Balancing Act - October 2016
FOR SOPHISTICATED INVESTORS ONLY
By Nikko AM Multi-Asset team - 15 November 2016
As we enter the final quarter of 2016, concerns around political risk are at an uncomfortable level. October saw further volatility in the UK Pound, as negotiations around Brexit drove the currency to its lowest level in over 30 years.
Italian bond yields spiked 0.5% higher, as the Italian referendum for constitutional reform on 4 December draws closer and investors remain concerned with the recent gains of the anti-Euro Five Star Movement.
But these pale in comparison to the potential political risks stemming from the US presidential vote. At the time of writing, US citizens were preparing to cast a ballot for the two most disliked presidential nominees in the history of US popularity polls. With both candidates referred to varyingly as ‘entitled’, ‘misogynistic’, ‘criminal’ and ‘pompous’, this is hardly a vote of confidence for the future US president. We will dedicate space in the November Balancing Act for an assessment of the outcome.
In this environment of heightened political uncertainty, we are inclined to be cautious. We do not have a high degree of confidence in selecting the president, but we are confident that the ensuing months will be volatile.
In the past, one of the key ways we have expressed a cautious view in our portfolios is through increasing our allocation to sovereign bonds. Unfortunately that avenue is not open at this time with sovereign bonds expensive, heavily manipulated by central banks and at risk of a dramatic repricing.
This means they provide little diversification benefit, as their correlation to growth assets has increased recently. We prefer to maintain our underweight to sovereign bonds, rather than using them as a risk hedge.
So what type of hedges have we put in our portfolios?
Over the course of the third quarter we took advantage of cheap volatility and increased our downside protection by purchasing a variety of option structures that will benefit the portfolio returns should equities fall.
We also initiated short positions in cyclical currencies like the Korean Won, which should fall in a growth scare. Within our relative value bucket, we entered trades that will perform well in a risk off environment, such as a short position in US consumer equities, and a long position in the Indian Rupee relative to the South African Rand.
We do not think that the current environment of heightened political risk will be short lived. Even if Hilary Clinton wins the US election, a large portion of the US population remains disillusioned with their government and will remain agitated.
The Italian referendum in December is key not only for Italian stability, but that of the European experiment. The European Central Bank is slated to end its quantitative easing in March 2017, while France goes to the polls in April 2017, and then Germany a few months later.
Political risk will remain at the forefront of the investing agenda and we continue to believe that a cautious approach is prudent in this environment.
Asset Class Hierarchy
Note: Sum of the above positions does not equate to 0 in aggregate – cash is the balancing item.
Japanese equities are high on our hierarchy by default
We have downgraded Japanese equities during 2016, mainly due to poor price momentum, question marks over earnings as the Yen strengthened and concerns the move to negative interest rates was a policy error.
Despite this downgrade, Japanese equities remain second on our hierarchy, due to a lack of favourable alternatives. Outside Asia, we are not positive on any equity markets. The US is expensive, Europe is facing an existential crisis that is also impacting EMEA markets, and Latin American equities are making some heroic earnings assumptions.
So Japan finds itself near the top of our equity hierarchy by default. This is a concern, as our research is suggesting that the worries we had over earnings are now coming through.
Chart 1 shows the deterioration in Japanese equity earnings is continuing, as companies struggle with the stronger Yen, poor growth outlook and mixed policy responses.
Chart 1: Japan equity earnings
Source: Bloomberg 2016
While we still have reservations on policy and earnings, it is not all bad news. Japanese equities are cheap, with forward P/Es at a reasonable 16x. The Japanese Yen also appears to have found a barrier at 100 versus the US dollar and has recently been weakening.
The recent decision by the ruling Liberal Democratic Party to extend a leader’s maximum tenure from six to nine years gives Prime Minister Abe a chance at a third term. This potentially gives him more time to enact structural reform, which will create stability in Japanese politics that didn’t exist prior to him coming onto the scene. While his reform agenda to date has been slow, this extra time increases the chances of him getting things right.
Indian equities are our favoured Asian allocation
Stretched valuations and crowded positioning remain headwinds for Indian equities.
However, in our opinion, multiple tailwinds of solid economic growth, a stable currency, falling inflation, continued monetary easing, a pick-up in reform momentum and, perhaps most importantly, a much-awaited earnings recovery, more than compensates for the negatives.
On the reform agenda, there have been two significant achievements recently:
- Bankruptcy law reform: India’s parliament passed its first national bankruptcy law in May, which could turn one of the slowest insolvency regimes of any major economy into one of the fastest.
- GST reform: The GST (goods and services tax) council finally approved a four-tiered nationwide GST structure, replacing a byzantine system of hundreds of different and conflicting state-level tax rates.
These two reforms have the potential to lift Indian GDP growth by as much as two percentage points a year over the medium term.
