trans-Atlantic electoral volatility (reminiscent of grinding
preoccupations over Y2K at the turn of the century), encouraging
defensive market positioning (high cash and passive allocations, with
ETFs exceeding $3 trillion in AUM) and coiling the spring for a forceful
catalyst-driven pro-cyclical bounce. Enter November 8’s Trump
takeover with hopes (euphoric in some cases) of executive stimulus
turbo-charging post-July’s reflationary confidence, rising inflation
expectations, ascending yield curve, strengthening U.S. dollar and
visible rotation into value stocks from momentum and growth stocks
after almost a decade-long underperformance cycle.
Widening political-economic fault-lines push this game into
overtime
2016’s sharp V-shaped trajectory revealed not only powerful forces
underpinning capital markets’ decade-long struggle to escape
deflationary pull with reflationary velocity, but also complex political-economic fault-lines likely to prompt reappraisals of historical
investment assumptions and influence future performance results.
Last year reinforced a steady trend in expanding nationalism worldwide, in some cases widening social divisions, often at the expense
of traditional multilateral arrangements, and almost always with
concentration of activist leadership.
Figure 1
International stock valuation discounts vs. U.S.:
(Cyclically-Adj P/E, Trailing P/E, Forward P/E, P/Sales, P/Cash, P/BV)
U.S. stock valuation percentile relative
to foreign country valuation range
110%
Sources: BCA, Thomson, MSC, Star Capital. Valuation metrics average of six factors indexed with U.S. set at 100%. U.S. in orange, DMs in green, EMs in blue.
| 2 |
Trailing P/E
Indonesia
India
Spain
Australia
U.S.
U.K.
Netherlands
Sweden
Switzerland
Canada
Mexico
China
Brazil
France
Germany
Japan
S. Africa
Italy
S. Korea
Russia
50%
P/Book Value
60%
P/Cash
70%
P/Sales
80%
Forward P/E
90%
CAPE
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
100%
2017 Investment and risk outlook | January 2017
Figure 2
International vs. U.S. EPS vs. Late-07 peak EPS
120%
70%
Favorable divergences in public policy support: U.S. vs. international regions
Policy/Region
U.S.
Europe
Monetary
QE expiring,
rising rates
hurt EPS
QE extended
Fiscal
Stimulus
hopes
Deficits still
consolidating
Stimulus in
action
Structural
reform
Potential
energy,
financials
deregulation
Self-help
restructuring
Targeted
corporate
governance
reforms
FX
Rising U.S.
dollar, rates,
wages hurt
EPS
Weak euro
and pound
buy time for
political
compromises
Weak yen
reflationary
20%
-30%
12/31/2015
12/31/2014
12/31/2013
12/31/2012
12/31/2011
12/31/2010
12/31/2009
12/31/2008
12/31/2007
12/31/2006
-80%
International EPS vs Peak
Japan
Emerging markets
(Value)
(Value trap)
QE / Yield
Flexible easing
curve control
Improving
deficits, fiscal
efficiency
Industrial
reforms
w/political aircover
Resilient
balance of
payments
No flexibility
Unsustainable
twin deficits
Inefficient,
corrupt
bureaucracies
Flight capital risk,
low FX reserves
U.S. EPS vs Peak
Spread of Int'l-U.S. EPS vs Peak EPS
Sources: MSCI, Bloomberg U.S. (MXUS) and International (MXWOU) trailing last 12-months’ EPS, indexed to 10/31/07 EPS peak.
This sea change has manifested itself in a variety of forms—from
transformative and consolidating power among leaders in Japan
(Abe), China (Xi), Russia (Putin), India (Modi), Turkey (Erdogan),
Philippines (Duterte) and Venezuela (Maduro) over the last three years—
to more inward-looking movements of “power-to-the-people,” just
evidenced in the U.K. (vote to extricate from E.U.) and U.S. (TrumpGOP landslide). Defying gloomy prognostications, at least in the
near-term, these two most recent transitions ushered in sharp
post-event risk equity market appreciation, with the U.K. FTSE index
outperforming G7 peers (in local currency terms) and U.S. Dow Jones
just crossing the 20K threshold; both cases illustrate the power of
non-consensus investing.
cross-currents to determine if cyclical inflections favor one investment
asset class and style or another. We expect this see-saw effect to be
compounded by growing political tensions that may further splinter or
harmonize global interests and cooperation. These strains are already
apparent, challenging traditional assumptions regarding free movement
of capital, labor and trade, with gyrating sovereign interest rate and
foreign exchange markets that are now serving as escape valves
allowing the release of steam when most necessary. Combining
fundamental stock and macro research guides us to favor compelling
micro investments with macro resilience and judiciously sized currency
hedges based upon conditions that support the U.S. dollar over the
longer-term, albeit during a period of heightened foreseeable volatility.
By the end of 2016, the broad international equity benchmark (ACWI
ex-U.S., showing negligible major DM country divergences) delivered
less than half the return of stocks in the U.S. and EM (MSCI EM, displaying acute inter-country divergences), providing little relief from the
post-GFC trend of lagging foreign stock market performance—now
amounting to more than 100% in cumulative return underperformance
versus domestic stocks (see Appendix). We expect the periodic waves of
volatility witnessed in recent quarters to persist, providing opportunities
to find individual stocks with compelling prospects from value re-rating,
earnings growth and yield, as well as resilience from unrelenting whims of
macro and political tensions.
“Make America great again”
Well-aware of ubiquitous popular media, market participants face a
perplexing dilemma in assessing implications of the new American
presidency: how can rhetoric imbued with an anti-establishment and
polarizing ethos that delivered local electoral legitimacy galvanize
sufficient broad-reaching domestic and international collaboration to
affect grand and lasting action? While it is at this stage far too early to
judge the ultimate efficacy of the business of the newly inaugurated
POTUS, we are generally constructive on pro-cyclical fiscal and structural reform priorities articulated to-date, balancing contractionary
forces from tightening domestic monetary conditions and potentially
aggravating international relations sensitive to “go-it-alone protectionism.” We ascribe a strong probability for collective U.S. policymaking
to navigate forward (albeit in a choppy ride not for the faint-hearted)
to achieve common missions, given clear vision for spurring nominal
growth, forceful CEO leadership, and a pragmatic and seasoned
nominated senior management team leveraging America’s solid
foundation for recovery, inherent institutional self-correcting checks
and balances, and unquestionably deep and long-established global
competitive advantages and leadership position.
