Note April 21,2018: Q2/2018 – Markets, Algorithms and the Political Economy. Adding up to expanded volatility when compared to 2017 are the actual market levels of today in equities and fixed income, the new algorithmic data centricity of today and the assumptions of many market and economic models compared to more classical behavioral views of actual economic activity as being not always rational. Geopolitics including those about trade appear seeping into markets. There appear requirements for higher risk premiums in capital markets as quantitative ease is sluiced back led by the Federal Reserve and fair value issues percolate, including about leverage. We are underweight fixed income with holdings focused upon the shorter durations. We also espouse diversifying asset holdings by including precious metals as overweight while also underweighting real estate. We expect currency volatility to include not just emerging areas but also the U.S. dollar, the Yen, the Euro and the Renminbi.
In equities, even as strong earnings growth is reported for the S&P 500, valuation is elevated. The value discovery process of volatility is likely to be sharply higher for the next 12-18 months. We see espousal as being overdone of the lower valuation hypothesis as favoring Europe and Japan. It is likely an extension of the momentum thinking that has predominated in this global cycle. Instead, we would devote more attention to stock selection and sector rotation. We have underweight Japan and Europe. We favor the diversity of U.S. equites, growth as driver in emerging markets as well as the commodity aspects to Australia and Canada. We see Consumer Discretionary as being in fundamental restructuring beyond simple leverage to better economic growth and have it as underweight. We are underweight Consumer Staples as it is quite likely that their business turmoil could be intense for some time. We are overweight Energy via leadership companies likely to dominate emergence from restructuring with oil prices in our $ 60-70/ Bbl. WTI target range. As events in Europe and Asia especially demonstrate, laggards in restructuring persist a decade later but in our Financials overweight we favor early movers mostly U.S. based as adding to their advantages. Within growth sector alternatives, we have underweight Healthcare as its dynamic undiscovered hypothesis phase based restructuring seems past and operations delivery from M&A accrued has to occur amid political policy flux.
On infrastructure and corporate spending, we have overweight industrial products as cyclically more favorable than consumer areas but various conglomerates appear wanting. We are overweight basic information technology with erstwhile favorites in this cycle of social activity have appeared to lose fangs. Precious metals as portfolio diversifiers amid currency volatility potential rising, tariffs in other commodities and economic growth all represent reasons to overweight Materials. We have underweight REITs after having progressively cut favor before from consumer areas to industrial and commercial – finance cost and its availability have classically been the bane for Real Estate as conditions change. As it seems consolidated from a free for all geographically, we have overweight Telecommunication Services but as alleged collusion reviews in the U.S. show, regulatory risk appears. With administered interest and fixed income yields likely to rise while global climate issues wax not wane (U.S. policy notwithstanding), we expect Utilities to underperform.
Asset Mix
Adding up to expanded volatility when compared to 2017 are the actual market levels of today in equities and fixed income, the new algorithmic data centricity of today, and assumptions of many market and economic models compared to the more classical behavioral views of actual economic activity as being not always rational. Geopolitics including those about trade appear seeping into markets. Conflagration appears very much part of the Levant. After its elections, a more assertive Russia remains very much evident. Post its National Peoples’ Congress in March 2018, a more assertive China both in global economics and in the Pacific can be expected. The belligerence of the United States on trade tariffs may be an opening gambit but many a dispute has escalated on tit for tat responses from opposing parties over trade. There appear requirements for higher risk premiums in capital markets as quantitative ease is sluiced back, led by the Federal Reserve.
Classically, economic activity and political considerations were not considered as being separate, even in academic circles. A skew away from such considerations took place with the advent first of econometrics in the 1960s driven by main frame computing and then further with the computing power revolution of the last two decades expanding into algorithm based market positioning alongside an impression of precision. Yet, both in economics as well as in investments, the actual delivery of results has been at best mixed when considering a plethora still of numerous economic crises, the 1987 portfolio insurance debacle, the emerging market debt crises and the credit crisis bubbling up in 2007. The subsequent massive use of quantitative ease appears part of this continuum of excess skew. We expect better balance in policy as likely to unfold. Actual behavior already demonstrates such change from trade to geopolitics. The rise of populism illustrates the depth of such change in numerous countries from the large and powerful like the United States to the small like Hungary.