And with the Indian economy already growing faster than any other large economy globally, this alone may justify the growth premium priced in by the equity market.
Chart 2: Indian GDP growth
However, a certain degree of caution and scepticism is warranted when it comes to the implementation of these two reforms.
India’s state-owned banking system remains woefully undercapitalised. In spite of robust economic growth, the banking sector reported losses of USD 3 billion in the last earnings season.
The current season’s results have still not been released for the majority of the banks. Any further deterioration of balance sheets would point to continued weakness in industrial lending, which could negate the positive effects of the bankruptcy law reform, at least in the near term.
Similarly, the feel good factor of the GST council’s recommendations could quickly dissipate in the face of implementation hurdles.
First, there is the not trivial issue of the agreed tax rate being approved by the Indian Parliament. This is expected to happen in the winter session but could easily be delayed, given the past history of India’s legislative process.
Then there is the administrative challenge of categorising the various product categories into the four new tax brackets proposed by the council: 5%, 12%, 18% and 28%.
A tiered system across basic necessities (remaining untaxed), mass market goods (taxed at the lower end of the scale) and luxury items (highest tax bracket) will in theory help to address the challenges posed by wealth inequality and the federal tax system.
While it could mitigate some concerns around an inflationary surge following implementation, it could also encourage vested interest groups to lobby for the delay of the new code’s implementation – something for which investors need to be prepared.
The earnings season is currently only three quarters of the way through but it provides us with more encouragement. Earnings are up 8% year-on-year on sales that have risen 10%, as shown in Chart 3.
The confluence of positive macro drivers suggest that this may well be the start of the long-awaited earnings recovery in corporate India.
Chart 3: Indian earnings and sales growth
EMEA equities facing political headwinds
EMEA remains at the bottom of our emerging market hierarchy, due to external imbalances and the deteriorating political capacity, mainly in South Africa and Turkey.
While Asia has continued to push reforms and Latin America has more recently shifted away from populism to its own reform agenda, EMEA has stubbornly drifted the other way. Leadership in these countries has been increasingly prioritising the maintenance of their own power and control, ahead of meaningful reforms.
Both South Africa and Turkey were members of the so-called ‘Fragile Five’ that sold off deeply following the taper tantrum in 2013, when US Federal Reserve Chairman, Ben Bernanke, discussed the eventual wind down of the US’ quantitative easing program.
The ‘Fragile Five’, which also included Brazil, India and Indonesia, all had structural current account deficits, leaving them vulnerable to a funding shortfall and a potential balance of payments crisis.
Since then, Brazil, India and Indonesia have all made progress in reducing their current account deficits and increasing more stable sources of funding, such as foreign direct investment.
As shown in Chart 4, current account deficits in South Africa and Turkey have also improved since the taper tantrum, due mainly to better terms of trade caused by falling oil prices. These deficits, however, are still uncomfortably high, given their funding relies on increasingly volatile portfolio flows.
Chart 4: Turkey and South Africa current accounts
Source: Bloomberg 2016
In late September, Moody’s downgraded Turkey’s debt to ‘junk’, due to concerns around capital outflows, a poor growth outlook and declining foreign exchange reserves. Since this downgrade, Turkey’s currency has also hit new lows.
Political risks in Turkey also continue to rise, with President Erdogan’s systematic removal of any opposition making the possibility of reforms increasingly remote.
South Africa is facing a similar challenge, with its structurally high fiscal deficit threatening to result in a downgrade to ‘junk’ by Standard & Poor’s in December. South Africa’s political institutions, including the Ministry of Finance, are generally deemed strong, with the exception of President Zuma, whose erratic behaviour has added to market volatility.
However, his declining popularity and recent failure to oust Finance Minister Gordhan after fraud charges against him were dropped, offer some hope that changes will be made. Populism has also risen in Eastern Europe, with Poland shifting to less business-friendly policies. Hungary’s referendum to reject the EU’s mandatory immigration quotas is also a blow to EU relations, although the referendum did not pass due to inadequate voter turnout.
Russia’s economy is improving, although political risk remains high due to tensions with the west, while tensions in the Middle East also remain high due to the conflict in Syria.
Not all high yield bonds are equal
US credit rates are at their lowest in history. While lower rates should help corporates by bringing down their cost of borrowing, some argue that the current policy is failing because borrowing rates for US corporates have not fallen in kind.
Our research shows that this is only true for the poorer quality companies rated CCC or below.
It is tough for poor quality companies to benefit from lower rates when their borrowing costs remain high.
Current yield-to-maturity on CCC and lower-rated US credit shows that their borrowing costs are still historically high, outside periods of crisis.
Chart 5: Yield-to-maturity (%) for US corporates by rating
Source: Bloomberg, BofA Merrill Lynch
The most recent spike in yield-to-maturity for speculative grade bonds can be attributed to the misallocation of capital to the energy sector, with the fall in oil corresponding to a blowout in yields during 2015 and early 2016.