Outlook
We begin 2017 with a constructive investment and risk outlook for our
positioning across Europe, Asia, and the Americas focused on individual
stocks that we believe offer compelling appreciation potential due
to their under-valuation with combinations of self-help and cyclical
catalysts, franchise earnings growth, and sustainable dividends. We
believe that public equity market valuation margins of safety, corporate
operating leverage and earnings normalization potential, and mix
of public policy favor certain stocks in Continental Europe and U.K.,
Japan, and select EMs—non-U.S. stocks with favorable gearing to the
improving trajectory of U.S. and global growth profiles.
We also recognize that the deflation-reflation pendulum mood swings
on display last year are far from over as markets interpret complex
Trump’s pro-business agenda to support jobs and manufacturing
Preliminary indications suggest the incoming administration has solid
prospects to reinforce a pro-business reflationary agenda with a host of
measures promoting American jobs and manufacturing, including: (1)
decisive streamlining of regulations with efforts to slash the Gordian
| 3 |
2017 Investment and risk outlook | January 2017
Figure 3
Rotation or reversal: Rising PMIs, inflation expectations, interest rates and global equity value versus growth
performance spread
Marrying micro and macro: Framework for balancing risk and opportunity
2.6
6.0
5.0
4.0
3.0
2.0
1.0
(1.0)
(2.0)
2.4
2.2
Cons:
“Wall of worry”
Pros:
Climbing the “wall of worry”
Profitability peaking
Self-help restructuring/catalysts
2.0
1.8
Few value margins of safety
vs.
Value versus value traps
1.6
1.4
Hard deleveragings (sovereign risk)
Soft debt extensions/jubilees
Political polarization (Brexit, EMU)
Reflationary policies (CB, fiscal)
Globalization stalling (protectionism)
Risk repatriation (banks, capital)
Geopolitics/nationalism volatility
Policy colllaboration/coordination
1.2
12/1/2016
11/1/2016
9/1/2016
10/1/2016
8/1/2016
7/1/2016
6/1/2016
5/1/2016
4/1/2016
3/1/2016
2/1/2016
1/1/2016
12/1/2015
11/1/2015
10/1/2015
1.0
MSCI World Value-Growth Equity Index Cumulative Return
Spread (Left axis)
JPM Global Composite PMI (Points Above 50 Baseline, Left axis)
Fed 5Yr-5Yr Fwd Inflation B/e (Right axis)
10-Yr U.S. Treasury Rates (Right axis)
Source: Bloomberg.
knot of Washington D.C. bureaucracy (reducing burdens on small- and
medium-sized businesses, softening enforcement by the Consumer
Financial Protection Bureau and SEC, eventually simplifying financial
services regulation), (2) comprehensive tax relief (reducing individual
and corporate taxes—the latter realistically moving midway between
35% current and 15% proposed, eliminating interest deduction and
state and local income tax deductions from federal taxes, potentially
ushering in some form of Border Adjustment Tax (BAT) and one-time
10% offshore corporate earnings repatriation tax holiday to help pay
for added spending), (3) structural reforms and fiscal infrastructure
stimulus ($1 trillion over 10 years, adding incentives for national
resource production to lower energy costs and for targeted corporate
innovation, promoting public-private partnerships with direct labor
participation improvement), and (4) re-striking of international trade
deals (improving U.S. corporate access abroad and defending homeland employment, correcting perceived unfair practices—already
pulling out from the Trans Pacific Partnership (TPP) with imminent
talks to update the North American Free Trade Agreement (NAFTA)
and Trans-Atlantic Trade and Investment Partnership (TTIP), tightening
immigration to deter lower wage offshoring H-1B Visas), intending to
keep counter-productive protectionist retaliation at bay. The Trump
economic team has cited aerospace, chemicals, electronics, energy,
motor vehicles, pharmaceuticals, railways, and robotics, among other
sectors, for targeted 2017 investment.
Stock markets anticipate economic trends—what about rising
wages, rates and currency?
Importantly, our constructive U.S. economic outlook does not automatically translate to an analogous stance on the general U.S. stock
market if market expectations for new policy stimulus have already
run ahead of underlying fundamentals. While we believe many of the
pro-cyclical elements cited above will bear fruit over several quarters,
their practical design and implementation will take time to sequence
and steer properly. The swift post-election U.S. equity market rally
into early-2017, led by a powerful 20% surge from the smaller capitalization Russell 2000 Index, suggests cautious optimism ahead mindful of
overheating expectations compared to realistic timetables to translate
campaign proposals into tangible earnings and economic uplift.
Challenges include relatively low market valuation support (with the
cyclically-adjusted U.S. price-to-earnings ratio today at the highest
levels since the early-2000s) and peak corporate margins (aided by
debt-financed share buybacks scaling new heights ($3 trillion) leaving
negligible cash spend for capital expenditure and R&D, doubling
corporate debt since 2007 and elevating median S&P Debt/Book
Values to 2000 peaks).
We expect U.S. margins to be pressured by rising wages (across all
segments, especially given recent Fed-cited limited U.S. employment
slack), rising interest rates (weighing on small and medium-sized borrowers more reliant on floating-rate debt), and rising U.S. dollar (impacting
large multinationals, more than one-third of S&P 500 earnings come from
overseas even with exports at only 13% of U.S. GDP), with uneven help
from potential corporate tax rate reductions (as effective marginal tax
rates for large firms are now at multi-decade lows).
Striving for the Goldilocks balance
Put simply, the U.S. executive and legislative branch, in conjunction with
Treasury and trade officials, have to achieve a Goldilocks balance:
sufficient nominal growth fast enough to offset the dampening effects
of a tightening monetary policy trajectory, yet not so heavy-handed
as to trigger a riot from an alert Federal Reserve (poised to raise rates
at least thrice in the coming year to satisfy dot-plot projections),
a touchy bond market (licking its wounds from last year), or wary
international partners (fearful that an America First doctrine unfairly
diminishes them). Trump’s first 100 days will indeed be eventful, with
early bilateral negotiations commencing with the U.K., Japan, and
Mexico, a looming mid-March Congressional debt ceiling deadline
debate centered on not aggravating America’s twin deficits with fiscal
stimulus leverage, and a host of executive actions in the works.