For momentum gorged markets with elevated valuation from P/E ratios in equities to fixed income market spread distributions low on already minimalist bases, better balance between algorithmic simulation and behavioral economic activity would represent substantive change when accompanied by changed quantitative ease, however sluiced. The IMF and others like the OECD have highlighted global growth as likely to be around 4% for annual GDP. However they along with the Bank for International Settlements and the U.S. Congressional Budget Office highlight the risks of funding costs and leverage. The Federal Reserve under new leadership has reemphasized a path to less quantitative ease. Given U.S. economic strength, we would expect its Fed Funds rate to reach 3.50% in 1Q/2019 and 10 year Treasury Note yields to concomitantly reach 4.50%. Other major central banks including the ECB, the Bank of England, the People’s Bank of China and even the Bank of Japan moot change in their quantitative ease policies. Even without yield curve inversion, funding cost risks appear to be rising. Yields in BBB corporate bonds and those of emerging markets collectively are now closer to 12 month highs and likely to go higher, not least with spread expansion on top of rising U.S. Treasury yields. Fair value and leverage risk issues loom as interest rates increase.
We are underweight fixed income with holdings focused upon the shorter durations. We also espouse diversifying portfolio holdings by including precious metals as overweight while also underweighting real estate. We expect currency volatility to include not just emerging areas but also the U.S. dollar, the Yen, the Euro and the Renminbi. In equities, we see espousal as being overdone of lower valuation as likely to favor Europe and Japan. It is likely a deliberate or inadvertent extension of momentum thinking that has predominated this global cycle. In contrast to hitherto momentum equity markets, we anticipate selectivity to come into increased focus based on quality of operating delivery and of financial statement strength. In equities, even as strong earnings growth is reported for the S&P 500, valuation is elevated. The value discovery process of volatility is likely to be sharply higher for the next 12-18 months.
Equity Mix
In equities, even as the corporate reporting season for Q1/2018 results moves into high gear especially in the United States with expectations for close to 18% operating result annual gains for the S&P 500 companies and then beyond worldwide, several issues come to mind. We see espousal as being overdone of a lower valuation hypothesis as favoring Europe and Japan. It is likely a deliberate or inadvertent extension of momentum thinking that has predominated in this global cycle. Taking into account their heavier weighting in Consumer Staples that we underweight and paucity in basic Information Technology that we favor, we have underweight Japan and Europe. We favor the diversity of U.S. equites, growth as driver in emerging markets as well as the commodity aspects to Australia and Canada. Markets do not per se discount the same event twice. Strong earnings gain potential from tax changes in the United States have been often mentioned. As well, earlier in this cycle that commenced in 2009, equity markets often rose even as consensus earnings expectations were cut often dramatically from initial levels to those at the cusp of reports for companies and indices alike. Both domestically and globally, political events of stress were ignored. Instead, ample quantitative ease was obsessed over amid little in terms of corrections.
Now, notably in the United States but not exclusively so amid better economic growth worldwide, quantitative ease and ample liquidity is likely to be sluiced back. Equity valuation multiples are already elevated to levels that require unprecedented earnings long term growth arguably over twice that of long history of 7% annually. Political events including not just on geopolitics but also on trade have acquired increased interest even as they are not easily modelled in the algorithmic terms so in erstwhile favor in this cycle. On momentum investing also much in erstwhile favor, the hypothesis has not panned out of Japan and Europe outperforming simply due to lower P/E valuation multiples and nor has it for individual sectors and stocks. As business competition remains stiff according to reporting by companies, we expect selectivity to prevail over indexation attributes like ETFs. The value discovery process of volatility is likely to be sharply higher for the next 12-18 months, as has already been the case compared to 2017 levels. We expect currency volatility to be returning as a business wild card, not just in emerging markets but also in the major exchange areas of the U.S. dollar, the Yen, the Euro as well as for the newly emergent Renminbi and for many smaller advanced countries.
We would devote more attention to stock selection and sector rotation. We have underweight Japan and Europe. We favor the diversity of U.S. equites, growth as driver in emerging markets as well as the commodity aspects to Australia and Canada. We see Consumer Discretionary as being in fundamental restructuring beyond simple leverage to better economic growth and have it as underweight. We are underweight Consumer Staples as it is quite likely that their business turmoil could be intense for some time. We are overweight Energy via leadership companies likely to dominate emergence from restructuring with oil prices in our $ 60-70/ Bbl. WTI target range. As events in Europe and Asia especially demonstrate, laggards in restructuring persist a decade later but in our Financials overweight we favor early movers mostly U.S. based as adding to their advantages. Within growth sector alternatives, we have underweight Healthcare as its dynamic undiscovered hypothesis based restructuring phase seems past and operations delivery from M&A accrued has to occur amid political policy flux.
