Note January 26,2018: Q1/2018 – Caveat emptor on market momentum arises due to risk, value and societal stress about the distribution of the benefits of global growth. Amid euphoria, diversification is necessary. In equities, valuation contraction is globally a risk. More effort should be devoted to value and progress in restructuring as opposed to momentum. Restructuring leadership in and from the financials remains crucial. We would put more emphasis on sector selection rather than on geographical discrimination. Relative sectoral weightings globally vary widely. On this basis, we expect overall market leadership to still be from the United States via sectors like information technology and industrials, be in emerging markets via growth and include materials/energy segments via markets like Australia and Canada. In overpriced fixed income markets now with changing central bank conditions again led by the Federal Reserve, we position our benchmark towards low to medium duration. Junk bonds especially face the potential for rising risk premiums and illiquidity if adverse conditions were to develop, such as higher inflation or weaker corporate revenues. Central banks need to evaluate systemic risk from the demographic and capital allocation impacts of their policies. In markets, ETFs liquidity is likely not as extensive as the prevailing fervor assumes. After all, iIt was the lesson of the portfolio insurance debacle of 1987 and credit in 2007. From trade to governance to geopolitics, there appear increased signs of political economy fracture. Currency markets need careful monitoring. For these reasons, we espouse holdings in alternate assets, more specifically precious metals.
Asset Mix
Instead of an assessment for markets produced at the end of 2017 or even early January 2018, we have deferred until now – subsequent to details pouring out of global meetings like Davos, the aftermath from U.S. tax proposals and currency change, including bubble like cryptocurrency behavior. Even as global prospects improve, as illustrated by the January 22, 2018 upgrade by the IMF of global GDP growth for 2018 and 2019 to 3.9% annually, issues remain outstanding for the markets. These market issues revolve around risk, momentum and value. At the societal level looms the distribution of the benefits of global growth, whether between countries as vociferously presented by the U.S. government or within populations as expressed in many countries. Irrespective of the momentum sweeping many capital markets, we assess that diversification is necessary. Our diversification includes that into cash as well as alternate assets. Our benchmark asset mix has equities at 52% and fixed income at 25% or globally below benchmark, with cash at 12%, private equity at 6% and other assets at 5% or globally above benchmark.
In equities, more effort should be devoted to value and progress in restructuring by companies as opposed to price momentum. Global GDP growth has improved but is well below the 5-5 ½% annual levels of the mid-2000s. Revenue competition remains intense. However, equity valuations are elevated. Fixed income yields are historically low but rising while administered interest rates increase, led but not exclusively so by the Federal Reserve. Optimal conditions seem currently incorporated into asset markets. On even minor change, volatility could be severe. Restructuring leadership in and from the financials remains crucial. Despite their size in economies, we eschew overweighting consumer areas due to business risk and erstwhile defensive areas like staples, healthcare or utilities due to valuation. Instead, we favor delivery in energy, materials and infrastructure whether in information technology or industrials. In overpriced fixed income markets amid changing central bank conditions led again by the Federal Reserve, we position our benchmark towards low to medium duration. On even minor change, junk bonds especially face the potential for rising risk premiums if adverse conditions such as higher inflation or weaker corporate revenue were to develop.
Central banks need to evaluate the demographic and capital allocation impacts of their policies, something that appears sorely missed in the decade long fervor for massive quantitative ease. Whether in aggregate or relative to a single sector, deliberate or inadvertent at or near its peak, complacency risk is mostly systemic. It was deliberate in 1979/80 for instance, when central banks forced in higher rates and upset corporate calculations that had been based on assuming inflation accounting and energy sector calculations that in particular were based on expecting profitability from frontier fields such as in the Arctic. While Wall Street has been criticized for unsavory practices on credit into 2007, the central banks did contribute (even if inadvertently) by failing to recognize the systemic risk arising from illiquidity in dark corners of credit and not just in mortgages. In the present environment in 2018, we see as especially relevant the BIS Working Paper 680 of December 2017 by H. Hesse, B. Hofmann and J. Weber titled “The macroeconomic effects of asset purchases revisited” in which rationale is raised that the 2008/11 quantitative ease may have been effective but subsequent ones seem less so. Economic activity has improved but is still constrained in real investment or distribution. Meanwhile asset prices have boomed, both geographically and sector wise. As administered rates are increased, systemic risk may once be more severe and less seamless than recognized. Potential impact includes that on the funding of government debt well beyond Greece, on the structure of corporate balance sheets after the spate of share buybacks and last but not least, for ETFs where liquidity is likely not as extensive as the prevailing market fervor assumes. These were after all the lessons for institutions of the portfolio insurance debacle of 1987 and that of credit in 2007 when conditions changed.