It is notable that the current U.S. expansion is already into its 90th
month, drawing parallels with comparable duration past expansions:
in the 1980’s (the Reagan Revolution from November 1982 until Gulf
War I, 92 months), in the 1960’s (Johnson’s Great Society, 106 months),
and even in the 1990’s (roaring economic boom until the TMT bubble,
120 months). While inspiring to invoke these great periods of economic
| 4 |
2017 Investment and risk outlook | January 2017
recovery and useful to appreciate investment-led productivity surges
take many years to realize, investors must recognize the starting
point of today’s dramatically different investing context: historically
high corporate leverage and equity market multiples, generational
lows in policy rates, and a paradigm-shifting conclusion to a long QE
cycle that had artificially suppressed term risk premium, stock-bond
correlations, and cross-asset class volatility.
prime money market funds (a leading source of overnight U.S. dollar
liquidity), and by Basel III-constrained bank lending that has tightened
globally available U.S. dollar liquidity.
Trumpeted tweets: Discern the forest from the trees
We expect ongoing U.S. political turbulence, made all the more
unstable by the increasingly publicized nature of policy debate at
home and the inevitably unpredictable tests to confront the new
administration from abroad. Consensus observations point to a
paradoxical presidential governance and communication style
that simultaneously leaves no room for nuance yet obfuscates. The
recent dizzying use of the digital bully pulpit to blitzkrieg messages
leaves many to their own devices to decipher and distinguish official
priorities along the broadest of spectrums—from innocuous and
well-intentioned rallying slogans designed to motivate or allay a base
electorate, to assertive negotiating tactics and posturing aimed to
exact concession, to fundamentally contentious disruptions to upend
long-held assumptions of order, shaking what has been the country’s
core inter-generational foreign economic policy orthodoxy and risking
unintended self-inflicted consequences.
Carefully and coherently characterizing these political impulses will
remain a critical ingredient for investors to judge when politicallyinduced whirlwinds, and importantly their impacts on securities prices
across capital markets, are structural with sustained investment
repercussions versus when they are just noisy distraction creating
ephemeral trading opportunity.
The case for the U.S: dollar: Long-term strength but short-term
volatility
This challenge of discerning the forest from the trees is no more
evident than in the more abstract realm of exchange rates, home to
macroeconomics’ most severe zero-sum trade-offs made ever-more
precarious by elevated volatility in sovereign interest rates, capital
flows, trade policy, and verbal intervention. We continue to believe
that we are in the early innings of a long cycle of persistent exchange
rate volatility—an important consideration from both a stock-picking
and portfolio management perspective.1 While we believe that the
new American administration will find it difficult to resist the short-term
temptations to promote a weak U.S. currency for its export-enhancing
benefits, especially after the eye-catching technically-overbought 15%
rise in the DXY U.S. dollar index from the Q2 2016 lows into year-end
(one-third of which occurred after the U.S. election), macro fundamentals point to longer-term U.S. dollar strength. Researching currency
cross-currents helps inform our evaluation of domestic-consumption
versus export-oriented international stocks, as well as portfolio
currency hedges.
Changes in official exchange rate policies, real interest rate differentials,
capital flows, balance of payments, and major public policy shifts
account for the lion’s share of fluctuations in exchange rates. With
an ongoing U.S. recovery and tightening Federal Reserve relative to
an accommodating ECB, Bank of England (BOE), and BOJ, real yield
differentials favor the dollar as short-term portfolio flows flock to
higher dollar-denominated rates. From a capital flows perspective,
medium-term demand for the dollar is underpinned by $10 trillion in
short U.S. dollar positions from institutional corporate and sovereign
borrowers (per the Bank of International Settlements, with EMs
holding a third), by recent higher Libor spreads from regulation of U.S.
Positive U.S. dollar capital flows and balance of payments are reinforced
by the potential for a U.S. corporate offshore earnings repatriation tax
holiday and very preliminary discussions regarding what still remains
a complex BAT debate. The former tax amnesty could generate close
to $2.5-3 trillion in overseas capital earmarked for re-investment
destined to return back home to the U.S., effectively adding to
demand for U.S. currency: an estimated 60% share not held in cash
or securities offshore is currently reinvested in European businesses
(typically first converted into euros, for example, for use in Belgian,
Dutch, and Irish affiliated corporate jurisdictions, but would result in
absent euro demand under a repatriation scenario), and the 40% balance held in U.S. dollar cash and securities sits in E.U. banks (for their
overnight U.S. dollar funding use and would be missed and need to
be replaced with U.S. dollar repurchases in the event of a repatriation
holiday). We suspect that 2015’s U.S. dollar strength following enactment of the 2014 Homeland Investment Act’s tax holiday provides
useful lessons regarding encouraging U.S. dollar repatriation.
From a balance of payments perspective, proposals surrounding a
current account-enhancing BAT (or “destination-based cash flow tax”)
induce trade volatility. This type of measure would tax U.S. imports
and subsidize U.S. exports to encourage domestic industry. Hot
corporate lobbying pitting industrial and technology interests against
retail, is likely to impact the design and applicability of final rules,
possibly exempting crude oil/refined products and apparel yet applying
to base/industrial metals and agriculture. In theory, the dollar should
appreciate sufficiently to offset the tax paid by importers and tax
advantage gained by exporters, keeping a steady trade balance and
after-tax distribution of corporate profits. Over time, this would likely
support the U.S. current account and inflationary impulses (depressing
imports and encouraging exports), affording America a stronger
currency; conversely, legislative delays could have inverse impact.
In essence, an “America First” policy associated with a balance of
payments surplus is tantamount to a U.S. dollar first policy, for only
a country with durable current account strength and associated
economic benefits can tolerate currency strength in the longer-run.
Early signs from the White House point to temperamental foreign
exchange volatility. It remains unclear if the new administration has
yet established a consistent currency policy that speaks with one voice.
Official statements remain cacophonous, evidenced by conflicting
remarks made days ago by National Trade Council Head Navarro (calling
the euro “grossly under-valued”) and the designated Ambassador to the
E.U. Malloch (calling to “short the euro”). While we do not underestimate the propensity of politicians to talk down a home currency for
domestic pyrrhic victories, we recognize that a strengthening dollar
can enhance America’s ultimate negotiation leverage, especially with
China, who has actually been intervening to avoid a reputationdamaging devaluation and prop up its yuan (managed to track a
U.S. dollar-heavy currency basket). We would not be surprised to
see U.S. officials embracing the value of the dollar’s reserve status
and associated “exorbitant privilege” as realities of foreign exchange
dynamics become evident and as the world inflects away from deflationary danger. Maximum U.S. trade negotiation advantage may yet
be gained from a position of dollar strength, as threat of substantial
subsequent dollar depreciation could materially impair a trading
counterpart’s balance of payments if it chose not to make concessions
to the U.S.—perhaps a consideration for the Trump team trying to
stabilize the dollar’s rise.
| 5 |
2017 Investment and risk outlook | January 2017
E.U. Economic and Monetary Union (EMU) or Dis-union?
