I was tempted to title this article: More of the Same Please Part 2 after the piece from this past June (2H Outlook: More of the Same Please, June 2017) but it felt a little too cute. The more of the same strategy has worked very well but it is likely to be more wishful thinking than reality over the coming twelve months. Investors are likely to face more drama next year, which is not exactly a tough call after this year’s abnormally smooth ride. 2017 was a simple three-decision year: get and stay invested with a bias to non-US equity.
Given the near existential business threat faced by active managers from the continued Rise of Passive its no surprise that investors of all stripes have joined the party: hedge fund net longs are at near record highs, CTAs are close to record equity exposure, there are signs of growing retail enthusiasm, short interest in SPY is at multi year lows and mutual fund cash balances of 2.8% are close to record lows. Recent intra market gyrations provide an opportunity to take some profits & stress test one’s portfolio while providing a harbinger of 2018.
Yes, 2018 is likely to be a more challenging year. Many equity markets are at multi year, if not all time, highs, credit spreads are tight and many investor segments are fully invested. Equity market valuations are less supportive (though thanks to robust EPS growth, global equity trades at a lower PE today than a year ago, even after a 20% up move – a stat you never see in all the “bubble” articles) and the pace of EPS growth is showing signs of tailing off.
More importantly, a number of supportive tail winds are morphing into headwinds; including declining US stock buybacks, dollar weakness turning to stability/strength, Central Bank liquidity starting to reverse and China credit fuelled growth turning into tough love deleveraging. All of the above imply a more challenging return outlook; investors should raise their volatility expectations and lower their return assumptions.
How should one think about 2018? At PGS we believe in making the complex simple. The Tri Polar World (TPW) framework’s three main regions: The Americas, Asia and Europe provide a good place to start while the Global Risk Nexus (GRN) monitoring system and its four part prism of economics; politics, policy and markets ensures that all bases are covered. As usual, we will wrap up with some ETF focused asset allocation and portfolio positioning thoughts.
INACTIVE AMERICAS: LATE CYCLE ECONOMY, UGLY POLITICS, POOR POLICY & EXPENSIVE MARKETS
Not to give away the plot in the title but it does seem like the Americas suffer from a fair number of ills, especially on a relative basis. The US economy is clearly late cycle with the historical record suggesting close to 95% odds of a recession over the next two years. Yet near term recession risk seems limited given 2.5% economic growth (above potential), benign inventory and credit conditions, subpar inflation, decent job growth and muted wage pressures.
South America is earlier in its growth cycle with Brazil just coming out of a deep recession, one that perhaps has finally put the nail in the inflation coffin (pension reform key here). Mexico is having to hedge its NAFTA related bets, raising the minimum wage above inflation, developing new trade lines and in essence trying to protect itself from its capricious northern neighbor.
While the economic outlook seems benign the politics just look ugly right across the Americas. In the US, the Mueller investigation draws closer and closer to the White House, raising the stakes for next year’s midterm elections. 2018 brings Presidential elections to Mexico and Brazil as well as a number of other South/Central American countries. Rather than deepening & extending the world’s most significant corporate value added supply chain, NAFTA negotiations continue with very little sign of forward progress. Central America struggles with its own socio-political upheaval.
Politics bleeds into policy on both the fiscal and monetary side. Deficit financed tax cuts in the US are unlikely to meaningfully boost economic growth though corporate earnings will benefit. These are “because we can not because we must” tax cuts and arguably will make the job of a newly constituted Fed board much more complex given the need to decide on the fly how quickly to raise rates amidst a balance sheet unwind. Policy wins in the US have been reduced to a two-week spending bill extension to avert a Govt shutdown. Contrast this with growing talk of a United States of Europe by 2025 or China’s Made in China 2025 program and one can understand the Inactive Americas moniker.