Even if glossed over at Davos, there also appear to be increased signs of political economy fracture developing. Currency markets need careful monitoring. On trade and pressures of systemic import, recent events include the U.S. Treasury Secretary wading into the currency arena in espousing decline in U.S. dollar exchange rates even as the administration touts tariff initiatives, eschews global trade liberalization structures like the Trans Pacific Partnership and threatens likewise for the North American Free Trade Agreement. Currencies are still the most heavily traded of capital market instruments and utilized by countries for flows, by corporations for business purposes and by institutions for investments. Currency breaks do flare with suddenness as seemingly disconnected events coalesce into fracture. The current major currencies to watch are the U.S. dollar, the Renminbi and the Euro. Break examples include those around the Plaza agreement period of the mid 1980s for major currencies ( like then the Deutschemark and the Yen) and the U.S. dollar or for that matter the Malaysian Ringgit and Russian Ruble in the 1990s or any number of emerging currencies in prior and subsequent times. The same can even be said for decades for Sterling. From Europe, Brexit negotiations with Britain appear raising myriad trade and services issues within the European Union itself and outside. While there have been positive developments like the non- U.S. members of TPP just now reaffirming their trade agreements, currency volatility and unilateral tariff initiatives do have a sorry history of unpleasant fissure and not just in the 1930s. The stresses between Russia and Europe at their mutual borders, the myriad violence in the Middle East/Levant including that over Iranian nuclear intentions, stresses around the south China seas and the bellicosity about North Korean nuclear/missile capabilities represent outstanding geopolitical risks of pressure. In this regard, stress eruption geopolitical and internal risk should not be underestimated from the Russia probes in Europe and the United States. Governance fissure in Washington was demonstrated in its shutdown, however short term and alleviated only with yet another continuing resolution. Such fissure is apparent as well in Brussels and internally in many countries in Europe. Constitutional change has long been a hot button issue in Japan, made more so by tensions in the Korean peninsula and south China seas. For these political and currency reasons, we espouse holdings in alternate assets, more specifically precious metals.
Equity Mix
During the later periods of quantitative ease, equity valuation expansion has been a salient development for markets worldwide. As quantitative ease diminishes as primary policy tool, momentum, growth at a reasonable price and valuation are not ephemeral considerations. Such evolution of valuation issues are relevant as global GDP growth in 2018 expands closer to 4% annually but is still likely not to be to the 5-5 ½% annual growth level of the five years to 2007 immediately prior to the credit debacle unfolding. The present equity valuation issues can simply be illustrated in two ways. Already at 2.65%, were 10 year Treasury Note yields to rise to even 3% (compared to an average of 5% as being neutrality), placing a 2% risk premium would lead to an S&P 500 P/E ratio of 20x. Alternately and compared to long term P/E ratios of 16x and earnings growth of 7%, present S&P 500 P/E ratios would need long term (not just quarterly year-over- year or even annual 2018) earnings growth to be sustained at an annual average of 11%. Either way and at least partly on momentum, equity markets appear already to be assuming a secular sustaining of both lower interest rates and higher earnings growth than in the past. Yet, central banks appear to have targeted lower capital leverage for financial institutions upon which to lend. We assess that consensus earnings estimates have already been incorporated into overall market index levels like the S&P 500, including the benefits of U.S. tax cuts. Our own estimates are lower. Any shortfall would likely to lead to volatility. In benchmark holdings, more focus on value and diversification seems to us to be appropriate.