Compared to high expectations for U.S. equities, investors view
markets in America’s largest trading partner, the E.U., with continued
skepticism and pessimism. The E.U. remains engaged in its own
delicate balancing act of deleveraging and entering a reflationary
sweet-spot while still struggling with dependency on the ECB’s
monetary largesse to buy time to consolidate greater fiscal union for
a more durable currency union that can withstand forces of political fragmentation. Critics of EMU point to failed “establishment”
plebiscites as harbingers of an inevitable retrenchment back to a
“multi-speed” currency union, even harking back to French President De Gualle’s famous 1969 failed constitutional referendum and
resignation that accelerated declines in the franc and breakdown
of the Bretton Woods fixed exchange rate system. These challenges
have propelled equities to significant global valuation discounts
leaving ample opportunity for some firms to outperform depressed
macro expectations by (1) taking advantage of self-help restructuring and
portfolio reshaping, (2) leveraging micro operating leverage to better U.S.
and global growth and (3) monetizing benefits from declines in home
exchange rates driven by a more accommodative ECB and BOE relative to
the Fed. In order to tuck in unwanted risk, our portfolios retain partial
hedges on the euro (initiated in 2014) and pound (implemented prior
to June 2016’s Brexit vote).
Brexit casts a long shadow
E.U. developments have been overshadowed by the upcoming U.K.
invocation of the Lisbon Treaty’s Article 50, starting the two-year clock
for negotiating terms for an exit from the single market and customs
union. Our base case assessment suggests that the U.K. referendum
reflects popular disaffection along economic and political lines: the
need to find economic relief from a weaker currency that can arrest a
spiraling current account deficit (which had grown to be the biggest
in the developed world) and frustrations about an ossified 28-country
administrative edifice perceived to be incapable of swift problem
solving without resorting to lowest common denominators (i.e.
migration crisis border security). Given that the U.K. has been at
its core a trading nation well aware and protective of commercial
interests, we interpret the current state-of-play as neither an outright
rejection of globalization nor an act of desperation triggering another
“1976 sterling crisis.” Rather, based on vested U.K.-E.U. interests as
each other’s largest trading partner, and prospects for enhanced
U.S.-U.K. relations with benefits for being front in queue at precedentsetting trade deals, we would not be surprised to see efforts move
towards better-than-expected Free Trade Agreements (FTA). In the
meantime, we remain wary of more domestic-facing firms exposed
to economic disruption, instead owning non-consensus and cheap
exporters with earnings resilience.
Beware the moral hazards of ECB largesse and rear view reflation
Cries of “referendum-contagion” and hard-to-shake-off bank solvency
concerns have pushed down stock valuations despite 2016’s E.U. real
GDP growth estimated to have exceeded U.S. growth for the first time
since the GFC. Inflation metrics have set five-year highs thanks to
steady manufacturing pick-up, services rebound, reversal of energy
deflation, and shelved Maastricht Treaty fiscal austerity. This reversal
of fortune speaks volumes for work orchestrated by primarily ECB
officials: ring-fencing, recapitalizing and repatriating peripheral bank
risk (still more to do), establishing a common bank supervisory and
resolution mechanism (the latter untested, awaiting deposit insurance
and risk-sharing compromise) and greasing liquidity wheels (extended
QE, targeted long-term refinancing operations (T-LTRO), and negative
deposit rates yet to spur private lending) with euro depreciation and
competitiveness improvement effects.
Two challenges dictate EMU’s future: (1) can recovery self-sustain long
enough to ensure orderly deleveraging but not fast enough to prompt
ECB tapering and/or sovereign yield escalation, and (2) can policymakers
march forward forging greater political and fiscal union without monetary
stimulus “moral hazard” lulling officials into a false sense of complacency
before the next financial, social, or political flashpoints can derail the E.U.
integration project.
Continental Europe’s mounting electoral event risks
Multiple 2017 elections will reflexively test commitments for a tighter
European union. Populist anti-E.U. parties have prominent voices in
each race: (1) mid-March in the Dutch parliament (Wilders’ Freedom
Party polling a distant 3rd), (2) April-May for the French presidency
and parliament (Le Pen’s National Front picking up speed versus
Macron and an embattled Fillon but with momentum potentially
buffered by a two-stage national electoral process), (3) perhaps June
for an early Italian interim government replacement (still needing
a stable coalition to flex real muscle, Grillo’s 5-Star Movement now
rivals Renzi’s Democratic Party after December’s failed constitutional
plebiscite and resignation) and (4) late-September for the German
federal coalition test following Merkel’s hosting the G20 in July (her
Christian Democratic-led bloc still the favorite deflecting a euro-skeptic
Alternative for Germany (AfD) likely to be the first right-wing party to
enter the Bundestag since 1945). Political observers remain acutely
aware of populist dominoes falling with center-left parties in disarray
and pollsters burnt by 2016’s failures to predict Brexit and Trump’s
ascendancy.
Surveying the event risk landscape suggests great variability in
outcomes, ranging from (1) any one or more populist parties either
winning, or eventually gaining, sufficient leverage to force E.U.
existential referenda at home (i.e. Le Pen has already called for a
return to a “two-speed” EMU, with a core set of states that have relinquished sufficient political sovereignty sharing a currency and other
members revolving around the core until prepared to join in), (2) a
muddle-through where satisfactory status quo compromises bide
time in hopes that incremental steps of political coordination can
address the crises du jour, and (3) upside surprises, perhaps through
sequencing of self-reinforcing positives, starting with a Macro or
Fillon win ushering in long-needed French structural reforms,
followed by Merkel loosening fiscal grip and reevaluating immigration
stance, mindful of how reinvigorating Franco-German mutual interests
and alliances, in keeping with the E.U.’s history of centripetal evolution
spurred on by its “core” members, can inspire deeper integration
by others. Regardless of the scenario interplay, some companies
continue to engage in profitability-enhancing initiatives, often with
new management teams and required reform air-cover from home
policymakers, ready to significantly outperform as improving micro
fundamentals outperform macro despondency.
