As the world turns, so do the various inputs that move markets. Over the past year or so, investors has migrated from a laser focus on policy (mainly monetary/CB related) to a world where politics is front and center. A gentle upswing in global growth, sufficient to boost earnings but not shock yields, has facilitated a positive return environment..
Politics can have both good and bad implications for markets. At the moment, politics are descending like a cloud over the US while representing a rising sun in Europe. Our Global Risk Nexus (GRN) framework, which analyzes the interplay between economics, politics, policy and markets is well suited to examine what the combination of healing economics and hard to model politics means for asset allocation.
Let’s begin with an assessment of the US, then move to Asia, Europe and a side trip to EM land before concluding with what it all means for asset allocation and portfolio strategy.
The US has been in the grip of heavy-duty political intrigue for the past several weeks as current events stimulate memories of Watergate & impeachment. Plenty of ink has already been spilled on these issues but several points bear noting.
First, many of the White House troubles represent self-inflicted wounds ranging from the Flynn affair to the firing of FBI Director Comey to the release of confidential intelligence. Candidate Trump’s treatment of the press and the intelligence agencies virtually ensured such self-inflicted wounds would be vigorously reported – reporting that is unlikely to change. The costs of these self-inflicted wounds range from turbocharging the human resource challenge (the administration remains woefully understaffed) to encasing the legislative agenda in cement.
Second, the bulk of these self-inflicted wounds come from the President himself and thus are likely to persist. The President is inexperienced in the ways of Washington and is being outplayed in its parlor games. He is out of his element and furthermore, his element has not prepared him well for the challenges he faces. At 70 years old, the President is unlikely to change while his personal history works against him; as the CEO of a family company he is unused to criticism and has never been bound by shareholders or a strong board.
Finally, the naming of former FBI Director Robert Mueller as a special counselor suggests much of Washington will be lawyered up and on tenderhooks for months if not years to come. Mueller, known to stand up to the powers that be, is a career prosecutor with a broad remit to go where the trail takes him. For its part, the White House is reported to be setting up a war room to push back against the media and intelligence onslaught. The US history of special counselors or prosecutors suggests that the average process tends to take just over three years. It is quite conceivable that policy paralysis will reign in Washington for the next several years; should the Democrats win the House in 2018 (increasingly feasible) the prospects for impeachment would be much less far fetched than one would have thought a month ago.
Policy inertia is worrisome for an economy that grew at under a 1% annual rate in Q1. Q2 is tracking well above 3% but any hopes for meaningful fiscal stimulus are at this point very faint indeed. Democrats are unlikely to support the Trump agenda while Republicans nervously eye the 2018 midterm elections. (See From Fluke to Fact: Is the Anti-Trump Trade Sustainable? April 2017)
An aging economic expansion, a White House & Legislative branch focused on who said what to whom when and a Fed looking to raise rates all suggest caution is in order. The risk of a Fed mistake is elevated, given record US household debt levels and an investor base that lacks experience of investing in a rising rate environment. The Fed is in a box; should it choose not to raise rates one might even see stocks sell off, worried about what the Fed knows that the market doesn’t.
WHILE DC IMPLODES, CHINA TAKES TO THE GLOBAL STAGE
Regular readers know my Tri Polar World (TPW) thesis: that regional deepening in the three main regions: Asia, Europe, and the Americas, driven by each region’s ability to: self-finance, self-produced and self-consume, represents the coming geo-economic framework. (See The Tri Polar World 2.0 – A New Global Growth Model, March 2015)
Amidst all the DC intrigue, China's President Xi hosted a One Belt, One Road (OBOR) summit that brought a large number of world leaders to Beijing to learn about the opportunities presented by the world’s largest infrastructure project. The OBOR has been criticized as uneconomic, grandiose, a Xi vanity project etc. From a Tri Polar perspective, it looks like regional leadership.
President Xi has utilized President Trump’s America First focus to press his case as a global leader first at Davos and now at the OBOR Summit. Any doubts as to what will happen at China’s upcoming Fall Party Congress should be dispelled by now.
The OBOR project together with the Asia Infrastructure Investment Bank (AIIB) represent China’s efforts to stitch Asia & Eurasia together to China’s benefit in both geo- economic and geo-political terms. The Trump Admin’s decision to walk away from the Trans-Pacific Partnership (TPP) further reinforces China’s regional leadership opportunity. Within the TPW framework, Asia has long been seen as the Proactive region; a split screen look at DC/Beijing over the past few weeks only reinforces that nomenclature. DC myopia is occurring not in a vacuum but rather in a world where others are moving forward – rapidly in some cases.
EUROPE: THE M&M TEAM PREPARES TO TAKE THE FIELD
Within the TPW framework, Europe has been known as the Reactive region given its firefighting efforts of the last 5 + years. A new moniker may be in order however as signs point to a much more positive picture for the European Union. As France’s new Economy Minister, Bruno Le Maire, recently noted, Brexit offers the chance to come up with a new direction for Europe. Greater EU cohesion suggests a hard Brexit and a weak pound. (See Trump, Trade & the Markets, February 2017)
Emmanuel Macron’s election, his subsequent Cabinet choices (many of whom are German speaking) and candidates for France’s upcoming Parliamentary elections together with his interaction with German leader Angela Merkel all serve to reinforce this positive outlook. Macron is intent on reforming France and re-energizing the European Union; more importantly, he understands the former must precede the latter in order to bring Germany along.