Fiscal and monetary policy interaction will set the stage for US financial asset performance. Growing slightly above potential and near full employment, it seems clear that the economy does not need such stimulus. Thus inflationary pressures may build leading to a faster and more aggressive Fed tightening cycle. With the 2-10 yr. yield curve already under 60bps and continued strong demand for safe, long duration assets, the risk of a Fed inflicted yield curve inversion is non trivial. Given a tapped out US consumer with a personal savings rate of just over 3% and little sign of wages picking up the economy will be looking for a late cycle cap ex expansion to drive growth. Such a cycle would be at risk to a rapid rise in rates.
What does all this mean for markets? One possibility is a test of the thesis that stocks can do well in a rising rate environment. Another is that solid earnings growth continues to underpin equities while bonds toggle between Fed driven rate hikes at the short end and a demand supported long end. Stocks and bonds could also both sell off leaving long only managers out of luck and hedge funds finally having a market they can outperform in. Such an environment would threaten the popular risk parity strategy.
This backdrop also implies 2018 will follow 2017 as another year of non US DM outperformance versus the US equity market. This would be in keeping with global equity leadership changes of this nature – when different regions take the baton they tend to hold it for several years at least. US equity also faces a leadership question; tech has been the big leader but analysis of the Trump tax plan suggests tech will be one of the least benefited sectors. Rising rates could hurt it while the animus towards Big Tech continues to grow. Election year talk could turn to anti trust discussions, a potential multiple contractor. Leadership will have to come from tax cut winners in the small cap space (IWM) & sectors such as Industrials (XLI) boosted by a cap ex up cycle, financials (XLF) bolstered by deregulation, energy (XLE), boosted by supply-demand improvement and perhaps telecoms (IYZ) the biggest sectoral EPS winner from the tax cuts.
After wrong-footing many with its current year weakness, the USD should be a more reasoned chap in 2018 remaining range bound versus the Euro and weakening against the Yen. An active Fed increases short rates while safe haven demand supports the long end leading to a pancake flat yield curve.
PROACTIVE ASIA – STRONG ECONOMY, STABLE POLITICS, AGGRESSIVE POLICY & ATTRACTIVE MARKETS
The Big Four Asian economies: China, Japan, India and ASEAN are all in pretty good shape. As noted recently (ETF Investing with the Global Risk Nexus System, November 2017), China’s decision to not verbalize a GDP growth target for the coming five years frees it up to deal with its many imbalances. Japan is demonstrating how to make lemonade out of lemons as its shrinking population leads to 40 + year highs in the job seeker to job ratio while inflation starts to creep up (core CPI +0.8% y/y) and Prime Minister Abe presses the bet with calls for 3% wage gains in the upcoming shunto.
ASEAN continues to benefit from rapid growth in many of its countries while e commerce drives integration and the development of a thriving venture capital and private equity scene, funded primarily out of China. It is an excellent example of the TPW’s three steps: each region’s growing ability to self-finance, self produce and self consume. India seeks to regain the upper echelon growth rates it enjoyed a few years ago while also working to clean up its banking sector.
After the 19th Party Congress and Japan’s snap elections, Asian politics should be much smoother in the year ahead. Both Pres. Xi and PM Abe are set in office for the next several years at least. This provides Asia with significant competitive advantage versus Europe and especially the US/Americas. Concerns about Chinese expansion and the continuing worries over North Korea are likely to remain in the background.
Political stability manifests itself in the policy realm as well with the Abe/Kuroda team continuing to drive Japan’s growth and inflation boosting policies including the BOJ’s now famous yield curve control (YCC) policy mix. Q3 GDP growth of 2.5% y/y is well above potential suggesting rising inflation, rates and a stronger Yen.
In China, Pres. Xi and his team work to liberalize the financial sector, delever & rebalance the economy and institute supply side reforms to cut down on pollution and reform the SOEs. Building off its recent tremendous success in developing global tech brands, leveraging its OBOR policy and focusing on its MADE in CHINA 2025 program, China is well positioned to further its internal adjustment process. Expect more SOE defaults which should boost productivity, growth and earnings. Financial sector liberalization will be a major story over the next few years. China’s policy mix epitomizes the TPW designation “Proactive Asia”.