Restructuring leadership in and from the financials remains crucial for equities. Due to the rapid current changes in business conditions that have ranged from evolving consumer preferences to consumer balance sheet leverage and the likelihood of rising interest rates, despite their size in many economies, we eschew overweighting consumer areas due to business risk. We underweight erstwhile defensive areas like staples, healthcare or utilities due to valuation considerations. For businesses that are likely more advanced in their internal restructuring, we instead favor delivery in energy, materials and infrastructure whether in information technology or industrials. As prevailing consensus appears to expect, benign and seamless transition into modestly higher rates and stronger global growth would indeed favor transition into lower valuation major markets like Europe. Despite being in a distribution spectrum and despite earnings growth, equity valuation worldwide is elevated and is, in particular, likely to feel the effects of increases in U.S. 10 year Treasury Note yields. Rather than on geographical discrimination, we would put more effort into sector selection. Relative sectoral weightings do vary widely globally. On this basis, we expect market leadership to be determined from the United States via sectors like information technology and industrials, in emerging markets via growth and from materials/energy segments via markets like Australia and Canada.
Consumer Discretionary: Previously in this cycle, consensus confabulated size with investment opportunity. It has been tardy in recognizing fundamental consumer change. Lately a view has again appeared that amid debacle, Consumer Discretionary offers overweight opportunity due to global growth. We disagree. To yield results, business restructuring takes years and not weeks or even months. In the United States, hitherto marque companies have amply demonstrated the business stresses inherent in restructuring in consumer discretionary, even when being managed by private equity investors. In consumer discretionary activity today and not just in advanced economies like the United States or Europe, we see ample evidence that consumer shopping patterns are still changing. Change includes that in emerging large economies like China and India that were anticipated to favor global brand based activity. Information technology or internet based companies have been earliest in recognizing this change and have evolved beyond just product/service delivery. In addition to financing it, they are integrating into brick and mortar locations as direct challenge as well. Among legacy consumer discretionary, entertainment appears most advanced in its own restructuring strategies to accommodate more consumer focus on the experience. We have overweight entertainment but are otherwise underweight consumer discretionary, expecting it to still reel from unanticipated change.
Consumer Staples: Amid increased worldwide penetration into broader consumer products by hitherto internet companies, other early mover basic staples companies have accrued consumer shopping aisle control advantages over both more tardy competition and over their manufacturing/brand name suppliers. On the urgency for brand pruning, detractors in consumer staples have appeared to have been misinformed in expecting leeway in scope and pace. In turn and not least in the hoped for growth segments of emerging countries, instead of leading in logistics and obliterating domestic players, global staples companies appear to have been forced to follow the packaging strategies of their domestic competition. From smart phones to consumer staples marketing, local market knowledge has appeared important. While the initial private equity forays into business and board change appear to have been parried by global marque consumer staples companies, substantive business change remains paramount to boost return on investment. Meanwhile and far ahead of the time required to engineer such change, yield oriented investors drove up the valuation of such companies. Despite our concern about overall equity valuation and the erstwhile defensive reputation of Consumer Staples, we underweight them due to their valuation given their present business conditions.
Energy: Despite excess euphoria about so-called shortage of supply drove crude oil prices up towards $145/Bbl. WTI only to be followed by lows of $25/Bbl. WTI as a result of U.S. shale oil discovery and conventional country revenue thirst driven mismatch, we have maintained that the stable zone for crude oil would likely be closer to $ 60-70/Bbl. WTI. Crude oil benchmarks like WTI and Brent have now entered this important threshold. The fundamental developments have been that weak oil prices have driven out leveraged oil production business strategies. Companies have been forced to sell or close facilities due both to balance sheet and production cost stress. In turn, both OPEC members and those outside like Russia have been forced to recognize the folly of “beggar thy neighbor” production strategies in hydrocarbons. Furthermore supply/demand data like that from International Energy Agency appears to indicate to us, that demand has room to rise especially from Asian countries like India. Pollution angst and inclement weather appears finally to be turning around even long suffering natural gas. Still, our $60-70/Bbl. WTI stable price zone target would mean that the advantages of restructuring remain, for alternate energy suppliers like solar or wind based technologies as well as for hydrocarbon based ones. The imposition of U.S. tariffs on solar panels would underscore such stresses. We have overweight Energy but it is based on expecting advantages to still accrue to the more strongly financed energy companies with diversified business strategies. It would hold for exploration, services and integrated companies as well as those companies engaged primarily in alternate businesses like solar power.
