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(February 2017)
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Roundtable

2017’s big picture

Thursday, February 16, 2017 - 16:53

GLOBAL growth appears to be on the mend, and inflation is expected to pick up. Yet challenges lurk, particularly with regard to political risk and potential hurdles to free trade. Our experts share their views and asset allocation calls for 2017.

  John Woods is Chief Investment Officer Asia Pacific, Credit Suisse. He is responsible for developing regional discretionary and advisory investment strategies across and within asset classes for private and institutional clients in the Asia-Pacific. He has 25 years of investment management experience in fixed income and currency markets. He enjoys a good game of tennis in his free time.

 

  Tuan Huynh is Chief Investment Officer Asia Pacific, Deutsche Bank Wealth Management. He is responsible for all discretionary mandates such as multi-asset, fixed income and equity portfolios. He studied Business Administration focusing on finance and banks at Dusseldorf University. He is passionate about golf.

 

  Herold C Rohweder is Managing Director and Global Chief Investment Officer (Multi-Asset), Allianz Global Investors. He has 27 years of investment management experience covering global equities and multi-asset. He is a member of the global executive committee and the global investment management committee. Apart from investments, he enjoys dancing and the movies.

 

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Genevieve Cua: What major themes do you see coming into play in 2017, and what implications would these have for investors?

John Woods: The investment landscape in 2017 is likely to be characterised by political uncertainty, combined with monetary policy divergence between the US and other central banks. In such an environment, we focus on investment themes that are likely to navigate such a landscape with improved risk-adjusted return potential.

These are our key themes.
i) Global equities: The effect of unconventional monetary policy is wearing out. Therefore, we see a trend towards combining monetary policy with fiscal expansion and private sector incentives in order to boost infrastructure investments around the world and to serve as an effective means of stimulating growth, creating jobs and raising productivity. In 2017, the US is likely to lead with infrastructure related fiscal expansion under President Donald Trump. As a result, we expect global infrastructure investment related stocks to benefit.

ii) Investing in a rising rate environment: For the US, we think it is quite clear that growth is starting to accelerate from 1.6 per cent in 2016 to 2 per cent in 2017, and possibly higher in 2018. But with growth comes inflation. Inflation is most apparent in the US, and we see core rates of around 2 per cent. Inevitably, bond yields – particularly US bond yields – are already starting to reflect higher growth and inflation expectations. In fact, we think bond yields have probably reacted too quickly and too much to expectations of accelerated growth in the US, and may well consolidate. But over the medium term, yields are likely to drift higher as interest rates normalise after spending so much time at levels close to zero.

We want to make it clear that the anticipated trajectory for rate hikes is reasonably shallow, which suggests that some fixed income instruments will perform better than others. The senior loan space is likely to perform well given that they offer some protection against a further rise in bond yields thanks to their floating nature, a strategy that still looks appealing in US dollar (USD). Moreover, senior loans are secured, hence are likely to exhibit higher recovery rates than high-yield bonds with the issuer assets to be used for disposal in the event of insolvency. In light of our expectations of rising default rates, this could be particularly important for the US issuers.

iii) China equities: Beyond the currency weakness, the macroeconomic outlook for China is improving noticeably. For the first time in recent years, there is no meaningful talk of a hard landing or deflation. Various macroeconomic data has improved over the past few months for China: PMI indicators have been back in expansion territory for six consecutive months, industrial profit has recovered, and the factory gate Producer Price Index (PPI) has staged a remarkable recovery from -5.9 per cent year-on-year (y-o-y) a year ago to +5.5 per cent y-o-y in the latest monthly reading. Specific to the equities space, we also see a strong recovery in the EPS (earnings per share) of Chinese equities. Owing to this and coupled with cheap valuations compared to global equities, we are positive on MSCI China.

