Chris Forrest, Senior Partner
Sovereign Wealth Partner
This month members of Sovereign attended the Portfolio Construction Forum Market Summit 2017. The purpose of this Summit is to deliver a wide range of investment views and perspectives to challenge our thinking. The theme this year was “The winds of change”.
The context each year reflects the themes of the day and, unsurprisingly, it was dominated by low interest rates, low global growth, Donald Trump and the rise of populism.
We heard political views as well as the economic rationalist ones and it can be difficult, when bombarded by conflicting but persuasive views to make any sense of it all. This article gives you an outline of the most interesting messages and our take on them.
Looking at it in three segments:
1. The geopolitical and economic commentary;
2. The bond gang (versus); and
3. The equity gang
Geopolitics and economics
On geopolitics we heard from Professor Niall Ferguson – Senior Fellow, The Hoover Institution (Stanford), Jeremy Lawson – Chief Economist, Standard Life Investment (Edinbugh), Linda Jakobsen – Director, China Matters, Jonathan Pain, Author, The Pain Report and Stephen Halmarick, Chief Economist & GM Economic and Market Research Colonial First State Global Asset Management.
Professor Ferguson highlighted two comparable eras: the Ronald Reagan administration of the 1980’s which saw a new republican president following a democrat perceived to be weak on foreign policy and a troubled economic environment and 2017 which sees a Trump administration following a democrat perceived to be weak on foreign policy and the cause of a troubled economic environment. Both had strong Russian links, the former with Mikhail Gorbachev and the latter with Vladimir Putin. Both wanted to revive America with slogans of “morning again in America” and “ make America great again”. Where the comparison differs though is that the Reagan administration kicked off globalisation in answer to economic malaise whilst the Trump administration blames it for America’s economic ills. Trump policy, however, is isolationist and he faces voter backlash (no president has entered the White House so unpopular), Republican antipathy and a low growth environment (the Federal Reserve expects around 2% growth in 2017, half of Trumps estimate). Trump is alienating China who may have only represented 3% of world output in the early 1980’s but now accounts for 18%. In Davos this year, Xi Jinping defended globalisation with the analogy “Pursuing protectionism is like locking oneself in a dark room. While wind and rain may be kept outside, the dark room will also block light and air. No one will emerge as a winner in a trade war.” Trump should not be underestimated but he is potentially underestimating his opposition, including his own administration.
Jeremy Lawson warned us that populism is a symptom rather than a cause and, if it continues without democratic accountability it will present challenges to globalisation and therefore markets. Over decades, global trade barriers have fallen and, alongside broad based deregulation, global GDP has tripled since the 1980’s. The evidence of the benefit of globalisation is best illustrated below in a chart commonly referred to as the Elephant chart – it shows that globalisation has helped lower global poverty with the exception of the absolute poorest– the losers have been the lower and middle classes in developed nations which have gone sideways to backwards.
Jonathan Pain asks the question, does political analysis matter when investing? In his view, yes. Jonathan looks for catalysts that are likely to change the prevailing environment. Look no further than the accession of Shinzo Abe in December 2012 (which was the catalyst for the Nikkei to surge in the subsequent 5 months) or Narendra Modi in 2014 (which saw the SENSEX rise by 30%). Both of these leaders have strong nationalistic tendencies. Then in 2016 the two events that weren’t supposed to happen, happened and they weren’t a disaster for the markets, but rather quite the opposite. And all we’ve been able to do is talk about what will happen under Trump – his view is, take him at face value: he’s likely to get through a Republican controlled Congress most of what he wants despite the so called checks and balances. Pain’s greater question is, how will China respond to the Trump administration populated by China hawks? His investment advice is implied by his approach: be nimble, be flexible and non-dogmatic.
Linda Jakobsen sees US-China relations under Donald Trump being strained and turbulent and sees more friction on the horizon. Governments in the region don’t want to be forced to choose between the US and China and at the same time no one wants to see the US neglect the Asia-Pacific. If the US does abandon the Trade Pacific Partnership, this may open an opportunity for China which would be a test for the economically interdependent region. A major crisis over Taiwan, the South China Sea or a trade war would be deeply felt. In Linda’s view, Canberra should reach out to China (our largest trading partner).