Financials: A decade after the emergence of credit and liquidity crisis in 2007, the restructuring of the Financials remains incomplete. Fines and capital building requirements remain. The advantages from changing business models still accrue to the early movers in finance. Lately, regulators have appeared adhering to Basle III type strictures, industry and political pressures notwithstanding. In emerging countries for example among the largest, China has had an ongoing program for provincial funding impairment recognition. In India, capital strengthening and loan impairment recognition have only now become upfront state banking issues. Not to be outdone in Europe, the restructuring marathon pack has been long rather than tight. For instance in Germany and Italy as well as Scandinavia, business and capitalization restructuring has arrived years after that in Switzerland and Britain, let alone Greece. Brexit remains a separate but lingering European issue. Meanwhile with the Federal Reserve on a path of rate increases to potentially Fed Funds of 3.50% by March 2019, economic growth appears pressing other central banks like the European Central Bank and even the Bank of Japan to move up reducing quantitative ease. We expect these developments to be pressuring fixed income and currency markets. In our Financials overweight, we continue to favor the early movers which globally appear more predominant in the United States.
Healthcare: From small and large generic pharmaceutical manufacturers facing severe operating issues to massive integrated global firms faced with patent expiry issues, a picture emerges of more prosaic business issues in Healthcare for 2018 and beyond. Healthcare market sizzle hitherto had come from a surfeit of merger and acquisition activity over several years. At current prices, acquisitions can no longer be regarded as an inexpensive method of diversification, not least in the biotechnology space. In the medical devices space, a spinoff of consumer products has come into the fore and highlights the management challenges being faced in creating value there. As demographic changes like aging and in emerging countries, rising standards of living boost up demand, in Healthcare services, revenue accrual, cost and political issues can be expected to rise. At present valuations, we do not regard Healthcare as especially defensive and instead andmore accurately to be in the early part of a post M&A delivery phase in which management stresses could emerge. We have Healthcare as underweight.
Industrials: Business realities have globally shaken several industrial conglomerates that had hitherto been regarded as possessing impregnable business models. Changes in power generation have been an issue but so has overexpansion in the last cycle. Recovery driven restructuring appears still underway. As not unusual in circumstances of financial stress, a spinoff of assets into private hands has ensued. Meanwhile, in the aircraft business, there is split between the sources of growth of demand and the home base of large manufacturers. It has resulted both in a resurgence of tariff fears and a flurry to diversify the location of manufacturing. The torrent of quantitative ease of recent years appears to have surfaced into share buybacks by companies attempting to restructure capital structure on the assumption of low interest rates. Still latent has been facilities expansion to meet competition. Yet productivity growth has been lesser than that in prior decades, in emerging and advanced countries alike. As global growth develops and interest rates rise, we believe that capital expenditures are likely to rise. After all, business competition remains intense globally. In our overweight in Industrials, instead of those leaning towards financial engineering, we favor under-the-radar companies, both large and small, that continually focus on improving operations and products to boost return on investment.
Information Technology: In the outperformance of Information Technology, a schism has nonetheless developed. Concept driven companies have drawn attention especially in social media. The hitherto concept companies of the 1990s have at the same time, experienced their business positioning evolving into ones of lower valuation vehicles with stringent business plans, strong financial statements and a stream of tangible products. It has raised issues of growth versus value in Information Technology and its position within market sector rotation. As has also been part of the history of Information Technology, erstwhile marquee companies have dropped back mercilessly, underscoring the Darwinian reputation of the sector amid limited government interference. For consumer and business usage alike, next generation products are likely to require both higher level computing power and cloud based facilities in infrastructure investment. On these aspects, we have overweight Information Technology over Healthcare or Consumer Staples for growth. However, we would also stress our overarching theme of favoring value over momentum by favoring strong financial statements and a steady stream of tangible products/services over concept euphoria that has also been gripping Information Technology.