What are the financial market implications of a smoother outlook across the board? Attractive risk adjusted returns for one, especially in Japan (EWJ), which offers compelling equity earnings growth and valuation with potential for yen appreciation for foreign investors. 2018 could be the year the Iron Coffin Lid is finally lifted in Japan. Deeply undervalued (FV at 90Yen to the USD), a safe haven currency in times of trouble, Yen exposure makes a lot of sense. Such exposure can also be found in Japan’s small cap space (SCJ). China’s booming tech sector as well as its banks and domestic demand plays (consumer confidence at 20- year highs) remain long-term themes (MCHI, FXI). Both countries remain well off their all time highs and offer a wide selection of opportunity. ASEAN markets (Thailand, THD, Indonesia, EIDO and Malaysia, EWM) present interesting opportunities as does India which boasts forecast EPS growth of close to 30% next year (PIN, INDU).
RESURGENT EUROPE – BOOMING ECONOMY, POLITICAL POTENTIAL, POLICY WINDOW, MARKET OPPORTUNITY
Job growth at a 17 year high suggests its fair to say Europe’s economy is doing quite well. Where it could do better is in providing more demand for the rest of the world given it’s near 3% Current Account Surplus, led by Germany’s surplus of close to 8% of GDP. The hope is that broad job growth across Europe leads to increased consumption, which stimulates imports and generates more demand for the rest of the globe.
Europe’s great worry has been its banks and here the news is looking up. Credit growth is expanding while the non-performing loan (NPLs) mountain finally starts to shrink. The European economic recovery, roughly a third as old as the US recovery given its 2011-2012 recession, has several years to run, absent an ECB policy mistake that on present form seems quite unlikely.
The third area of good economic news lies with Greece and its potential to draw a line under its bank related woes. Having returned to growth (2018 GDP forecast to grow 2.5%) and with an agreement with its EU and IMF creditors seemingly in place, Greece should be able to exit the EU-IMF aid program in mid 2018. Strong enough to offset a near 10% appreciation of the Euro vs. the USD, with a functioning credit system and a return to good standing by its southern periphery, Europe is in quite good economic shape.
While not quite as robust, the political outlook is much better than a year ago when the argument that Brexit & Trump were bullish for Europe (2017 Global Investment Outlook: America First?, December 2016) was a decidedly minority view. Today Europe waits for the Germans to get their political house in order after the very unGermanlike failure of coalition talks. The good news is that Germany’s two least EU friendly parties, the AfD and the FDP, are now both out of the coalition discussions. This suggests that should the CDU and SPD come to some arrangement, Europe could be the big winner (United States of Europe) as the SPD pushes Chancellor Merkel to fully embrace the Macron project, restoring the France – German European integration motor and setting the stage for more ambitious policy.
The policies necessary to complete the remaining 25% or so of the EU institutional framework are known & ready to be put into place. What is needed is the political will. Economic recovery and its beneficial impact on the banks and the NPL problem should encourage Europe to complete the banking and capital markets union as well as converting the European Stability mechanism into a European Monetary Fund. There is a limited time frame for these actions to take place, namely the next 18 months or so before campaigning begins for the 2019 European Parliament elections.
The tech space is one other area where Europe urgently needs to consider its policy options. Europe seems intent on carving out a regulatory role as opposed to a corporate champion role. Clearly regulating Big Tech is an issue of some salience. But whether one looks at tech unicorns on the private side or tech sector weightings in the public markets, Europe is falling further and further behind Asia and the Americas.
Europe does offer a mid cycle economy with a second stage booster driven by the integration process. No other region offers such a powerful one –two potential punch.
What does this suggest for markets? For dollar-based investors, European financial asset performance in 2017 was flattered by the Euro’s near 10% appreciation versus the USD. 2018 is likely to offer a more paired return profile with both local currency and USD returns in good shape led by solid earnings growth and attractive valuation. Europe’s lack of technology shares, which was such a blow to 2017 performance, should be less of an impediment this coming year while the Southern periphery of Spain, Portugal and Greece should offer the better return profile within the region. Banks continue to be appealing on a sectoral basis while fixed income is unlikely to offer the stellar USD returns provided this year.