Japanese reflation back on track
Turning to Japan, where similar skepticism and pessimism pervades
the consensus investment view, Prime Minister Abe continues to
drive ahead with his agenda to break the back of deflation that has
inhibited animal spirits for decades. To his advantage, he is inhibited
by neither complexity of having to corral competing national interests
as in the E.U., nor concerns of coordinating divided branches of
government with questionable popular legitimacy as in the U.S. Abe
must instead promote a radical cultural transformation to ultimately
deliver intended reflationary achievement with peak popular ratings
entering his fifth year in office (his term likely to extend to 2021, making him the longest-serving post-WWII Japanese prime minister) and
with clear alignment across the multiple arms of governance. Leading
| 6 |
2017 Investment and risk outlook | January 2017
Japanese economic and inflation indicators inflecting upwards in
late-2016 suggest the deflationary scare from 2014-2015’s commodity
collapse had masked some of his administration’s early wins—fears
that may still spook, or at least stagger, shy foreign equity investors
from returning to Japan with the same magnitude as during their
2013-2015’s risk-taking.
Sporting among the cheapest DM stock valuations globally (P/BV and
P/Cash at 30% and 50% discounts to U.S., respectively) in a country
carefully complementing years of aggressive monetary stimulus
(QQE began in 2013) with newly-enhanced fiscal stimulus and targeted
reforms, Japan provides appetizing hunting ground for non-consensus
value equities with substantial upside potential. Our notable Japanese
exposures date back to 2013 and have evolved from initially including a number of export beneficiaries as the “rising tide” of BOJ-led
Abe-nomics pressured the yen 40% and “lifted all boats” from 2013 to
mid-2015, to reflation-oriented stock beneficiaries, and now to more
under-owned idiosyncratic corporate governance and shareholder-sensitive equities restructuring, reforming, and realizing high global operating
leverage with innovation (“new” versus “old” Japan). While we have
hedged a portion of our bottom-up yen risks for years (starting
in early 2013), these positions were closed last year as NIRP raised
concerns over monetary policy efficacy. We would not be surprised to
see hedges re-implemented in the future based on evolving currency
fundamentals and portfolio exposures.
Handing over stimulus baton from ongoing monetary to fiscal
and structural reform engines
We believe that several considerations bode well for a reflationary
backdrop as many companies reporting earnings this year have
topped 2007 highs: (1) transition to forceful fiscal stimulus (largest
package since the GFC: $275 billion in infrastructure spending and
targeted low interest loans and projects to improve transportation,
communication, energy, technology, and defense pre-2020 Tokyo
Olympics), (2) adaptive and aggressive BOJ stimulus (QQE and capping
of JGB yields out 10 years pressures the yen; whereas U.S. corporates
have become the largest buyers of U.S. shares, in Japan, the BOJ holds
that throne), (3) quasi-public sector stimulus (pensions/insurers continued
equity allocations and January’s Government Pension Investment
Fund (GPIF) announcement of plans to buy U.S. corporate debt to
finance U.S. infrastructure, joint R&D projects/trade and employment—
perhaps a quid pro quo template for further bilateral collaboration as
Japan supplants China as the largest holder of U.S. Treasuries), and (4)
ongoing industrial reforms (Stewardship and Corporate Governance
Code enforcement, now with 80% of firms having two or more independent directors, 30% annual rise in corporate share repurchases,
rising dividend payout ratios, and inklings of corporate cross-holdings
starting to unwind).
Japan’s eventual path to deleveraging and sustainable recovery rests
on balancing the falling role of monetary with rising use of fiscal,
structural and industrial reforms in an environment of added trade and
bond market tension. While the early U.S. scrapping of the TPP raises
protectionist flags, Japan does benefit from some trade volatility
insulation: exports represent less than 15% of Japan’s GDP, and the
country sells 45% of its offshore production in the U.S. In addition, as
sovereign bond markets appear to become less liquid with dwindling
inventories for central banks to buy, it remains worthwhile keeping a
keen eye on signals of undesirable swings in JGB yields, amounting
to market tests of central bank credibility and ultimately pressures on
the BOJ to follow the Fed in tapering.
China balancing national strengths with external uncertainties
into the 19th National People’s Congress (NPC)
Global equity investors need not look any further than China to
appreciate feverish extremes in risk appetite, assessments of fundamental worth, and ability to influence cross-asset class volatility.
Starting the year with one of the worst annual performances of any
major international equity market, Chinese shares have lagged other EMs
in performance (under-owned by dedicated EM funds) and valuation
(mainland and Hong Kong P/BVs among the lowest in the world)
given complex super-cycle deleveraging and macro imbalances.
Smoothly transitioning to a consumption-led efficient economy this
year will have to leverage key national advantages—reflationary
momentum (no longer a deflation exporter), centralized policymaking power (to be magnified by President Xi at October’s 19th NPC
generational leadership reshuffle), and rich savings ($3 trillion in
reserves, albeit down a trillion since 2014)—to overcome heightened
uncertainties—currency volatility (as a “managed peg,” the yuan is not
yet permitted to float freely) and protectionism (rhetoric and reality).
Our stock picks include under-valued domestic-oriented firms (primarily
H-shares) benefiting from consumer growth and specific corporate/regulatory reform, rather than debt-burdened banks or industrials vulnerable
to external trade friction.
Juggling fiscal expansion and targeted reforms with tightening
(but still flexible) monetary policy
We expect China’s policymakers to remain generally accommodative
this year to safeguard an ongoing recovery aided by debt-fueled
stimulus recharged in the wake of mid-2015’s A-share market collapse,
targeting a smooth period for NPC transition, and standing ready to
offset negative shocks from abroad. Signs of China’s reflationary pivot
abound: last month’s PPI figures hit five-year highs, and the Li Keqiang
index of freight, electricity consumption, and bank lending metrics
grew at its fastest pace since 2009, providing relief for private and
state-owned enterprise (SOE) profits, bank NPLs and a housing sector
adjusting to October’s Politburo clamp-down.
While China skeptics argue policy activism induces binge stimuluscontraction cycles (inflating-deflating cycles in Macau gaming, real
estate, A-shares, and commodity futures in years past), we expect
policy flexibility offers latitude in maneuvering around near-term
obstacles to satisfy 6.5%+ growth expectations. Fiscal expansion has
become a powerful growth engine: (1) tailwinds from $1 trillion in
infrastructure public-private partnerships (PPP) recently deployed
(mid-2015-2016, fueled a 15% annual investment spend increase), (2)
over $350 billion to develop the energy sector (renewable power to
amount to half of new electricity generation by 2021), and (3) $1.75
trillion in infrastructure PPPs likely to be announced in Q1, focused
on urbanization and transportation, linking Beijing-Tianjin-Hebei).
