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Quarterly Report

Management report – Q4 2016 Q4 2016

20.01.2017

A crucial development from the standpoint of our investment strategy is that fiscal policies are becoming more expansive at the same time that inflation is staging a moderate comeback. This cyclical shift marks the end of a lengthy period during which central banks had the ability to turn any macroeconomic bad news into good news for financial markets.

The global outlook

In our two preceding reports, we predicted a regime change in terms of economic and financial policy with greater emphasis on fiscal stimulus, after a decade of unprecedented central-bank interventionism. We anticipated such a shift for political rather than economic reasons, given that popular pressure in favour of a new policy approach was palpable, and still is. “In light of Brexit, support for Donald Trump, ‘no’ campaigners’ lead in opinion polls for Italy’s constitutional referendum, and the increasing popularity of extremist votes in Europe, a return of these expansionist fiscal policies seems likely,” we wrote.

In the intervening time, Donald Trump has ridden to power on a platform and political narrative calling for higher fiscal spending to boost domestic growth. The Italians, meanwhile, have voted down a proposal to modernise their political institutions that might have helped the country’s economy operate more efficiently, but through the kind of belt-tightening likely to depress the business cycle.

Election after election reveals mounting dissatisfaction with an economic and political system that has left the middle class increasingly vulnerable, just when inflation is picking up in the United States (+2.1%) and even in Germany (+1.6%). The stage is therefore set for a cyclical upturn. Moreover, in this expansionary phase, growth will be less hampered by a massive global debt overhang and, as deflationary pressures subside, central banks will feel less compelled to take action at the slightest sign of a faltering economy. This cyclical shift marks the end of a lengthy period during which central banks had the ability to turn any macroeconomic bad news into good news for financial markets.

A crucial development from the standpoint of our investment strategy is that fiscal policies are becoming more expansive at the same time that inflation is staging a moderate comeback. Rising bond yields – something we correctly predicted – coupled with a sector rotation into cyclical industries and markets – a trend we should have done more to leverage in our equity portfolios – and a stronger US dollar – which we failed in part to cash in on just after the November elections – all bear witness to the sea change taking place. The question at this stage is what investment opportunities and what financial-market risks that sea change will generate.

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United States

Today as much as ever, the United States is the epicentre of the cyclical upswing. How should we interpret Trump’s promises – which may or may not be kept – to use fiscal policy to spur economic growth at a time when a return of inflation looks probable?

Infinitely more important than his pledge to spend heavily on infrastructure is his proposal to cut the corporate tax rate, possibly from 35% to 20%. Such a policy could lead to a cyclical turnaround in profit margins, which have historically been a key determinant of the business cycle. Since the Lehman Brothers meltdown, corporate revenues have fallen faster than costs, with the result that profit margins have tended to shrink. That decline has been a major obstacle to capital expenditure in recent years – even with rock-bottom lending rates. Companies with heftier margins will be more inclined to invest, and thus better able to respond to the uptick in consumer demand that Trump’s victory at the polls has served to strengthen.

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Source: Carmignac, CEIC, 30/12/2016

The year-on-year growth rate in durable goods orders climbed from 0% to 1.8% in November, while the Consumer Expectations Index has hit a thirteen-year high. This renewed consumer confidence should be strong enough to offset slower growth in real disposable income, which at +2.3% year-on-year represents a thirty-three month low. But what these figures show above all is how high hopes in the US currently are. High hopes, however, have a way of being disappointed.

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Source: Carmignac, CEIC, 30/12/2016

If the new US President’s economic programme fails to go through, or goes through too slowly, a rebound in capital expenditure will become a more iffy bet. And that would also be true if companies chose to use the prospective tax cuts to engage in financial engineering. But these possible let-downs are not our baseline scenario. We anticipate more vigorous growth accompanied by mounting inflationary pressure. Several points lead us to believe that inflation will rise faster than the consensus currently assumes. To start with, manufacturers of non-discretionary goods have got into the habit of raising their selling prices in order to offset the downward pressure on profit margins. The same goes for the owners of buy-to-let properties. To make up for low returns on their financial assets, they have hiked rents for the part of the population that can’t afford home ownership. In addition, a steady appreciation in energy prices can soon be expected to lift overall inflation. Finally, after eight years of unprecedented wage moderation, an upward drift is now observable (particularly for managers), with hourly compensation increasing 2.9% over the past year.

This shows that US inflation is by no means a temporary phenomenon caused by rising energy prices, but reflects prices across the underlying economy. And upward wage pressure is starting to feed into it. Even if the expected pick-up in economic growth doesn’t materialise, we believe the inflationary momentum will be strong enough to deter the Federal Reserve from transitioning to a more accommodating monetary policy stance. What we are describing here is merely the standard workings of the business cycle, whose key drivers have clearly swung into action in the United States. Their upside potential is visible today, as is the basis for a subsequent trend reversal.

Given the debt overhang left by a string of crises in preceding years, the Fed is initially likely to take a hands-off approach to inflation in order to facilitate deleveraging. This policy should result in real interest rates staying as low as possible and a steepening yield curve as the economy starts humming in earnest. Further on, after inflation picks up steam due to a lack of intervention during the expansionary phase, it will lead to higher long-term yields and cyclical contraction. In other words, the good old economy is back in town.

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Europe

Although the upturn in Europe is nowhere near as strong as in the United States, two recent developments suggest that GDP growth on the other side of the pond is still having a knock-on effect here. First, German factory orders have reached a thirty-month high, and they are being driven by exports. This means that growth abroad will spread to Europe via Germany.