Tuan Huynh: The main focus for 2017 will be on how last year’s calls for political or policy change are now translated into reality. Pressures from this could result in multi-dimensional policy divergence. Monetary policy should continue to diverge among countries as the Fed raises rates further while the European Central Bank (ECB) and the Bank of Japan stick with a much more accommodative approach. Fiscal policy may also further diverge, as some economies seek to boost growth through cutting taxes (most obviously, the US) or boosting spending. And, perhaps most dramatically, trade policy could start to diverge. Even before coming into office, new US administration had indicated its intention to leave the Trans-Pacific Partnership (TPP) and also change bilateral trading relationships, most obviously with China. Even as Mr Trump’s withdrawal from the TPP is an aggressive announcement, we continue to think that Mr Trump might pursue his combative trade reset aggressively, but not in an extreme manner. As we are still in early days, we continue to watch for further moves from the Trump administration.

Meanwhile, the triggering of Article 50, and the UK’s subsequent attempts to redefine its international relationships is likely to add to stresses around global trade policy.

Volatility is likely to be another intermittent theme throughout 2017, as political and policy change and one-off events (for example elections) unsettle the markets. For an investor, it will be important to take a longer-term view in order to navigate effectively through market fluctuations.

One way to do this would be to keep a firm focus on the opportunities provided by longer-term themes such as population ageing, cybersecurity and millennials’ spending patterns. NextGen tech should also be a focus, with infratech, healthtech and fintech all interesting areas.

Asset class specific themes are likely to be subsidiary to these overall themes of political change, policy divergence and secular and technological change. For equities, one key theme could be corporate earnings, as investors look for further evidence of improvement to support stretched valuations in many markets. We expect an improvement in earnings generally, but the improvement is unlikely to be steady through the course of 2017 and the pattern may vary between regions.

As regards fixed income, we would characterise the environment as “cloudy with some showers” rather than a perfect “storm”, but concerns around inflation could increase, at least in the first half of the year. The key oil market theme is likely that moderate price rises are expected from current levels, as Opec (Organization of the Petroleum Exporting Countries) enjoys only partial success in cutting output, and higher oil prices bring more US shale oil to the market.

Herold Rohweder: From a macroeconomic perspective, financial markets will remain in a tug of war between a broad-based cyclical recovery and reflation of the world economy on the one hand, and lingering political and policy risks on the other in 2017. We don’t expect a material change in the prevailing structural low-growth environment, with potential output weighed down by detrimental productivity and demographic trends, as well as high debt levels and ongoing de-globalisation tendencies. Still, global GDP (gross domestic product) might grow slightly above potential this year.

Although political event risks will continue to rank high on investors’ agenda, the imminent change in the US macro policy mix might have even more important near-term implications for the global economy and asset markets. The Trump administration’s ill-timed plan to add fiscal stimulus to a US economy that is already operating close to full employment might lead to an artificial extension of the already matured business cycle, and could also provoke a more forceful than anticipated policy response by an ever more politicised US Fed. This comes on top of the potential longer-term negative impact of a more restrictive trade and immigration policy. Despite the anticipated tightening by the US central bank, global monetary policy will stay accommodative in 2017, with global central bank liquidity unlikely to peak until next year.

Furthermore, China should stay in the limelight over the months ahead, not least due to the forthcoming leadership reshuffle in autumn and risks associated with the managed economic slowdown and ongoing capital outflows. Notwithstanding, we see longer-term opportunities in Chinese bonds and equities – a topic that should be reinforced by the inclusion into major international market indices over time.

Genevieve: What major asset allocation calls are you making for 2017 on a multi-asset view? How should investors be adjusting their expectations of returns for the various asset classes?

John: The US election is over, the markets are anticipating higher US interest rates and the macroeconomic outlook is still modestly positive. We have thus lifted our equity allocation back to neutral. The US economic fundamentals should remain supportive thanks to a promised increase in infrastructure spending and lower taxes. Mr Trump proposes ending trade agreements and introducing trade barriers, which we think is detrimental to emerging markets.

Sector-wise, we prefer healthcare which, combined with below historical average valuations, may be a positive driver for Swiss stocks. We favour China, Swiss and Australian equities. In fixed income, we have raised our allocation to convertible bonds to overweight. Our portfolio duration is slightly longer, but we remain neutral overall. We still prefer investment grade corporate, emerging market and now convertible bonds over government bonds. We remain neutral on commodities and real estate and are mildly overweight in hedge funds. Our currency allocation is unchanged – we favour the JPY and the USD at the expense of the EUR, CHF and CAD.