Structural reforms have varied: financial services and technology
reforms have moved apace (Shenzhen-Hong Kong Stock Connect,
productivity-enhancing robotics-cloud initiatives), but others have
lagged (capital misallocation-prone SOEs with few changes to local
government financing vehicle debt extensions and social safety nets).
Monetary policy remains flexible, but with a tightening bias for foreign
exchange controls, money market, and lending rates (1) to curb
domestic capital flight (and its pressures on the yuan) and (2) to reign
in speculative excesses perhaps spurred by 2015’s increase in system
leverage (futures on steel/iron doubled and copper spiked 40% since
early-2016, China’s 70 major city housing price index has alarmingly
spiked to early-2010 and late-2013 cyclical peaks).
| 7 |
2017 Investment and risk outlook | January 2017
Keeping China’s currency and trade policy in perspective
China’s yuan and trade policy require scrutiny to better understand
2017’s investment and risk outlook. Government priority for maintaining stability points to gradual yuan depreciation as the path of least
resistance, with associated delays in capital account liberalization. While
China’s trade sensitivity has declined since it joined the World Trade
Organization (WTO) in 2001, halving its GDP export share to 22%, top
officials consider yuan stability paramount. The PBOC remains intent
on squeezing domestic capital exodus and watching key currency
crosses, recalling that its A-share bubble popped in the summer of
2015, when the yuan surprisingly devalued days after the yen hit its
multi-decade trough aggravating Sino-Japanese trade competition.
China exhibits relative dependency on the U.S., as exports to the U.S.
are close to 4% of Chinese GDP, but U.S. exports to China are less than
1% of U.S. GDP. However, China and the U.S. share strong bilateral
inter-dependency, as it is in neither country’s interests to see the
value of U.S. Treasuries sink in a “Clash of the Titans” trade war pitting
Chinese heavy industry interests against America’s transportation
equipment and agriculture exporters.
and macro fundamentals. Our current positioning is steered towards
under-valued firms benefiting from domestic consumption and investment with combinations of exceptional franchises, sustainable earnings
leverage and attractive yields supported by responsible and determined
reform mandates and public policy backdrops; we seek to avoid perceived
value traps where stock-picking can be overwhelmed by dodgy corporate
governance in markets with untenable twin deficits, stagflation, intractable
structural problems, and over-dependence on foreign capital and trade.
China’s international standing looks likely to elevate with the recent
U.S. withdrawal from the TPP (that excluded China), making the
proposed Regional Comprehensive Economic Partnership FTA the
most interesting multilateral trade alternative in town (its 16 members
account for 30% of world GDP). In May, President Xi will host a summit
for its One Belt One Road (OBOR) “Silk Road,” linking China, Eurasia,
South Asia, Oceania, and North Africa investment collaboration and
chair deliberations for the new Asian Infrastructure Investment Bank
(57 countries and growing). Favorable prospects for advancing international arrangements (whether imperial in intent or practical bridges
for sustainable development) provide China cushion against rising
protectionist impulses.
On the margin, energy foundations more stable than metals
We marginally favor energy equities with oil more stabilized than
unsettled metals markets given cross-currents from (1) China’s
restricting trading excesses, (2) reflationary tilts from the world’s
largest economies, (3) supportive U.S. dollar fundamentals despite
countervailing short-term pressures (and traditionally negative U.S
dollar-CRB correlations), and (4) supply-demand dynamics.2 Oil supply
discipline (capital expenditure cuts of 60% by U.S. shale and 40% from
international oil companies in 2014-2016), in conjunction with U.S. and
DM demand strength (amounting to 50% of global oil consumption),
appears to allow incremental demand to eat into overstocked crude
inventories, placing a medium-term floor on price. We expect it would
still take several quarters before any Trump renaissance from the Texan
Permian Basin to North Dakota’s Bakken Formation, combined with
likely cartel cheating, could tilt “swing producer” status back to the
U.S. and materially depress prices. On the other hand, iron and copper
output continues to grow with large Chinese inventories unlikely to
be shaken even by rising DM fiscal infrastructure stimulus demand.
The U.S. contributes to only 8% and 4% of global copper and iron
demand, respectively; Japanese demand has largely been sourced
through long-term contracts; and EM demand prospects remain highly
uneven due to China carefully tracking metals market speculation
and high variability in EM fiscal programs given their limited ability to
ignite spending until debt burdens shrink.
Prefer domestic-focused EM firms to externally-facing manufacturing exporters
We believe that EM equities will continue to deliver among the most
differentiated performances globally given vast divergences in micro
Generally, EM equities may very well be in a bottoming-out stage of
what has lasted as more than a six-year cycle of underperformance
versus DM stocks. EM equities are under-owned and globally cheap,
some having benefited from positive political and economic reforms
in a “virtuous cycle” climate of (1) compressing credit debt spreads
(J.P. Morgan EMBI Global Spread just reaching 2008’s lows thanks to
yield-seeking foreigners’ EM bond fund purchases), (2) stabilizing
local currencies (at least from 2014-2015’s U.S. dollar acceleration),
improved current account balances (especially in Asia), and (3) constructive commodity signals (recovering from 2014-2015’s fallout).
However, the mixed country records of growth and productivity, fiscal
and political responsibility, and sensitivity to rising U.S. dollar and
protectionist waves warrant caution from EMs that may be the source
of future deflationary shocks.
Discriminating between EM values versus value traps
In today’s volatile world, discriminating EM equities and countries
along the spectrum of values and value traps remains a particularly
fluid challenge. We expect that many EMs are well on their way to
buying time to sustainably extend recoveries with thoughtful reforms,
but others will be forced to adjust through currency depreciation. Put
simply, some EM local currencies are likely to sweat profusely to allow
adjustment, while others may just perspire lightly as the gravitational pull of falling real yields versus the U.S. dollar exerts itself. We find a
favorable backdrop for selected equities in Hong Kong-China (scheduled
to replace an unpopular chief executive this March), South Korea
(sustainable balance of payments surplus accompanied with a December
presidential election potentially ushering in fresh governance and
reform), Russia (improving oil-based fundamentals and potential
boost from U.S. sanctions lifting) and Brazil (ongoing long-awaited
political transition and steps to address corruption, selected reforms,
declining inflationary pressures), among others. Less cheap equity
markets may also offer opportunity tomorrow, including India (last
November’s “shock and awe” demonetization set growth backwards
in the short-term for improved long-term prospects given other
fiscal and structural reforms leveraging digital banking and strong
demographics) and Mexico (past structural reforms have paid-off but
immediate outlook remains in cross-hairs of protectionist backlash).
