I was working on an eclipse analogy but saturated media coverage plus it being a bit of a bust here in New England put an end to that. Then I woke this morning to find the view obscured by a shape shifting, light altering combo of mist & fog. It struck me that as investors we often find ourselves peering through the mist of data and a deluge of information, trying to avoid pitfalls/drawdowns and seeking the clarity in both outlook and positioning similar to when the sun breaks through and all is revealed.
Well, I can’t promise to reveal all but I can offer my Global Risk Nexus (GRN) framework to assess the key variables of economics, politics, policy and markets. Combined with my Tri Polar World (TPW) global growth model of regional integration in the three main regions of Asia, Europe and the Americas, we can try and chart a course through the mist and fog of global, multi asset investing.
THE INACTIVE AMERICAS
I am contemplating a possible GRN scoring system, contemplation which has helped me think through what has happened in the US these past few weeks. If one were to score the politics and policy variables of the US on a scale of 1 to 5 with 5 being the best it would suggest the US at a 1.
Its hard to imagine a worse week for the Trump presidency than the one just passed; its also hard to conceive of a month worse than the one just completed given staff turmoil & turnover, the health care fiasco, Charlottesville and its aftermath, the war of words with N Korea, the collapse of the Presidents’ councils & the encouragement of a Gov. shutdown, all serving to deepen speculation on who and what is next.
Impeachment would be worse but remains a low odds prospect that would occur only after the 2018 midterm elections and a Republican loss of the House; itself an open question given that President Trump remains popular among Republican voters. In the interim, the personnel focus is on Gary Cohn, head of the President’s National Economic Council, who is expected to stay in post until President Trump names him as the next head of the Fed in early 2018.
On the policy side, a jam-packed Fall calendar awaits. Key Congressional issues include the passing of a budget and the raising of the debt ceiling in order to keep the Federal Gov. operating and avert a potential default on UST. The deep divides exposed over the past few months within the Republican Party itself as well as between the President and Congressional leaders suggest neither of these issues is likely to be easy.
If achieved then there is the long hoped for tax reform, which at this point seems quite unlikely at least this year. And yet, Republicans running for office next Fall need something to run on and tax reform looks like the only game in town. The DC mess seems pretty well discounted, creating a potential positive surprise on tax reform. Depending on what tax reform actually looks like it could revive the hoped for transition from pure monetary policy to a joint venture between monetary and fiscal policy which at this point appears stillborn.
With the Fed’s Jackson Hole confab focused on Fostering a Dynamic Global Economy the reality is that Central Banks are shifting from a major tail wind for risk assets to a modest headwind, making that joint venture all the more important. As an aside, the way to foster a more dynamic global economy is simple: embrace the TPW, deepen regional integration and foster each region’s growing ability to self-finance, self produce and self consume.
On the regional integration front, the opening of NAFTA talks has already revealed some “deep fissures” between the US proposal and those of Canada and Mexico. President Trump’s continued shout outs to build the wall are unlikely to be helpful in this context. The integration of value added corporate supply chains across the US – Mexican border are some of the most significant in the world suggesting little will be done especially given US midterms and Mexican Presidential elections next year. From a TPW perspective, the US is missing a huge opportunity to extend NAFTA southward and deepen the integration of the Americas (Expert Insights: The Rise of the Tri Polar World, July, 2017).
The net result of all this political dysfunction has been to introduce a bit of volatility into illiquid summer markets and spark some healthy profit taking in equities. USD and small cap equity weakness would suggest the “unmoored” Trump Presidency outlined in my 2017 Outlook piece (2017 Global Investment Outlook: America First? December, 2016) has been pretty fully priced in.
I was struck by the number of Chinese companies on the recently released Fortune 500 Global List. China had the second largest number of companies on the list with roughly 110 vs. 130 for the US, 50 for Japan and less than 10 each for the other BRIC countries. Chinese companies on the list include the large banks & state owned enterprises (SOEs) but also a growing cohort of tech companies. Amazingly, Chinese banks constitute four of the top five most profitable companies in the world (though its likely much of that profit will be used to write off bad debts in the years ahead).
Much has been written about China’s geo political leadership of the Asian region in areas ranging from trade to financing to the OBOR project but it seems clear that the focus needs to broaden to the corporate level. Global investors are going to have to pay a lot more attention to Chinese companies in the years ahead… they are too many and too big to ignore.
While global investors need to start really honing in on Chinese companies, reports suggest that individual Chinese investors may soon be allowed to invest abroad, a subject broached a few years ago but put on the back burner once capital outflows accelerated in 2015-16. Renewed stability in the capital account may facilitate investment outflows by individual investors in the years ahead, something that may even come out of the upcoming Fall Party Congress.
Investment flows to /from Chinese financial markets in the next few years are going to be a huge story given that China’s debt & equity markets are in the top three globally while China investor home bias is close to 100%.
Of course Asia also includes the Korea conundrum as well as sabre rattling between China and India and the growing importance of the ASEAN economies. For all the ink spilled on N Korea and its risks to the US and S Korea its pretty amazing to see that the won/USD rate has been roughly flat while the South Korean stock market, up over 25% ytd, sold off only 5% or so. Such calm would seem to imply that investors either expect all sides (there are at least four) to act rationally or they are dangerously complacent. I favor the former.
Europe remains the most attractive region over the next 3-5 years as political populism ebbs, enthusiasm for the EU rises, the economy continues to recover and the Franco-German European integration motor restarts.
