Analyst Research
1 March 2020
Overarching view: In our last quarterly update in July we pulled back our exposure to Asia / Emerging Markets and Europe, whilst increasing our weight towards the U.S. Pleasingly, the market conditions played out exactly the way we had anticipated – U.S. equities outperformed their global counterparts (as the U.S. economy continues to outperform), U.S. dollar appreciated, and Emerging Markets experienced a major sell-off. This is reflected in our solid performance for 3-months to 30 Sept-18. Whilst we are inclined towards low portfolio turnover, we also believe we need to remain dynamic and responsive in what is clearly a highly uncertain period in markets. Having said that, we continue to see more of the same in the short term hence we have left our strategies unchanged. The number one question on our radar is when to increase exposure to EM equities.
- (Still) Keeping it simple – Equities, Bonds and Cash. Whilst we continue to assess alternative assets to introduce to the portfolio for diversification purposes (Hedge Funds, Asset Backed Securities, Secured Loans etc), we continue to adopt the simple strategy of viewing the world in three asset classes. In our view, the best form of alternative to equities and bonds is cash. Broadly in the current environment we continue to favour equities over bonds, as the risk to global rates remains to the upside, and also increased cash.
- Geopolitical tensions continue to rise. Policies out of the Oval Office in Washington D.C. President Donald Trump continues to put pressure on China on matters of trade and China hacking issues have emerged. Further, developed nations continues to allege Russia makes blatant attacks on the sovereignty of various nations.
- Emerging Markets (EM) take a bath. Whilst we were on the right side of this trade, still the sell-off in EM was aggressive, in our view. Turkey and Argentina led the negative sentiment, with their respective currencies (lira & peso) plunging. Also, not assisting the overall sentiment towards EM, was a stronger U.S. dollar, with all time high EM U.S. dollar denominated debt spooking investors. Whilst the valuations are looking oversold, we have not look to increase exposure yet. Simply because U.S. dollar will find support in the short-term (long-term we do see headwinds), we see moderating growth across EM and moderating China growth (large customer of most EM economies).
- S. Fed not worried about EM volatility but when will they be? Investors may be grappling with the question whether the U.S. Fed will consider any market volatility or slowing down in EM economies as part of its decision to aggressively raise rates. It is important to remember the three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices and moderating long-term interest rates. With all cylinders firing in the U.S., we see little reason for the U.S. Fed not to move towards the path of raising rates to more normalised levels despite growth in other regions moderating. Further, the potential inflationary pressures from trade wars and solid economic growth (increasing wage pressure) will also likely keep the U.S. Fed motivated to stay the course. However, given the U.S. economy and businesses export to EM, EM economic pressure materializing within U.S. GDP growth data will give the U.S. Fed more a cause for pause. Investors need to watch the U.S. PMI numbers for signs of this.
- Given the recent sell-off in equities markets, valuations across the spectrum appear less stretched than previously especially when considering earnings growth estimates. In our last quarterly update, we lowered exposure to EM / Asia and Europe, whilst increased exposure to U.S. equities. At this stage we do not feel the need to reverse this despite EM clearly looking good value at these levels.
- Rising bond yields around the globe remain a key risk to bond returns in the short term, hence whilst there is heighted uncertainty we see little value in going long duration.
- Multi-Asset Strategy MP. We have made no changes to our SAA multi-asset strategies and TAA strategy since our previous update in July 2018. We remain:
(1) Inclined towards active management versus passive (lower exposure to ETFs);
(2) S. remains our major exposure, however we continue to monitor EM valuations; and
(3) More cash deployed to more defensively positioned fixed income managers and Australian fixed interest.
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Emerging Markets – Value is emerging but hold fire…
Over the last three months, EM has experienced a significant sell-off as contagion fears from Argentina and Turkey spooked investors. Added to that is the constant trade war talks between the U.S. and China (key trading partner for EM countries) and higher rates in the U.S. India has also seen aggressively selling across the spectrum.