Materials: We have overweight Materials utilizing its industrial materials and precious metals prongs. Despite its critical products for society, we have not been so impressed by the agricultural prong. Industrial materials have been undergoing severe restructuring into greater realism. After excess expansion that has long been the bane of long dated projects in industrial materials and which this time developed on the basis of emerging country growth, especially in China, a severe dislocation developed. As is classical, weak financial structures and marginally cost competitive investments were hit hard. Currently, global growth expectations have expanded. They have come on the heels of years of industry restructuring from base metals to chemicals. Despite their strong performance, we believe the industrial materials segment still offers opportunity. For the Federal Reserve and increasingly other central banks, the pressures to exit massive quantitative ease have increased. Rising interest rates would ordinarily be considered as a negative for precious metal performance. However, the elevated prices of other assets, the potential for heightened currency volatility as interest rates change and severe political/ trade tensions being present have us continuing to favor precious metals for diversification of investment portfolios.
REITs: In anticipation of greater stress for leveraged assets as a result exit of massive quantitative ease, we have underweight real estate oriented exposure. The Federal Reserve has been overt about change but central banks like the European Central Bank and the Bank of Japan also appear reacting to circumstances beyond their expectations. Excess leverage and overbuilding have already moved emerging country central banks like those of China and India to closely monitor real estate. In many ways, real estate prices had been among the earliest to reflect expanded quantitative ease and now in centers like London and New York show elements of stagnation. Changed business parameters like consumer preferences for online shopping and the entertainment experience have squeezed investment yield opportunities in shopping centers- hitherto a much preferred asset class for REITs and pension funds alike. On rental, the demographic impact of quantitative ease distorting real estate prices is little discussed as a source of risk but should not be underestimated. In otherwise underweighted REITs, we do favor exposure to the commercial and industrial segments.
Telecommunication Services: We see telecommunications as increasingly part of the infrastructure space. Another phase of Telecommunication Services restructuring is also underway, this time incorporating content acquisition. The rationale is clear. Horizontal mergers have run into market dominance concerns. Meanwhile, legacy operations like landlines languish. Even in wireless, vicious restructuring continues in markets as disparate as the United States and India. For increasingly sophisticated devices like smart phones and for which the consumer has been willing to skimp on spending in other areas, filling in the entertainment pipeline could augment telecommunications revenues. Compared to other erstwhile defensive or yield areas like Utilities, as interest rates increase due to changes in Federal Reserve policy, we prefer to overweight Telecommunication Services, albeit with the business environment still favoring those that are most strongly financed.
Utilities: We believe that Fed Funds rates could rise to 3.50% by Q1/2019. Fixed income yield benchmarks are also rising. For instance from a low of 1.36%, 10 year U.S. Treasury Notes are already close to 2.65% in yield. Meanwhile, from those in many emerging markets and now increasingly in Europe and Japan, several central banks appear also to be in the process of or on the cusp of pulling back from massive ease. On Utilities, capital market pressures are likely to increase from fixed income. Amid renewed favor for cleaner power generation, cost pressures emerge. After years of having languished, the price of natural gas has demonstrated recovery as emerging countries like China and inclement weather have impact. However for reasons linked to inflation and notwithstanding U.S. administration bluster, thermal coal appears under stress as energy source. The potential remains obscure for expansion of the less regulated market space for water utilities. We believe that business and capital market pressure points are being underestimated for the Utilities and are underweight but would channel holdings into the pipeline space in which new routes for growth are being developed.
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 for cloud growth
Materials 8.0 5.0 Over-weight esp. prec. mat. as hedge
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
Kind Regards,
Subodh
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