Most vulnerable markets remain Malaysia (high foreign capital
dependency, twin deficits and low political legitimacy), South Africa
(high twin deficits and stagflation, rising political volatility, exposed
to further material currency depreciation), and especially Turkey
(perhaps mired in the most difficult-to-escape vicious cycle that
can precipitate either currency crisis or debilitating capital controls).
Turkey suffers from a compromised central bank caught in the middle
of stagflation and topping credit cycle, 20%+ foreign funding requirements as a percent of GDP with dwindling U.S. dollar reserves to satisfy
untenable short-term external liabilities, and shattering confidence
from international observers in the face of autocratic and intransigent
leadership tightening grip after mid-2016’s failed coup, effectively
shunning traditional IMF-E.U.-Russian-Gulf or other “white knight”
rescues in case of a future funding emergency.
| 8 |
2017 Investment and risk outlook | January 2017
Any sharp rise in the U.S. dollar hurting the largest EM U.S. dollar borrowers (such as Turkey, Indonesia, Chile) or U.S. bilateral trade bluster
(East Asia most directly vulnerable, in particular Taiwan, where investors
have flocked seeking safe haven) could precipitate further EM equity
volatility cycles in quarters to come; conversely, any pauses in reflationary, U.S. rate and dollar recovery could further encourage EM carry
trades extending the runway for continued self-reinforcing positive
EM adjustments. We intend to deploy our disciplined non-consensus
investment philosophy marrying stock and macro fundamental research
to find what we expect will be more idiosyncratic EM investment ideas as
sentiment and fundamentals swing from one cyclical extreme to another.
Concluding remarks: Cycles, risks and opportunities
We believe that ongoing swings in long-term investment cycles favor
disciplined fundamental global equity investors who are ready and
capable of sifting through periodic sharp short-term volatility to season
portfolios with long-term under-appreciated values.
The last six months’ worth of reflationary signals around the world,
coupled with a healthy pace of rising sovereign rates, begs the question
of whether the best days of the 35-year U.S. bond bull run are over
and if equity value investing is finally distinguishing itself against the
momentum growth-oriented investment styles in vogue since herculean central bank stimulus was unleashed almost a decade ago. While
we are currently in the camp favoring an improving environment for
fundamental stock selection mindful of macro considerations, we
recognize that growing political extremism today aggravates the
ability of long-established cycles to turn easily.
Determined corporate managements leveraging self-help restructuring
and targeted reforms to boost earnings and valuations in markets with
resilient, adaptive, and flexible public policy frameworks remain bestplaced to deliver outstanding investment results.
We recognize that corporate and government policymakers must remain
vigilant, not taking for granted recent signs of improved global economic
performance. Deflationary risks lie around a number of corners in DMs
and EMs alike. For example, fiscal stimulus hopes can be disappointed
by unexpected legislative and implementation delays without requisite
popular support to catalyze reform, or bond markets may re-test
monetary policy credibility by negatively reappraising sovereign risk
faster than officials can react. Unchecked extreme populism can
damage international relations to a point where its participants believe
that the rules of the game have been suspended, precipitating rapid
disintegration of global institutional architecture and igniting systemic
risk. On this note, lacerating rhetoric of mercantilist ultimatums can
easily make world players sleep-walk into a financial and economic
trade war, and reactive nationalism can splinter alliances into unstable
geopolitical spheres of influence ever more combustible in an era
of cyber insecurity fueling a visceral public sense that decades-long
globalization has only fostered wider and unsustainable inequality.
Moves away from traditional globalization—already in force since the
GFC after which financial and trade flows began to recede—can sow
the seeds of inflation: control of immigration from lower-wage domiciles and national industrial policies can raise the cost of labor, capital
controls can tighten financial conditions and the cost of capital, and
protectionism can raise the costs of tradable goods and services.
Geopolitical volatility itself can elevate cross-asset class risk premiums.
As such, we believe it is worth watching out for well-intended promotions
of nominal growth to eventually be beset with creeping inflation—not at
first so visible, but eventually recognizable and translating into lower real
economic growth. Policymakers, companies, and investors will need to
adapt accordingly.
We are cautiously optimistic that there are also opportunities for
developments to outperform expectations. Surprise bilateral (or multilateral) arrangements fortifying obvious common vested interests or
modernizing outdated existing relationships inspiring others to follow
remain far from consensus investor views but are not improbable
possibilities in quarters to come (i.e. what if, when the first mutually
positive U.S. bilateral deal gets struck, and/or a revised NAFTA?).
Resolutions to what are assumed to be intractable dilemmas can pave
a way forward with alacrity rather than the sluggish muddle-along
base case of most market prognosticators (i.e. could a multi-speed
EMU eventually facilitate a more orderly E.U. recovery adjustment;
could continuing Japanese reflation ease a transition to an inter-generational domestic wealth transfer diffusing Japan’s debt predicament?).
What if more stable equilibriums can be negotiated in markets at the
sharper end of the geo-political-economic volatility stick, even if only
for a few quarters at a time (i.e. what if leaders from major economies,
or just the U.S. and China, recognizing mutual benefits from lower
currency volatility, meet to stabilize exchange rates for some time,
perhaps satisfying ambitions of those hoping to ink a landmark deal
at another New York hotel down the block from where the famed
Plaza Accord was struck?). We appreciate that unforeseen transitions
to sustain global recoveries are ultimately critical to build bridges
for the wider and more resilient prosperity needed to spur a positive
re-embrace of globalization spirit.
Regardless of directional swings in sentiment and fundamental rebalancing
of macro risk and opportunity, we will continue to deploy our time-tested
investment and risk management approach to season your portfolios in
the years ahead. Thank you for your trust and support.