On infrastructure and corporate spending, we have overweight industrial products as cyclically more favorable than consumer areas but various conglomerates appear wanting. We are overweight basic information technology with erstwhile favorites in this cycle of social activity have appeared to lose fangs. Precious metals as portfolio diversifiers amid currency volatility potential rising, tariffs in other commodities and economic growth all represent reasons to overweight Materials. We have underweight REITs after having progressively cut favor before from consumer areas to industrial and commercial – finance cost and its availability have classically been the bane for Real Estate as conditions change. As it seems consolidated from a free for all geographically, we overweight Telecommunication Services but as alleged collusion reviews in the U.S. show, regulatory risk appears. With administered interest and fixed income yields likely to rise while global climate issues wax not wane (U.S. policy notwithstanding), we expect Utilities to underperform.
Consumer Discretionary: We see Consumer Discretionary as being in fundamental restructuring beyond simple leverage to better economic growth and have it as underweight. Notwithstanding better global GDP growth closer to 4% per year, consumer spending uncertainties are likely being increased by the aggressive threats even with only partial implementation of tariffs, most particularly initiated by the United States but also inevitably being responded to by other countries like China. Rather than being ring fenced to say automobiles as highlighted by the U.S., agriculture has also come into play from commodities to value added items like dairy products and liquor. Meanwhile in many industrialized countries, consumer debt levels appear extended. Wage growth seems muted while administered interest rates appear likely to rise. In Asia generally and in emerging countries especially, the consumer may be transitioning from pure brand aspiration and towards alternates, including those derived domestically that have been improving their quality postures from hitherto shoddier reputations. Companies from Scandinavia to Spain in Europe as well as from North America and even from Asia are finding that fast changing tastes seem creating havoc in erstwhile carefully laid out logistics chains. Online purveyors appear engaged in fierce market share competition and thus pressing traditional companies. Entertainment seems an exception as consumers , especially millennials, seem disposed to spending on experiences over say fashion.
Consumer Staples: We are underweight Consumer Staples as it is quite likely that business turmoil in the space could be intense for some time. Shedding and/or exchanging entire product lines appears to be raging in Consumer Staples, even among companies that previously claimed to be predators and be building on decades of experience. Claiming to be dominant due to size appears not have panned out both for companies based in Europe and deriving high revenues from emerging regions as well as for such companies like the United States based ones that derived high revenues from advanced countries and subsequently attempted to expand to tap the aspirational emerging country spenders. Stresses in consumer staples businesses have been sufficient for companies to engage even in wholesale changes in their location of registration in order to capture some income tax or product tariff advantages. These fast paced adverse developments seem to us not mesh with neither with the emergence of high multiples in this cycle in the investor chase for yield in the face of suppressed interest rates nor with Consumer Staples historical reputation as being defensive and safe.
Energy: We are overweight Energy via leadership companies across the sector as being likely to dominate as the industry emerges from restructuring with oil prices in our $ 60-70/ Bbl. WTI target range. Solar panels and applicable tariffs have been making the political news on fair trade. When compared to the hitherto dominance of hydrocarbons and that of coal a century ago, alternate generation methods are likely to increase in importance as energy sources. However energy change has always been measured in decades and not in immediacy. It is even more so for the myriad products from high technology to pharmaceuticals to kitchen utensils that include components based on manufactured polymers. Meanwhile amid more constrained supply, the International Energy Agency and others point to rising hydrocarbon demand from emerging countries. OPEC members as well as major external producers like Russia appear to be more circumspect about increasing production and indeed have held numerous meetings likely coordinating supply. Shale oil as major disruptor remains a force with the United States as major producer but for self-preservation and finance reasons alone, shale production appears as less of a free for all. Therein seems to us to lie the evidence for the energy industry as now shaking off the severe restructuring stress that gripped the industry for close to a decade. From a recent 2016 low close to $25/Bbl. WTI after a high close to $145/Bbl. WTI a decade before, crude oil at $68/Bbl. WTI has entered into our target stable zone of $60-70/Bbl. WTI of balancing back supply from less efficient sources against rising demand. Crude oil prices are not likely to reignite free for all behavior but seem high enough to benefit leadership companies across the sector. Such companies are after all well versed in risk assessment and in being opportunistic in asset acquisition.