In Germany, the clean sweep by Merkel’s CDU Party in three recent State elections makes clear she will be returned for a 4th term as Chancellor this Fall. The payoff is a joint cabinet meeting with France in July, before Germany’s elections, suggesting both confidence in the outcome and a willingness to leverage the energy Macron’s election represents. Expect a much-needed revival of Franco – German leadership to reinvigorate the European project.
Think of the M&M ( Merkel & Macron) team taking the field to push the ball of European integration down the field. The game plan will be for Macron to demonstrate fiscal control in France, which in turn would provide Merkel an opening to take on board subjects such as fiscal union, Eurobonds and faster movement to capital markets union and the digital single market. After years of playing defense, look for European politics to go on the offensive in support of deeper Union integration.
The fact that Europe’s economy is posting its best growth profile in a decade will certainly help. A currency whose fair value is roughly 1.25 to the USD coupled with near 10% unemployment illustrates the significant amount of slack in Europe’s economy; an economy which remains far behind the US in terms of recovering from the 2008-9 financial crisis. Europe has real room to grow at the regional, national and corporate level.
The 2017-2020 period should be Europe’s time to shine. Europe's potential for a prolonged recovery in economic, political and policy terms has yet to really enter the mindset of US policymakers and investors alike. It needs to.
EMERGING MARKETS IN THE TRI POLAR WORLD
Politics has long been a part of the EM investment process, sometimes providing opportunity, other times wreaking havoc. Today, the asset class should be well prepared to handle political volatility; certainly domestic & dedicated investors are quite experienced while non-dedicated investors, who usually exacerbate selloffs, have only recently begun to return to the space. The risk is two fold; first that record inflows reverse and secondly, that polticial volatility impedes the search for new growth policies.
Very strong year to date performance stems from strong inflows leading to a catch up trade. To perform going forward, EMs need new growth policies. The EM export to the West model expired in 2008 while the export to China model died a few years later. Subsequently, domestic demand was tapped in many countries leading one to wonder what the go forward EM growth model might be.
One option to consider is how various EMs fit into the TPW concept of regional deepening. In Asia, this could mean being a part of the OBOR effort as well as ASEAN integration. In Europe, it might suggest taking advantage of Brexit to position oneself as a low-cost service center as countries like Poland and cities like Warsaw are doing today.
In the Americas, it could mean updating NAFTA to support Mexico’s push into services. For example, Mexico’s IT service sector is growing at 15% per annum today, faster than India’s IT service sector. For Brazil, Argentina, Chile, Peru, Colombia it might suggest pushing to have NAFTA extended southward in order for it to become a true hemispheric trade agreement.
An effort to incorporate South and Central America into NAFTA would jumpstart the Americas (known as the Inactive region) and provide a much-needed economic model for these countries. Yet any such effort may be held hostage to DC’s self-inflicted wounds. The risk is rising that the Trump Admin misses this regional integration memo, sapped by the Mueller investigation and unable to think strategically about the world around it. One worries that the US and the Americas more broadly might wake up in 3-4 years to see the geostrategic map having been redrawn and not in its favor.
PORTFOLIO IMPLICATIONS – THE 5 POINT PLAN TO INVEST DURING THE TRUMP TROUBLES
I have spent quite some time thinking about how to tie all these issues together and came up with the following five-point plan during some prep work for a Bloomberg TV appearance a few days ago. (BloombergTV Day Break May 22, 2017)
Trump Troubles = US policy inertia = weak US growth = questionable US Earnings = poor US equity risk reward = rest of world (ROW) outperformance.
Solid Q1 earnings have helped US equity stay afloat during the political fireworks but the big story has been the relative outperformance of the rest of the world led by EAFE up 15% and EM up 18% vs. the US up 7%. On a strategic, multi-year basis, stay overweight non-US equities with a focus on developed x US markets in Europe and Japan. The shift to non-US global equity leadership is just beginning with EAFE related ETFs in general and European ETFs in particular looking to break out of multi-year trading ranges. However, these same instruments now look quite overbought.
Consequently, Japan looks more interesting as it has lagged while the economy enjoys its best growth run in a decade, leading to stellar earnings ( Q1 + 28% y/y) at very attractive valuations. Hedged Japan ETFs in particular have underperformed suggesting that if one believes in multiple Fed rate hikes this year these instruments could present an opportunity.
Over the near term, it’s conceivable that the US might make up some of this relative underperformance. US sectors of interest include Industrials that could benefit from a new capital investment cycle together with Consumer Staples that provide a relatively low volatility way to stay invested. The traditional sell in May and go away strategy may not be very effective this year as sentiment and technicals look supportive.
Recently, much has been written about China’s efforts to delever its financial system with such efforts being blamed for commodity price selloffs and even the end of the “reflation trade”. A more benign outlook suggests this effort will impact China’s financial sector rather than the real economy which is doing well, with new economy companies in particular reporting solid results and very rapid growth rates. China ETFs with tech exposure remain of interest; China tech stocks are outperforming US big cap tech, something one would never know reading about China’s supposed impending doom.
Within fixed income, yield differentials support USTs as Bunds sell off to reflect a better EU tone while the BOJ holds the JGB market captive. Yield curve flattening suggests US investors have pulled the plug on fiscal stimulus hopes. This environment supports positions in US High Yield, preferreds and EM USD debt as the search for yield continues. The growing gap bteween market pricing of Fed rate hikes (one and done till mid 2018) and the Fed's stated path (2 more this year + 3 next) is worrisome. My bet is that the market has it more right than the Fed, as it has for years.
The transfer of political risk from Europe to the US together with Fed uncertainty is likely to keep the USD rangebound. In the commodity space, precious metals remain of interest given that environment. Should the Fed not raise rates next month gold and silver should benefit.