Stephen Halmarick gave us the Colonial First State position, pulling it together for investors. As he sees it, the dominant theme is global growth and reflation inspired by Trump’s positive policies including tax cuts, repatriation of profits tax discount, infrastructure expenditure program, deregulation and increase in military spend. The negatives being protectionism, anti-migration, no support for free trade and the potential changes to the US Federal Reserve (3 positions will become vacant). He expects three phases: 1. “Risk off” – this lasted 12 hours after the election result; 2. “Risk on” with focus on stimulus – there will be a bond market selloff as the US Federal Reserve continues to move on interest rates. This selloff could be aggressive but will come to an end as the Fed rate rises come to an end in 2018/19. 3. The impact of higher interest rates may end in a recession in 2018/19. Debt in the US will rise from 76% to 105% of GDP by 2026 but the intended impact is an increase in the growth rate of the US economy. Can we expect to see this target growth rate (of around 4%pa)? Probably not without an increase in productivity. In Australia, business investment is a drag but strong growth in the first quarter of 2017 is expected due to the rebound in resources and improved terms of trade. Exports in resources are at record highs before West Australian gas exports hit the numbers later this year. Tourism and education exports are rising (Australia’s 5th and 3rd largest exports). Inflation is at the low point and can be expected to drift up to the target range of 2%-3%. He made is sound all so predictable if it weren’t for the Bond gang disagreeing with him.
The Bond Gang
We heard from Joachim Fels, Managing Director and Global Economic Advisor, PIMCO (Newport Beach), Robert Mead, Managing Director & Co-head of Asia Pacific Portfolio Management PIMCO (Sydney), Charles Jamieson, Executive Director, Jamieson Coote Bonds (Melbourne), Jeffrey Reemer, Director, Senior Analyst & Client Portfolio Manager, Invesco Senior Secured Management (New York), Brett Lewthwaite, Executive Director& Head – Fixed Income and Currency, Macquarie Investment Management (Sydney) and Vimal Gor, Head of Income & Fixed Interest, BT Investment Management (Sydney).
Ask a Bond Manager what they expect and they will tell you the sky is about to fall down. And they didn’t disappoint!
Joachim Fels encouraged us to consider ‘left tail risks’ i.e. potential downside outcomes. He wants us to think scenarios rather than baseline outlooks. Sounding very much like a statistician, he wants us to consider a ‘probability distribution’. In his view the left tail risks are generally being ignored – what would the impact be of a currency war? He sees three broad scenarios for the US: 1. Base – orderly transition, moderate fiscal boost, trade war avoided, Chinese currency depreciates a little; 2. Bull – smooth transition, bigger boost, Trump trade continues, Chinese currency stable; 3. Bear – fiscal stimulus under delivers, severe trade tensions, world recession continues, Chinese currency depreciates by 15%. His predominant concern was the US has little spare capacity at a time when stimulus hits –wages are accelerating and this will show up in inflation. Markets have not priced in enough inflation – so much so he fears the US Federal Reserve could turn quite hawkish and tighten too much at a time when the ‘new neutral’ is lower.
Jeffrey Reemer of Invesco thinks bonds are dead. Perhaps he’s a wolf in sheeps clothes and not really one of the Bond Gang. His key message is to seek out alternative debt investments, namely senior secured loans – debt investments which are exposed directly to corporate debt rather than through a bond structure with attractive floating rates of interest and low default rates. Yes, of course Invesco has a fund offering just this type of opportunity.
Back in the gang is Brett Lewthwaite who was very matter of fact. He says rates will rise but just a little and this is being reflected in the yield curve. The world is just far too indebted – high levels of debt and high interest rates are not natural partners and, if you do believe in high interest rates coming then you believe in debt destruction and asset value depreciation. Brett’s view: it’s time to take on duration in bond portfolios. Highly controversial as many other chicken-little’s are keeping duration very short. But Brett’s track record is pretty good and he wasn’t shy about telling us so.
Vimal isn’t so matter of fact. They sky really could fall down. And credit will be to blame. As credit spreads narrow (the premium paid by higher risk bonds over the government bond rate, also known as the ‘risk free rate’), credit becomes susceptible to higher defaults as interest rates rise and a blowout in the credit spread potentially leads to contagion in bond markets.
The Equity Gang
We heard from Charles Dallara, Partner and Chairman of Americas, Partners Group (New York), Ronald Temple, MD, Co-head of Multi-Asset & Head of US Equity, Lazard Asset Management (New York), Olivia Engel, Deputy CIO & Head of Quantitative Equities APAC, State Street Advisors (Sydney), Jacob Mitchell, MD, CIO & Portfolio Manager, Antipodes Global Investment Partners (Sydney), Martin Conlon, Head of Australian Equities, Schroders (Sydney) and Kerr Neilson, CEO and Founder, Platinum Asset Management (Sydney).