However, with the oil price stabilising at between $40-50 a barrel in 2016, yields for the high yield energy sector have, on average, come back in line – something that hasn’t happened for speculative grade credit.
This disconnect comes from poor fundamentals, and we have previously spoken about the sharp rise in US High Yield default volumes in the second quarter of 2016, as low oil prices took their toll.
While these default volumes have come down in September, there has been a worrying collapse in recovery rates to levels below that seen during the global financial crisis.
Chart 6: US high yield recovery rate (%)
Source: Fitch Ratings
While energy prices are stabilising and energy credits are returning to more normal borrowing rates, lower quality companies are still suffering, as their borrowing costs remain high and their fundamentals are deteriorating.
Lenders willing to take the risk have seen positive returns in the recent rally, but those who chose the wrong credits are experiencing an increase in defaults, with recovery rates falling to below 30%.
We prefer to remain on the sidelines while this misallocation of capital works its way through.
We continue to favour high quality credit and remain underweight high yield. Within high yield, we favour BB-rated names and have zero exposure to US energy.
Inflation continues to move higher
The persistent disinflationary trend, amplified by the collapse of the oil price two years ago, appears to be subsiding.
Core inflation measures in the major developed economies are moving up with the exception of Japan, as shown in Chart 7. Wage inflation is also picking up, as labour markets tighten.
Chart 7: Major economies core inflation
Source: Bloomberg 2016
Bond bulls would suggest that short-term metrics like core inflation are subject to transitory dynamics, and do not reflect investors’ real expectations for long-term inflation.
It is these long-term inflation expectations that are more important for bond investors which, as shown in Chart 8, are also moving higher.
Chart 8: Major economies inflation expectations
Source: Bloomberg 2016
Sovereign bond markets have been slow to price in this change in underlying fundamentals. The spectre of deflation still looms large and investors remain reluctant to adjust bond yields higher.
This may be a rational response, given central banks (except the US) remain determined to keep interest rates exceptionally low and, in some cases, persist with quantitative easing.
We remain concerned that, in this highly-manipulated environment, the slightest suggestion that inflation may persist will be enough to cause a dramatic repricing in bonds.
This becomes more troubling when we consider the defensive role that sovereign bonds are supposed to play in our portfolios is under question, as their correlation to equities continues to increase.
We will maintain our underweight position to sovereign bonds until valuations reflect the change in fundamentals or their role as a defensive asset becomes clearer.
Cash remains our favoured defensive asset.
We maintain our neutral stance in commodities
As we have often said, gold is a reasonable hedge against rising geopolitical risk, on the proviso that fundamentals matter – mainly driven by the direction of real yields and the US dollar, which can be quite volatile.
Gold has been a better performing and less volatile risk hedge than sovereign bonds year-to-date.
Chart 9 shows the rolling correlation of gold and bonds to equities versus implied volatility, as measured by VIX.
You can see that both have a low correlation to equities, however after the credit crisis in the early 2000s, bonds shifted to a deeper negative correlation to equities – a good hedge.
Both gold and bonds are good hedges in ‘risk off’ scenarios, where volatility spikes and correlations dip.
Since the taper tantrum in 2013, the correlation of bonds to equities has fallen but remained negative, while the correlation of gold to equities has steadily declined – remaining negative since the summer of 2015.
US dollar strength and rising yields remain potential headwinds, but gold still serves as an important hedge – both to rising geopolitical risk, and also as a store of value in an environment of rising inflation expectations.
Chart 9: Rolling correlation of bonds and gold to equities versus implied volatility
Source: Bloomberg 2016
Gold remains at the top of our hierarchy, followed by agriculture, energy and base metals.
Volatility is increasing
Currency markets are often thought of as ‘the canary in the coalmine’, as changing investor sentiment towards a country generally shows up in its currency first, due to its substantial liquidity and breadth of participants.
The recent increase in currency volatility is troubling, with the UK Pound falling to 1.2 against the US dollar in October, its lowest level in 30 years. Across the Atlantic, the Mexican Peso broke 20 against the US dollar, its lowest level in history.
The UK Pound remains firmly at the foot of our hierarchy, while we have recently moved the Yen down the hierarchy. Our main concern is whether to place the US dollar at the top of our hierarchy.
Valuations suggest the US dollar is expensive but momentum has improved recently. With volatility increasing, the relative safety of the US dollar may become attractive. We will look to review this position once the policies of the new US President become clear.
In house research to understand the key drivers of return:
|Quant models to assess relative value||Quant models to measure asset momentum over the medium term||Analyse macro cycles with tested correlation to asset|
|Example for equity use 5Y CAPE, P/B & ROE||Used to inform valuation model||Monetary policy, fiscal policy, consumer, earnings & liquidity cycles|
|Final decision judgemental|
|Final Score +|
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