Financials: As events in Europe and Asia especially demonstrated recently, laggards in restructuring persist a decade later. In our Financials overweight, we favor early movers, mostly U.S. based as adding to their advantages. Led by the policy changes already initiated and by the abundant plain talk from the Federal Reserve, there seems little doubt that quantitative ease is passing its apex in substance in U.S. finance. Such signals appear as well from other central banks like the European Central Bank (despite southern European debt), the People’s Bank of China, the Bank of England (despite Brexit for March 2019) and even from the Bank of Japan. We expect as benchmarks, U.S. Fed Funds rates to move towards 3.50% and 10 year Treasury Notes to be concomitantly be at 4.50% yields in a year. Increased market volatility could help trading revenues and higher rates help net operating margins. Still, the laggard banks are likely to still come up against problem loan book albatrosses that should have been addressed much earlier. In Germany with its robust economy and fiscal management, banks still have significant capital weaknesses on top of significant loan portfolio duress. Insurance companies in high growth areas like China have already not been spared the consequences of risk misjudgment as central bank policy changes. India has seen major lending fraud. In the market stretch for yield in this cycle, lower grade junk corporate bonds have ambient yields incorporating low risk premiums. Higher currency volatility seem to us as being likely to pressure emerging country debt denominated in foreign currencies as well. Despite a decade of massive ease that has masked immediate problems, the advantages in Finance still favor those companies most thorough in restructuring their businesses.
Healthcare: Assessing growth sectors alternatives, we have underweight Healthcare as their dynamic story that was based on restructuring seems past and operations delivery from M&A accrued has to occur amid political policy flux. Amid pressures in public finance, drug pricing even for generics has returned as a political policy imperative, currently. It includes that in the United States that is likely to have trillion dollar annual deficits by 2020, according to the Congressional Budget Office in its latest April 2018 projections. Medical product companies have found it challenging to also manage consumer product portfolios and marked them for divestment. After a decade old restructuring in existing operations and strenuous mergers and acquisitions (M&A) into biotechnology, drug companies are now likely faced with scrutiny of operating delivery – long a bane in many industries after a prolonged M&A phase. Notwithstanding stresses in social media, Information Technology is likely to attract greater interest arising from an ongoing communications revolution for consumers, companies and governments alike.
Industrials: On infrastructure and corporate spending potential, we have overweight industrial products as being cyclically more favorable than consumer areas but various conglomerates do appear wanting. Not for the first time and just as notably as in previous cycles going back at least to the 1970s, both operating delivery by segment and overall equity performance has been seen as wanting in many conglomerates. It illustrates the difficulties of managing even all-star portfolios. Not surprisingly, now a late cycle spurt of divestment has followed, often at fire sale prices, in North America, Europe and Asia from aviation manufacture to energy generation equipment, including in the nuclear, solar and turbine manufacture businesses. As is also classical, private equity has appeared to have a role. In big companies and small, the overweight advantages are likely to lie in the focused industrial companies and with less regard being paid to location as engineering talent appears geographical well dispersed.
Information Technology: We are overweight basic information technology while erstwhile favorites in this cycle of social activity have appeared to lose fangs. In many ways for information technology, it seems to be a repeat of prior cycle developments of excess euphoria driving valuation up while management weakness emerge not withstanding technical prowess and hence force change. In this cycle, it has to do with understanding that about multibillion dollar companies do come social responsibility management issues from gender diversity to the protection of client privacy and assets. Meanwhile, the more basic information technology companies are also exposed to the communications revolution such as in software, hardware and entertainment, have already learnt key management lessons in the last cycle and have lower valuations and thus offer investment opportunities, including that of income from dividends. These basic business cohorts make Information Technology as more attractive than Healthcare and more attractive than Consumer Staples as growth defensive hybrids.
Materials: Precious metals as portfolio diversifiers with currency volatility potential rising, tariffs on other commodities and economic growth all represent reasons to overweight Materials. Until very recently, this investment cycle had not been kind to the Materials sector. Some wounds were self-inflicted, in particular the massive overexpansion and overpaying for assets that had characterized its industrial segments. In agriculture ever dependent on natural factors, harvests were generally bountiful. Within the peculiar context of protection for farmers in many countries, new markets did still open up especially in Asia. The chemicals sector was beset with new competition. All of these market elements resulted in massive restructuring of the Materials sector. Meanwhile and amid better global economic growth now touching close to 4% annually according to organizations like the IMF and the OECD, tariff threats appear. Such threats are never far below the surface in both industrial and agricultural commodities but have now increased due to U.S. belligerence and due to the threat of equivalence in response from areas like China and Europe. Amid quantitative ease of unprecedented proportions, currency volatility has been muted between major currencies like the U.S. dollar, the Euro and the Yen as well as the newly emergent Renminbi. Even as quantitative ease is withdrawn in the U.S. and is potentially muted as likely from Europe to Japan, almost on cue, the United States has been raising issues of so-called unfair currency competition. General global political stress remains high and not just in the LeVant. We expect the mainstream focus to rise on commodities areas, even as the momentum fervor drops back in other hitherto favored areas.