Well, what a cast. They all did sound like equity managers except for Martin Conlon of Schroders – for him the sky is about to fall on our heads. Martin doesn’t think we have been in a low inflation environment but rather a very high inflation environment if you look at the long term impact of leverage on financial assets, exacerbated since the GFC by low interest rates and quantitative easing. If you are trying to buy a house in the Sydney market you may be sorely attempted to agree with him. In fact, his words were “reserve banks have been sponsoring a Ponzi scheme”. So, Australian equity portfolios are vulnerable to inflation at a time when company debt exceeds pre-GFC levels – he is concerned about the prospect of rising inflation and interest rates. Quite the contrast to Brett Lewthwaite of the Bond Gang. In fairness, Martin doesn’t think we will see huge interest rate rises but the inflation of financial assets will come to an end and so he seeks out companies with very strong free cashflow – his very large overweight to the mining sector paid off handsomely in 2016 after two years of particularly poor performance. He chooses to avoid defensive industrial stocks because they are too bond like (i.e. vulnerable to being sold off as interest rates rise) and banks sit somewhere in the middle since they are both beneficiaries of inflation and attached to credit growth. Finally, he pointed out that almost every sector is aging its asset base to support free cashflow, meaning they now have minimal capacity to cut back on investment and the age of high dividends at the expense of investment have limited days. In short, everything has been distorted by monetary conditions and nothing is cheap. Mid single digit returns will be a good outcome and the index is a dangerous place to be.
Kerr Neilsen was as sanguine as ever. Investors should not believe they are armed with appropriate knowledge from headlines and opinion pieces and nor should they believe in the stereotypes of the world like Japan’s demographics, Europe’s sclerosis, China’s excessive leverage, India’s chaos. Rather, investors are well served pursuing investment opportunities based on data rather than feelings and impressions. The data points to opportunities offered by Japanese exporters, Chinese consumer companies, Indian utilities and European banks over the medium term. Unsurprisingly, we heard some similar themes from Jacob Mitchell, formerly of Platinum Asset Management – specifically European banks. Jacob’s view is that there are plenty of places to invest if you go looking and the approach of Antipodes was emblematic of his presentation “we seek out companies who win in multiple ways” by which he means they have a number of levers they can pull to enhance their business and he contrasted Apple (maker of hand devices) to Samsung (maker of hand devices and parts, including those Apple buys off Samsung for the iPhone). Neither presenter concerned themselves with Trumponomics –it’s all about the stocks, judged on their own merit.
Albeit a different approach, Olivia Engel’s message was to seek safety in numbers. Well, of course, that’s how they manage portfolios at State Street! You may often hear about the concentrated portfolio but the State Street view is you can have a 100 stock portfolio and each one is a conviction call. The result being a portfolio not vulnerable to a few poor performers hijacking the portfolio but rather an actively managed portfolio generating outperformance with lower risk.
So, if we believe the most strident of these speakers, the world is on the cusp of a trade war between the US and China, populism is rife and leads to protectionist policies which will lead to higher inflation and an interest rate response by Central Banks. Currency wars will ensue and equity markets will be in turmoil. The populist vote of the developed world middle and poorer class will undo globalisation and we shall go back to the good ‘ole days, the cost of which will lead be debt destruction and asset prices being devalued. Unless they don’t of course because a highly indebted world can’t afford high interest rates and the central banks won’t let that happen. Just in case, don’t buy bond like stocks. Then again, it doesn’t matter if it’s all about the quality of the stocks you’re investing in and so much the better if interest rates don’t go up very much, you can buy some longer dated bonds to bolster the yield of your portfolio.
Business as usual, carnage or a reason to be cautiously optimistic?
There is no doubt that the winds of change are afoot. Economic expectations world wide have improved markedly in the last two months. Long term interest rates and inflation expectations are heading up. Geopolitical risks have increased and value is hard to find.
Be cautious and nothing is cheap were perhaps the clear message coming from this Summit. All of these speakers believe in active investment and they have their strategies to deal with uncertainty and the winds of change. Sovereign’s philosophy revolves around taking an active approach to investing – as there is the potential threat of rising inflation and interest rates, we have our views on how fixed interest should be used in portfolios, the use of floating rate instruments, equities to avoid and the benefit of hard assets. Invest in a good set of sails to navigate the winds of change.