Figure 1: Valuations and price performance for key indices
Source: BTIG, Bloomberg, Thompson Reuters, Datastream
Stronger USD. The stronger U.S. dollar has exacerbated investors’ concerns for USD denominated EM debt. However, as the chart below shows, despite the USD leveling off after the initial rise, it appears the markets have paid little attention to this.
Figure 2: U.S. dollar vs. major world currencies
Source: Bloomberg, BTIG
Brazil – comes good, but potentially more to come…
At our last quarterly review in July, we reduced the weighting towards emerging markets and Asia across our portfolios, but we persisted with our tactical asset allocation towards Brazil despite significant negative sentiment towards the country (election uncertainty) and EM in general. This trade in the last quarter has been a positive contributor to our performance, given our exposures via iShares MSCI Brazil ETF and Vaneck Vectors Brazil Small-Cap ETF. Our TAA Model Portfolio delivered close to 4% over the 3-months to 30 Sept-18.
Figure 3: BTIG Tactical Asset Allocation (TAA) Brazil exposures
Source: BTIG, Company, Bloomberg
Brazil elections results boost markets. The 63-year-old Jair Bolsonaro, who is ex-military and right-wing, has pulled off a surprising result in the Brazilian presidential election. Whilst he did note receive the 50% majority to avoid a run-off ballot later this month, the pro-dictatorship former military officer beat his presidential rival by a 17% margin to achieve 46% of the vote in the first round. He now needs only 4% to achieve majority. The markets have responded positively to the results given Mr Bolsonaro’s liberal views and potential for pro-business structural reforms. He noted the following post-election results: “…people of Brazil want to rid themselves of socialism…they want a liberal economy and they want to defend family values”.
More room to outperform, but not without risk. In our view, there is further upside to Brazilian assets as the potential for pro-growth policies being passed start to become more evident if Mr Bolsonaro wins a clear mandate. This will be more easy given the increased clout of right-wing parties at the congresional level. He is in favour of privatisation and tax cuts. Further, he has taken a strong stance on corruption and violent crimes, vowing to give the Brazilian police more power . The following are Mr Bolsonaro’s key economic policy proposals:
- Interest rates. He has spoken about the need to reduce interest rates, which should help with borrowing costs of Brazil’s significant public debt.
- He is open to privatisation across all sectors, but “strategic sectors” such as mining and energy, he will regulate should foreign entities want to purchase. The likes of oil company Petrobras could be on the sale agenda.
- Foreign trade. He has expressed desire to increase trade with the U.S. and is cautious of Chinese investments given the level of concessions offered.
- Pension reform. Much needed, he has offered to take a more systematic approach to addressing Brazil’s unsustainable pension system.
We retain our tactical asset allocation to Brazilian equities, as we see further upside from improving business sentiment (should support business investment), potentially lower taxes and borrowing costs.
Economic Surprise Index – Improving for Eurozone…
Citi Economic Surprise Index. These indices are objective and quantitative measures of economic news. As per Bloomberg, they are defined as weighted historical standard deviation of data surprises – that is, actual releases versus Bloomberg consensus estimates. Therefore, a positive reading of an index would indicate economic releases have been, on balance, coming in ahead of consensus expectation. As we have previously noted, investors shouldn’t interpret a negative reading as an indicator of an economic downturn or a strong correlation to predicting stock price movements. We use it as a mechanism to see market’s expectations of various economies around the globe.
U.S. & Eurozone. Whilst the U.S. experienced a solid doze of high market expectations at the end of 2017, this has since retreated over 2018, but bounced out of negative territory. What this suggests is that market estimates are now largely in line with the actual data. On the other side, the Eurozone has bounced out of deep negative territory, suggesting negative data surprises are diminishing. If the trend continues, this may suggest consensus may have become too bearish on the Eurozone in their forecasts.