Growth is both widespread and better than expected with cap ex the best since the financial crisis. This has led to a bond sell off, Euro strength & an equity market marking time. German elections next month should set the stage for a positive outlook into year-end.
One of Europe’s key challenges lies in its need to develop big tech winners a la the US and China. Instead Europe seems to be seeking the role of global tech regulator with key countries pushing Brussels to lead the way. Offsetting this is the larger role President Macron seems to be seeking for France and its tech aspirations. European tech is a key area to focus on the years ahead. It is hard to see Europe remaining resurgent if it doesn’t place the tech sector front of mind and not solely from a regulatory perspective.
ASSET ALLOCATION & PORTFOLIO POSITIONING
The request for “More of the Same Please” (2nd Half Outlook: More of the Same Please, June 2017) has worked out pretty well to date, with non-US developed markets (DM) equity sustaining its outperformance vs. the US. I continue to believe we are in the early stages of a multi year shift in global equity leadership from the US to the non-US DM.
Some of this relative outperformance can be placed at the doorstep of US political disarray and policy inertia to the extent that so far in Q3, long duration UST are outperforming the S&P. A Fed that leads the CB parade out of QE coupled with the Fall legislative calendar laid out above and more challenging 2H earnings comps suggest a US equity market that is likely to mark time in the months ahead. Seasonality is also a concern.
Non US DM positives include a better economic environment outside the US, better earnings growth and room to grow those earnings, more attractive valuation and continued underownership coupled in both Europe and Asia with a more vital regional integration effort. Japan and Europe remain attractive with the key question being whether to hedge the FX risk or not. I remain unhedged in European equity (EZU, EUFN, EWP) and hedged in Japanese equity (DXJ), which has worked in Europe but not in Japan.
Yen sentiment is at extreme bullish levels suggesting good prospects for at least a tactical reversal which could lead to more interest in Japanese equity. Japan is enjoying its broadest economic recovery in several years as domestic demand revives, inflation picks up and the global economy enjoys its most synchronized recovery since 2007. Earnings growth is running at roughly 20% y/y and valuation remains compelling while foreign ownership has plenty of room to expand.
Emerging Markets have done very well this year on both the debt and equity side. A go slow Fed backstopped by an administration in turmoil leading to a weak USD has all been good news for EM. At this point it is hard to see how it gets much better suggesting a Neutral position helped by some specific country selections in China (MCHI) and Mexico (EWW) that remain appealing.
The main equity worry at the moment regards the tech sector, which has been the leadership sector in many markets. The concern is that tech seems to be in the cross hairs of governments in each main region: in the US because of its size & role in social media, in Europe because of the regulatory focus Europe is adopting (Google fine etc.) and in Asia where China’s leadership is making it clear to the tech mavens who is really in charge. It’s hard to quantify this risk but it seems real and one that must be considered from both a tech sector and a broad market leadership perspective.
Potential sector leaders in the US include Industrials (XLI), which would benefit from growing interest in capital expenditure spending. This potential is underlined by a recent Philly Fed survey suggesting companies have their most aggressive plans to boost cap ex since 1984. GE, an Industrial sector bellwether, is flirting with 52 week lows, offers a 3% + dividend and may be worth a look. European sector leadership remains the banks (EUFN) that both hedge Euro strength and benefit from rising rates. In Asia tech, consumer and OBOR related plays remain appealing.
There may also be an opportunity to position in US small caps (IWM) for a surprise legislative achievement in the tax space; the weak dollar has been a boon to large caps and the potential exists for a dollar rally. A tactical trade out of large caps and into small might be the surprise trade of the 2H. Small caps are roughly flat year to date, have been sold pretty aggressively and are testing significant technical support… worth a ponder.
The focus here has been on USD fixed income with particular focus on USD EM debt (EMB), US High Yield (HYG), preferreds (PGF) and mortgages (REM). In local currency terms both Asian and European bond market returns have been roughly flat year to date while US Agg is up close to 4% and USD EM up roughly 7%.
Credit is late cycle and HYG is down so far in Q3 suggesting a caution flag at the least. On the positive side, recent significant outflows from HY ETFs do suggest the bond bubble/stock market bubble talk may be misplaced.
There continues to be more demand for long duration safe assets than there is supply; it’s a structural issue that is unlikely to change in the near term. With JGB rates capped by the BOJ and EU sovereigns heading higher to reflect the better economy, EM sovereigns and UST offer the only game in town.
Gold and silver remain important portfolio hedges in case bad stuff happens; continued outperformance Q3 to date is no surprise given what has already been discussed.
The real question in this space is the industrial metals rally with Dr. Copper up 36% over the past year and 11% Q to date while zinc, iron ore and other metals have also rallied sharply. Is Dr. Copper suggesting another leg up in the global economy fueled by the cap ex pickups noted above or is the move supply related or perhaps just a head fake? I lean toward the former but hesitate to jump in after such a run.
Infrastructure continues to do very well, especially in the limited public equity ways to invest. This remains a huge global theme that will play out over years. Another area of opportunity lies in the logistics sector as discussed previously. XPO, one of the largest US logistics companies, is off roughly 15% from its recent high after some profit taking and may present an interesting opportunity. There are few ways to play either theme, especially logistics, a growing sector that I have taken to referring to as the “pick & shovel of the Ecommerce Age”.
All in all, plenty to peer through… enjoy the last few weeks of summer… Fall is gonna be busy!