ASSET ALLOCATION & PORTFOLIO STRATEGY
Lower global equity return assumptions (+5-10%) and a tougher environment for fixed income performance suggest investors should review and where appropriate rebalance their portfolio positioning. Entering 2018, equity remains favored over fixed income; having an allocation to cash also makes sense. The out of favor commodity complex, down six of the past seven years and down 5% over the past month could be an area of opportunity. Sentiment is horrible, funds are closing, China growth slowdown pessimism is overdone and US shale worries miss the new focus on profits rather than production; all suggest commodities are worth a good look. The global economy has room to grow over the next few years; a procyclical exposure to energy and metals coupled with a defensive exposure to gold could prove both portfolio supportive and a good inflation hedge (DBC, IXC, GLD).
Regional equity allocations favor Asia (AAXJ, ASEA) and Europe (EZU) over the Americas (SPY) given the economic, political and policy comparison made above. Small caps are favored over large on a global basis given their heavy industrial weight and exposure to regional growth in Asia and Europe (IWM, VSS, SCZ). EM equity exposure is increasingly folded into the regional approach; within EM equity it is very important to note the near 27% weight of tech within the index.
Overweighting the non-US markets is a carry over from 2017; the difference in 2018 is likely to be that USD weakness plays a much less important role in non-US performance. Expect Yen strength and a range bound Euro to allow underlying economic and earnings growth to drive Europe’s equity market forward. The true test: can non-US equity outperform in a down US equity market may have to wait; modest US equity appreciation & relative underperformance could be just what investors need to expand their non-US equity allocation.
In Asia, Japan remains the preferred market with a focus on small caps (SCJ) given the expectation for yen appreciation, which also suggests switching from hedged Japan equity (DXJ) to unhedged (EWJ). China (MCHI, FXI) is also attractive within Asia given its continued profit growth, market opening and development of its tech sector.
Japan’s YCC policy may be eased somewhat as the year progresses, allowing the 10 yr. JGB rate to break above the zero bound, bolstering the yen and perhaps stimulating some domestic allocation shifts into equity. Local currency debt in Asia (ALD), including China (DSUM), may also offer some interesting opportunities.
Within Europe the southern periphery could be the area of best opportunity next year. Spain (EWP) with its robust growth rate, Portugal (PGAL) where 10-year rates have halved and Greece (GREK) with its hoped for exit from its aid package could all add to European (EZU) performance. Financials (EUFN), which did quite well for much of the year but lagged badly in Q4, remain attractive given the backdrop described above.
In fixed income sovereign rates are likely to rise as growth continues, economic slack is taken up and the ECB ponders pulling back on the monetary spigot. Euro area high yield (HYXU) is unlikely to be as good a performer in USD terms as it was in 2017 though fundamentals remain solid.
Within the Americas, Brazil (EWZ, EWZS) looks most interesting given its nascent economic recovery, inflation collapse and the potential for further interest rate declines. Should Brazil be successful in curbing inflation then the huge inflation premium built into its fixed income markets should gradually bleed away, allowing equity valuations to rise (there is a reason why Brazil has long been among the world’s cheapest equity markets) and perhaps sending domestic Brazilian investors abroad. Argentina (ARGT) seems to be getting is economic house in order and could be an interesting opportunity. Mexico, an early favorite last year, faces NAFTA and election related risk.
US equity is unlikely to have as good a year as the one just ending as headwinds become stronger. Having said that earnings growth is likely to be solid; corporate tax cuts are likely to elongate the profit cycle, leading consensus EPS to be around $160 or + 15% which puts the market at 16x forward earnings; pretty good support for a small up year. It is likely to be the same in fixed income space though as elsewhere in the developed markets the supply demand balance suggests continued strong demand for safe, liquid, long duration assets. The search for yield is getting long in the tooth and the areas to find it are becoming few and far between. At this point USD EM debt (EMB) and financial preferreds (PGF) are among the most attractive. Roughly $1T in global bank related debt issued post crisis matures next year – finding a suitable replacement is going to be quite difficult which could bode very well for PGF.
Well that’s all for now. Have a wonderful holiday and all the best for 2018!