| 9 |
2017 Investment and risk outlook | January 2017
Appendix: Global equity markets overview
Global equity market capitalizations ($bn) with returns YTD & since March 2009 lows (local currency & USD)
2016 YTD
Since 3/09 Low
Mkt
2016 YTD
Since 3/09 Low
North
Mkt
America
Cap
%
w/FX
%
w/FX Europe
Cap
%
w/FX
%
$25,338
10%
10%
231%
231% U.K. (W)
$3,092
14%
-4%
102%
$1,996
18%
21%
102%
95% France (W)
$1,940
5%
2%
93%
$27,335
10%
10%
219%
218% Germany (W)
U.S. (W)
Canada (W)
Total
% of World
Latin
41% % YTD % w/FX
Mkt
America
2016 YTD
Since 3/09 Low
Cap
%
w/FX
%
39%
69%
64%
Venezuela
$483
117%
37%
N.M
Mexico (EM)
$310
6%
-11%
169%
%
80% Russia (EM)
$586
27%
52%
224%
89% Japan (W)
61% Turkey (EM)
$165
9%
-10%
239%
74% % of World
2016 YTD
Since 3/09 Low
Cap
%
w/FX
%
w/FX
$5,084
-2%
1%
114%
81%
8% % YTD % w/FX
% PTD % w/FX
105%
3%
211%
159% Poland (EM)
$139
11%
4%
128%
91%
117% Czech. (EM)
$24
-4%
-7%
44%
22% Non-Japan
Mkt
Sweden (W)
$672
5%
-3%
146%
148% Croatia
$21
18%
15%
58%
29% Asia
Cap
%
w/FX
%
w/FX
Spain (W)
$645
-2%
-5%
37%
$21
34%
31%
219%
167% China (EM)
$6,463
-12%
-18%
46%
44%
$528
-10%
-13%
52%
$486
9%
6%
142%
w/FX Italy (W)
20% Neths. (W)
14% Hungary (EM)
27% Romania
102% Total
94% % of World
N.M Belgium (W)
$408
-3%
-5%
132%
101% Denmark (W)
$356
-13%
-15%
312%
245%
175% Middle East
13%
19%
75%
60% Norway (W)
$247
15%
17%
234%
18%
25%
32%
12% Finland (W)
$218
4%
0%
115%
$63
45%
18%
1676%
306% Ireland (W)
$106
-4%
-7%
240%
100% Austria (W)
80% & Africa
184% Saudi Arabia
2016 YTD
Since 3/09 Low
$16
1%
-3%
261%
185% HK (W)
$3,977
0%
0%
94%
94%
$972
20%
25%
203%
86% India (EM)
$1,550
2%
-1%
226%
149%
1% % YTD % w/FX % PTD
Mkt
2016 YTD
% w/FX S. Korea (EM)
$1,214
3%
1%
89%
142%
Australia (W)
$1,167
7%
6%
80%
105%
Since 3/09 Low
$951
11%
13%
100%
115%
Cap
%
w/FX
%
w/FX Singapore (W)
Taiwan (EM)
$465
0%
-2%
98%
112%
$448
4%
4%
75%
75% Indonesia (EM)
$422
15%
18%
312%
265%
278%
$103
9%
6%
85%
$423
0%
13%
179%
115% Thailand (EM)
$411
20%
21%
275%
47% Portugal (W)
$58
-12%
-15%
-19%
-32% U.A.E. (EM)
$223
12%
12%
131%
131% Malaysia (EM)
$354
-3%
-7%
91%
58%
% PTD % w/FX Greece (EM)
$36
2%
-1%
-56%
-63% Israel (W)
$154
-2%
-1%
123%
146% Philips. (EM)
$235
-2%
-7%
262%
254%
$12,224
4%
-3%
113%
89% Qatar (EM)
$153
0%
0%
118%
118% Pakistan
$96
46%
46%
744%
552%
-15% Vietnam
$85
15%
13%
168%
106%
-10% N. Zealand (W)
$73
9%
10%
179%
292%
$17,461
-3%
-6%
99%
97%
$74
58%
60%
94%
$1,951
41%
32%
112%
3% % YTD % w/FX
Mkt
w/FX Japan
w/FX
-9%
$206
% of World
Since 3/09 Low
%
7%
$104
Peru (EM)
2016 YTD
Cap
-7%
Chile (EM)
Total
Mkt
$1,861
Colombia (EM)
Argentina
Frontier
w/FX Europe
$1,468
% PTD % w/FX Switz. (W)
$711
Brazil (EM)
Developed
Total
% of World
Index Returns
2016 YTD
Since 3/09 Low
S&P 500:
10%
231%
World:
8%
200%
55% S. Africa (EM)
18% % YTD % w/FX % PTD % w/FX Kuwait
$79
2%
2%
-12%
$57
32%
29%
5%
Egypt (EM)
$35
76%
-24%
244%
Nigeria
$29
-6%
-41%
35%
$1,602
4%
5%
108%
77%
2% % YTD % w/FX % PTD
% w/FX
Morocco
ACWI:
8%
189%
Total
ACWI ex-US:
4%
127%
% of World
EM:
11%
115%
Index Returns
2016 YTD
Since 3/09 Low
S&P 500:
10%
231%
World:
8%
200%
ACWI:
8%
189%
ACWI ex-US:
4%
127%
EM:
11%
115%
Period-to-date (PDT) returns from March 9, 2009 GFC lows.
Source: Bloomberg and FactSet for selected MSCI ACWI (ACWI) markets.
Country equity indices from Bloomberg STAT Market Caps function.
(W) MSCI World Index (MXWO) member.
(EM) MSCI Emerging Markets Index (MXEF) member.
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6% Total
-37% % of World
26% % YTD % w/FX
% PTD % w/FX
2017 Investment and risk outlook | January 2017
Venkateshwar “Venk” Lal
Director of Investment Risk & Strategy, EverKey Global Equity
Venkateshwar Lal is the director of investment risk & strategy for the EverKey Global Equity team at Wells Capital Management.
He joined WellsCap in 2012 from EverKey Global Partners where he served as a founding partner and head of risk and trading
since 2007. Since 2013, Venk has also served on Wells Fargo Asset Management’s WealthBuilder Investment Committee. Prior to
joining EverKey, Venk served as an executive director in the Consolidated Equities Division at Morgan Stanley, advising hedge
funds and other investment management firms on implementing and managing risk exposures in global equity markets. In
addition, he previously advised and structured capital markets solutions for corporate clients seeking to issue or repurchase
capital in the equity, convertible, and fixed-income markets. Venk joined Morgan Stanley as a sales and trading associate
and previously served as a financial analyst for Goldman Sachs & Co. He has been in the investment industry since 1991. Venk
earned a bachelor’s degree from the Woodrow Wilson School of Public and International Affairs at Princeton University, where
he graduated summa cum laude, and a master’s degree in business administration from Harvard Business School. He has
served as a term member of the Council on Foreign Relations.
1 Currency risks for U.S. dollar-based global equity investors are discussed further in our October 2014 review, Currency Volatility Revisited, an update to a global equity risk discussion we published for clients in February 2013.
2 Cross-asset class commodity considerations for global equity investors are detailed in Spotlight on Global Currencies and Commodities, published for clients in February 2015.
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