Second, the latest German inflation readings point to an unusually sharp rebound, with food, energy and rent prices as the biggest contributors. While prices in the rest of the eurozone have yet to pick up to the same extent, the experience of previous cycles leads us to view widespread spillover from Germany as a very likely scenario. As in the United States, a good many political platforms in Europe call for greater public spending. That has long been true in France, but the same may now be said of Italy and Spain as well. This suggests that we may be seeing business cycle synchronisation between the US and Europe, with the usual delay. At a time of resurgent inflation, the ECB will be unable to go on expanding its balance sheet indefinitely through massive bond purchases.

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Source: Carmignac, CEIC, 30/12/2016

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Emerging markets

Though the emerging world seems to be sharply divided into commodity-exporting countries and the others, Donald Trump’s victory at the polls and his protectionist agenda area causing fear in both groups. Mexico is a case in point: the peso has lost 18% of its value since the US elections in November. In contrast, Brazil, a country grappling with a highly unsettled domestic environment, has seen its currency bounce back to its pre-election level. The Russian rouble has likewise gained 6%. The equity markets in both countries have held up rather well, buoyed by stronger GDP growth. Brazil, for example, has gone from a 6% contraction in output to nearly flat growth in the space of a year.

China is still the country with the greatest potential to derail the entire emerging world. Its huge stock of corporate debt has resulted in a systemically fragile economy that is nothing less than a time bomb. Just how worrying that bomb is can be gauged from the capital flight it triggers at increasingly regular intervals. Even so, the economy is recovering and the latest statistics, such as electric power production, are reassuring enough to keep China’s systemic risk from materialising in the near term.

Meanwhile, the newly-developed countries seem fairly well-equipped to deal with further dollar appreciation and rising US bond yields, thanks to a secular improvement in economic fundamentals – first and foremost their declining dependence on foreign capital.

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Japan

Japan is sticking doggedly to its policy of keeping nominal ten-year government bond yields close to zero. The result has been to drive the yen way down (by -16% against the dollar) by encouraging Japanese savers to invest abroad. At the same time, economic activity has continued to recover. Manufacturing output growth surged from 0.2% to 2.9% in November, with all industries contributing to the increase. Japanese policy offers a welcome counterweight to monetary tightening in the US in that it helps reduce global upward pressure on bond yields.

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Source: Carmignac, CEIC, 30/12/2016

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Investment strategy

The general view among pundits is that the election of Donald Trump has created substantial economic and geopolitical uncertainty. Yet financial markets seem to disagree, judging from their highly positive reaction to the event. Developed-country equity markets are ahead by 8% on average, while ten-year sovereign bond yields have gained 65 basis points in the United States and 23 in Germany. The greenback has appreciated against all other currencies – including by 11% against the yen and 6% against the euro. Visibly wagering that the policy mix shaping up in Washington will boost output at a time of renewed inflation, investors have accelerated the sector rotation into the sectors with the greatest sensitivity to changes in GDP growth and the least vulnerability to inflation.

It’s hard to say right now whether the new US President will end up dashing the market’s high hopes, or whether his protectionist policies will turn out to be as drastic as critics fear. Granted, both stocks and bonds already trade at rather lofty valuations. But with strong global economic growth coming on top of continued monetary policy accommodation in Europe and Japan, equity markets look set to scale new heights.

We have accordingly increased our exposure to equity markets to near-maximum level. Our basic strategy is as follows: The unfolding scenario of less erratic growth, coupled with a moderate pick-up in inflation, is likely to put commodities – first and foremost oil, particularly since the recent agreement among OPEC members – at an advantage over stocks with “good visibility”. Chief among the latter are the stocks of drug companies, which will remain a favourite target for populist governments. Our portfolios also include substantial holdings of Japanese financial stocks. They have shed a great deal of their market value – even as their issuers are getting a boost from the global upswing and a weaker yen. At the same time, the political and global economic shifts we discussed above haven’t caused us to lose faith in our tech names, whose bright prospects become brighter every day.

Fixed income markets show as much contrast as ever. A number of emerging-market local currency bonds offer extremely high yields – exceeding 11% in the case of Brazil. Moreover, the hunt for yield can make this an attractive asset class, although careful risk analysis is imperative. As credit spreads narrow, corporate issues may well be buoyed by positive global growth forecasts, but in light of their broadly high valuations and discontinuous liquidity, we don’t see a great deal of investment opportunity here at this stage. It should also be mentioned that the outlook for safe-haven government bond yields has yet to improve. While it’s too soon to proclaim that the long-term slide in sovereign yields is over and done with, we do believe that they still have room to rise further in the near term. We’d like to see ten-year government paper trade at 3% in the United States and 1% in Germany before we move away from our current negative modified duration. Although the Fed has been slow to normalise monetary policy, the change under way may prove to be surprisingly bold if our analysis of US inflation is correct. At the same time, the uptick in German inflation (currently +1.6%) can be viewed as a harbinger of things to come across Europe.

In the foreign exchange market, the growth and inflation differentials between the United States and Europe, and the resulting monetary policy mismatch, have understandably created a broad consensus that the dollar will continue to strengthen. We are wary of this near-unanimous forecast, particularly because it has led many investors to take massive long positions in the US currency. We will therefore be keeping our exposure roughly in line with performance indices. As we argued in our previous report, the outlook for the yen is clearer, given the Bank of Japan’s policy of deliberately forcing the Japanese currency down. We will seek to leverage any pronounced reversal of the weakening trend observed in the past few months by initiating a short position that is positively correlated with risk assets. The currencies of emerging-market commodity exporters will likely remain a major allocation in our portfolios, whereas we hold a large short position in the yuan versus the dollar. We consider this an effective way of hedging all our assets against the risk that the Chinese time bomb will go off.

Source of data: Carmignac, CEIC, 30/12/2016

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