In Asia, equities are vulnerable to potential protectionist trade policies under Mr Trump. However, barring a major escalation of events, we expect market focus to return to domestic fundamentals. We remain constructive on Chinese equities given robust macro economic data, policy support and solid earnings story. Thailand joins Indonesia as our least-preferred equity market.

We expect temporary short-term consolidation in Asia FX, followed by renewed weakness. Expect Asia hard currency bonds to remain resilient amid US treasury consolidation. Remain positive on India and negative on China local currency bonds.

Tuan: Our asset allocation calls stem from our belief that global growth is likely to modestly improve this year, led by a pick-up in the US economy. Any slowdown in the Chinese economy is likely to be slight and emerging markets with continued domestic fundamentals are likely to be able to ride out concerns around protectionism and capital outflows. We also believe that increases in inflation are likely to be modest and containable, with core government bond yields only moving slightly higher from current levels.

Against this background, we remain cautiously optimistic on equities, and have an overall medium-term overweight here. Within equities, we are positive on US equities; US earnings could continue to grow in early 2017, and in the longer term may be boosted further by corporate tax cuts. We are also positive on Japanese equities; they should benefit from modestly improving domestic earnings and the boost given to exports by a weaker Japanese yen. We are, however, neutral on European equities, as the benefits of slightly stronger economic growth may be outweighed by continuing political uncertainty, although a weaker euro may provide some support.

We would argue for a country-by-country selective approach to emerging market equities: Some may remain overshadowed by domestic problems, but others may benefit from a cyclical upswing, and rising commodity prices should also help to boost growth and earnings in commodity-exporters. Within emerging markets, we maintain a regional preference for Asia over Latin America.

We think a highly nuanced approach will be necessary as regards fixed income. We are underweight on sovereigns, being well aware of the danger of rising yields, but still see opportunities in investment grade. We are also positive on emerging markets hard currency bonds, but on a selective basis. We have grown more cautious on high yield, even though spreads remain well above recent lows. For many investors, currency movements will play a key role in determining returns. We still expect a further long-term strengthening of the USD against other currencies, but the currency will see periods of weakness, with investors reassessing the role of safe-havens and funding currencies.

Overall, investment returns are likely to be acceptable rather than spectacular in 2017. A high proportion of returns may come from coupons or dividends.

Herold: In a structural low-growth world that is still suffering from financial repression, investors should brace for lower market returns over the medium term. At the same time, the rising frequency of political and other exogenous shocks poses severe downside risks to their asset holdings. An active asset allocation and broad diversification over multiple asset classes and strategies remain of utmost importance to counter these challenges.

Beyond that, the attention of investors needs to shift from the limited compensation for beta risk to alpha generation. Temporary cyclical upswings will continue to offer tactical opportunities in financial markets – in particular for active multi-asset managers.

Accordingly, we recommend a moderate overweight in risky assets for the time being with a general preference for equities over most spread products and a more defensive stance in global government bonds. In addition, selective income-generating strategies (for example, cyclical dividend stocks, infrastructure debt) should help to enhance returns and mitigate downside risks in the current environment. As pending political and economic uncertainties are expected to spill over into financial markets and trigger at least temporary bouts of higher volatility, it’s necessary to stay agile and flexible throughout this year.

Genevieve: Political risk is high in 2017 with elections slated in a number of European countries, and the uncertainties of a Trump presidency. What possible scenarios do you foresee and how may clients hedge against negative outcomes?