Figure 4: Citi U.S. Economic Surprise Index
Source: BTIG, Bloomberg
Figure 5: Citi Eurozone Economic Surprise Index
Source: BTIG, Bloomberg
Figure 6: Citi Emerging Markets Economic Surprise Index
Source: BTIG, Bloomberg
Figure 7: Citi Major Economies Economic Surprise Index
Source: BTIG, Bloomberg
Equities…
Global valuations. In the figure 8 below, we have provided consensus earnings estimates by key developed markets and regions. Further, we have provided the PEG ratio to put into context the headline PE-multiple and growth estimates.
DM vs. EM. Given the recent sell-off in equities markets, valuations across the spectrum appear less stretched than previously, especially when considering earnings growth estimates. In our last quarterly update, we lowered exposure to EM / Asia and Europe, whilst increased exposure to U.S. equities. At this stage we do not feel the need to reverse this despite EM clearly looking good value at these levels.
Hold fire on EM but looking like a great contrarian play. In our view, not all EM economies are created equally, but certainly the sell-off in EM equities suggests investors are treating them all the same. We expect sentiment towards the region to remain one of caution given rising interest rates and the impact of a firming U.S. dollar on EM debt. U.S. equities continue to signal good value given the solid economic prospects and earnings growth. Europe continues to signal reasonable valuation; however economic growth is moderating. Should economic data surprise on the upside, this may see support for growth assets in the region.
Figure 8: Global valuations and earnings growth estimates by region
BTIG, Bloomberg, Thompson Reuters, Datastream
Figure 9: Consensus valuations by key markets and sectors
Source: BTIG, Bloomberg; Thompson Reuters Datastream
USA = S&P500, Australia = ASX200, Europe = Stoxx Europe 600, Japan = Topix
Fixed Interest…
Bonds. Rising bond yields around the globe remain a key risk to bond returns in the short term. U.S. long-term bond yields have recently broken through the 3.0% mark, after trading in a range since start of 2018. Given U.S. rates generally set the direction for global long-term yields, we have also seen long-term yields in Germany, Japan and Australia push higher in recent times.
Still not keen on duration. We remain cautious in adding duration as we continue to see upward pressure on U.S. rates from a solid economic growth.
Figure 10: US 10-Yr Bond Yield (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
Figure 11: German 10-Yr Bond Yield (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
Figure 12: Australian 10-Yr Bond Yield (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
Figure 13: Japanese 10-Yr Bond Yield (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
When will the U.S. Fed pause for EM? Investors may be grappling with the question whether the U.S. Fed will consider any market volatility or slowing down in EM economies as part of its decision to aggressively raise rates. It is important to remember the three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices and moderating long-term interest rates. With all cylinders firing in the U.S., we see little reason for the U.S. Fed not to move towards the path of raising rates to more normalised levels despite growth in other regions moderating. Further, the potential inflationary pressures from trade wars and solid economic growth (increasing wage pressure) will also likely keep the U.S. Fed motivated to stay the course. However, the given the U.S. economy and businesses export to EM, EM economic pressure materializing within U.S. GDP growth data will give the U.S. Fed more a cause for pause. Investors needs to watch the U.S. PMI numbers for signs of this.
Trump vs. U.S. Fed. Having noted the above, we do note U.S. President Donald Trump has voiced his displeasure at aggressive rate hikes. President Trump’s tenure has been anything but traditional. Hence, whilst in the past U.S. Presidents have not meddled with the U.S. Fed, this may not be the case with President Trump.
Credit markets. Given EM debt is denominated in U.S. dollar, rising U.S. bonds yields, and USD have seen financial conditions for EM corporates and governments deteriorate. Added to this environment is the continuously moderating Chinese & global trade war talk, we seen spreads on EM IG continue to widen. Whilst there may be short-term opportunities to selectively add exposure to U.S. high yield, even at current low spreads, we retain a cautious view on credit markets.
Figure 14: U.S. High Yield credit spreads (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
Figure 15: U.S. Investment Grade credit spreads (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
Figure 16: EM Investment Grade credit spreads (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
Figure 17: Pan-European High Yield credit spreads (%)
Source: BTIG, Bloomberg, Thompson Reuters Datastream
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