REITs: We have underweight REITs after having progressively cut favor before from consumer areas to industrial and commercial – finance cost and availability have classically been a bane for Real Estate as conditions change. After close to a decade of minimal and suppressed interest rates as well as ample funding derived from quantitative ease, we believe adequate appreciation of the risks may be underappreciated of leverage as conditions change. Whether the bursting of the real estate euphoria on existing assets in the 1970s in New York or Tokyo and the tribulations of Canary Wharf in London in its early inception in the 1990s or centuries earlier over Suez Canal funding as well as no doubt within earlier and later crises, the very nature of its funding has made real estate vulnerable to the vagaries of changing winds in finance. Even if sequential in being led by the Federal Reserve to be followed by others, the exit from global quantitative ease is likely to be one such event. Already erstwhile commonly favored areas like shopping centers for cash flow have instead been showing signs of stress worldwide due to fundamental changes such as in shopping habits. Depending on continuing momentum without change has current risks for long dated assets that is likely being underappreciated not least in Real Estate and its linked areas like REITs.
Telecommunication Services: As it consolidated from being a free for all and into just select entities in each geography, we have overweight Telecommunication Services on restructuring but as alleged collusion reviews in the U.S. show, regulatory risk is also appearing. The issues of pricing of services in oligopolies have long been a favored target of regulators and also in political circles. It would appear that the emergence of similar such aspects are coming into the newer technology of wireless communications that is still far from complete. In the extension into content that is increasingly favored by many telecommunication giants both large and small, political and regulatory elements appear wrangling over not just the pricing of services but also about the more nebulous aspects of control and influence over content. The furor over social media and political interference demonstrate how heated such issues have become worldwide. Still, Telecommunications Services have long been used to dealing with governmental oversight and we anticipate its strong balance sheets, consolidation accomplished and growth have more appeal than the classical alternative of Utilities.
Utilities: With administered interest and fixed income yields likely to rise while global climate issues wax not wane (U.S. policy notwithstanding), we expect Utilities to underperform. With long dated and high value assets, Utilities have long been dependent on considerable external finance, often from foreign sources, then and now. Our expectation is that amid growth trending towards 4% annually for global GDP and myriad signs of fuller capacity and labor utilization in the United States, as cost benchmarks, Fed Funds rates could reach 3.50% into Q1/2019 as 10 year Treasury Note yields concomitantly touch 4.50% from present levels already closer to 3%. Meanwhile even in our favored subsector of pipelines as events in Canada show, environmental pressures appear both intense and bifurcated , replete with numerous pressure groups. For electric utilities, increases in power demand accompanys better growth but currently could also be driven by expanding smart communications use. It would raise the pressures to invest in cleaner power facilities beyond simply bringing back mothballed facilities. Private ownership of water facilities appears a political hot button issue and hence at best to be a niche investment opportunity.
Asset Mix
Global U.S.
Equities-cash 52% 57%
-priv. 6 6
Fixed Income 25 20
Cash 12 12
Other 5 5
Total-% 100 100
Geographic Mix
Currency/ Equities Fixed Cash
Real Income
Americas 61% 65% 67% 55%
Europe 22 20 26 37
Asia 9 13 6 3
Other 8 2 1 5
Total -% 100 100 100 100
Global U.S. Stance
Cons. Disc. 6.5% 5.5% Under-weight but favor entertainment
Cons. Stap. 5.0 5.0 Under-weight on valuation excess
Energy 12.0 13.0 Over-weight via strong companies
Financials 19.0 16.0 Over-weight restructuring leaders
Healthcare 9.0 12.0 Under-weight as M&A needs delivery
Industrials 13.0 13.0 Over-weight for capex recovery
Info. Tech. 19.0 23.0 Over-weight basic over social
Materials 8.0 5.0 Over-weight broadly
REITS 2.0 2.0 Under-weight esp. retail space
Telecomm. 4.5 3.5 Over-weight on refocus delivery
Utilities 2.0 2.0 Under-weight but favor pipelines
Total-% 100.0 100.0 () prior weight
StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e