John: The start of the year may have brought back memories of 2016, when a violent drop in Chinese stocks dragged global equity markets lower. Fast forward to 2017 for quite a different, decidedly more orderly picture. Despite uncertainties over the direction of Mr Trump’s policies, the details of Brexit and other political risks looming in Europe, the year began on a friendly note on both the equity and global government bond markets. In fact, it even featured a number of very encouraging economic data releases, with global purchasing managers’ indices reaching relatively high levels in December. With this backdrop in mind, in the Credit Suisse Investment Committee, we retain a neutral stance on equities, fixed income and commodities overall, as we remain mindful of the potential challenges ahead. In a nutshell, our strategy is to take profits on assets whose momentum has been strong (crude oil), avoid high valuations (Bunds) and seek out pockets of value (financial credit).

On potential scenarios, let me start with the discussion on “Trade War”. Mr Trump’s anti-China trade narrative resonates strongly among his supporters. And were he to label China a currency manipulator – as we consider likely – a jarring trade war would likely ensue. Why then, in the face of such danger, do global markets continue to rally? Is it complacency? Or an inability to accurately price in the risk of a trade war? More likely, we believe that measures taken by the US to correct its trade imbalance will be largely symbolic and will not negatively affect its trade relations with China.

In Europe, the economic prospects for the eurozone appear quite good as well this year, with a series of important political events unlikely to throw the economy off course. In some economies, business surveys have reached the highest levels in more than five years.

Furthermore, the weaker EUR versus the USD as well as the potential for rising export demand from the US should help to keep business sentiment upbeat. Unemployment rates, while still elevated, are declining in France and Spain, but also in Germany, where they continue to reach levels not seen since the reunification. These improving labour market conditions should also support private consumption growth.

The core inflation outlook for 2017 is still relatively subdued, but monetary policy in the eurozone is largely on a preset track. Only later in 2017 will the ECB have to decide how it wants to proceed with its asset purchase programme in 2018. Otherwise, political events in Europe remain a wild card, after the Trump card is played.

Clients are generally holding a high level of cash, reflecting their concern and the lack of conviction in market and economic directions.

Tuan: Our main scenario is that uncertainties surrounding the Trump presidency do not stop a continued recovery in the US and among global economies. As we are still in early days, we continue to watch for further moves from the Trump administration.

We think that European elections constitute a major event risk but are reasonably confident that they can be navigated through. The Chinese Party Congress later in the year could set the tone for future Chinese policy direction, but seems unlikely to have a dramatic effect on markets.

Investors, even under this core scenario, should unfortunately have to handle a considerable amount of uncertainty throughout 2017. Alternative scenarios (for example, around European politics or more restrictive trade policy) will result in further uncertainty. Under all scenarios, some of this will be predictable, in that it will be triggered by events held on known dates (for example, European elections). But other uncertainty will be much more difficult to anticipate, for example that resulting in unexpected shifts in US policy and other countries’ reaction to it.

For investors, the key factor could be to differentiate between short-term market overreaction and more sustained market change. We would suggest staying focused on longer-term sectoral trends (most obviously in the technology sector). Some investor portfolios might also benefit from a degree of tailored risk engineering designed to provide a degree of protection against market volatility. And, as noted above, currency movements could play an important role in determining returns.

Herold: Financial markets have, by and large, shrugged off negative political events over the course of last year. Bluntly said, while Brexit took three days to go through the markets, the US election took only three hours and the Italian constitutional referendum in December just three minutes. Obviously, investors have become more resilient to an adverse political news flow. But there is no guarantee this will last.

Apart from the missing details on the policy agenda of the new Trump administration and their unorthodox communication approach, we will face numerous political events in Europe which might become a headwind over the course of this year, in particular the “election super cycle” in the eurozone and the start of the Brexit negotiations. While our base case doesn’t call for a major political accident to happen, last year’s events have taught us to be more humble and not to underestimate political risks.

Forthcoming elections in the Netherlands, France and Germany will most likely confirm a shift towards more populism and nationalism, but centre mainstream parties should remain in power in all three countries. Currently, we see the greatest political risks for the eurozone emanating from Italy, which is suffering from political instability, sluggish growth, high unemployment and public debt, a struggling banking sector and souring public sentiment towards Europe.

In general, as the outcome of political events has become harder to predict, it’s key for asset managers to thoroughly model the potential downside risks of their strategies in light of the risk-bearing capacity of their clients.

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