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THE BUSINESS TIMES' WEALTH ROUNDTABLE
BT Wealth Editor poses questions to wealth experts for their insights on mega-investment themes.
John Woods is Managing Director and Chief Investment Officer, Asia Pacific, Credit Suisse. John is responsible for developing regional discretionary and advisory investment strategies. He is an avid tennis player.
Michael Fredericks is the Head of Income Investing for Multi-Asset Strategies at BlackRock. Michael has more than 20 years of financial markets experience. He is an ardent sports car enthusiast.
Bhaskar Laxminarayan is Chief Investment Officer and Head of Investment Management Asia, Julius Baer. He is responsible for developing discretionary solutions in Asia. He collects vinyl records and loves art and photography
2017 was a rewarding year for most assets, whether equities. bonds or multi-asset. But what is in store in 2018? We ask the experts to share their highest-conviction calls
Genevieve Cua: What major macro-themes do you see playing out in 2018 and how do you think clients can be positioned to take advantage of them?
John Woods: In 2018, the synchronised global growth story remains very much intact and will provide a boost to corporate earnings and confidence. Inflation is likely to pick up but at a moderate pace as there remain structural disinflationary forces in place. Consequently, the benign inflation outlook will allow central banks to proceed gradually with monetary policy normalisation. Liquidity conditions should remain supportive of the markets.
Given the favourable macro-backdrop, we are constructive on the markets and have a preference for equities over fixed income. Broadly speaking, we expect corporate investment to finally pick up in 2018 with companies looking to deploy their cash to invest in either organic expansion or inorganic acquisition for growth. A key focus area for us is the ongoing revival in Europe. Macroeconomic momentum in the eurozone has been strong while political risks have very much abated, which equities have not fully priced in. In particular, we like domestically oriented companies that can benefit most from the ongoing recovery in the eurozone.
In addition, after a first wave of eurozone revival in 2017, a second wave is expected to benefit specific European assets like real estate equities given that yields are still high. Emerging market (EM) assets should also continue to do well after a stellar performance in 2017. We are positive on EM equities (including Asia) especially consumer companies that can benefit from solid domestic demand growth. We also see attractive carry opportunities in EM local currency bonds given our positive view on EM FX in general.
On the other hand, we expect the fixed income market to be more challenging on the back of rising interest rates and tightening credit spreads. We recommend our clients to consider a variety of fixed income investments (eg inflation-linked bonds, investment grade corporates, convertibles).
We continue to encourage clients to consider longer-term investment opportunities that could benefit from multi-year societal trends. Despite the long-term nature of such trends, there are numerous catalysts that could benefit the related investments in 2018. For instance, the millennials - one of the largest generations in history - are coming of age and beginning to make their influence felt in all realms of life. The trends they shape and their preferences as consumers could drive new innovations and opportunities; but at the same time, also lead to the potential demise of traditional sectors.
Michael Fredericks: We believe the current global growth expansion has room to run, at least for a longer period than many expect, supported by a backdrop of synchronised global growth, subdued inflation and low interest rates. According to analysis from BlackRock Investment Institute (BII), even when growth is only slightly above trend, economies can run beyond potential for a long time before peaking. We believe the current expansion could continue for several more years. That said, we see less scope for upside growth surprises as consensus expectations have mostly caught up with BII's analysis for G-7 economies in 2017. The above-trend level of growth should be positive for risk assets as well as corporate profits.
However, a strong fundamental backdrop has contributed to elevated valuations across most asset classes. 2017 was a near-perfect year for risk assets, and it will be a hard act to follow. The road ahead looks more challenging: higher asset valuations suggest lower returns going forward, while market volatility has stayed very low and many perceived risks have not materialised. This makes markets more vulnerable to temporary sell-offs sparked by the bubbling over of risks, including those related to rising trade tensions and geopolitical risks. The risk premia on all financial assets have declined. BII's measure of the US equity risk premium - one gauge of equities' expected return over government debt - has fallen since the global financial crisis. We believe 2018 is poised to be another solid year from a fundamental perspective; however, with valuations increasingly stretched, selectivity and prudent risk taking remain at the heart of our investment strategy.
Bhaskar Laxminarayan: Monetary policy that has determined asset prices ever since the financial crisis of 2008 may well be the main determinant of market direction in 2018 as well. We continue to favour equities as the asset class of choice. However, the portfolio mix will need to be monitored closely. The key to watch will be earnings. Based on broad asset allocations and portfolio tilts, we do believe some value plays have a place in the portfolio this year. The second would be to get more comfortable with a higher allocation to emerging markets which are showing a certain resurgence in both economic conditions and earnings profile.
Genevieve: There is a continuing hunger for yield. What assets do you recommend in this space; or where do you see the most value?
John: The hunger for yield and growing risk appetite mean there is a need to be more creative in identifying repositories of value and potential returns.
- Asia USD IG - defensive income
Asian Investment Grade corporate bonds might be less negatively impacted by rate hikes. Strong local investor demand and improving fundamentals harbour a potential for further credit spread tightening of 50 bps in 2018. The asset class offers a healthy yield pick-up of 65 bps over its US-equivalent; issuers with lower duration profile than global bonds are also particularly attractive in a rising rate environment. More importantly, its low beta nature positions it as a defensive asset class generating steady returns amid a gradual shift in global liquidity conditions.
- EM local currency debt to outperform global fixed income
Structurally, EM economies also look less vulnerable to the higher core rates compared with the Federal Reserve's tantrum episode in 2013. The yield differential has reached approximately 250 bps, which is the highest in over a decade, thereby exceeding the readings logged during the financial crisis. We expect EM local debt to outperform global fixed income markets this year.
- Dividend yields in Asian financials
Another reservoir of value is in Asian (particularly China) financials. Market participants are belatedly warming up to the idea of owning shares in Chinese banks; and we believe that they deserve a place in investors' portfolios. A firmer growth environment in China and higher local bond yields are leading to an earnings recovery for banks. We believe policymakers could announce a capital injection plan over the next 12 months to address any lingering asset quality and capital inadequacy concerns. China's recent move to open the financial system strengthens the case for recapitalisation of banks as this would help clean up balance sheets and improve valuation multiples.
2017's US$32.5 billion capital injection plan by the government of India suggests that, if banks were to be recapitalised in China, their price-to-book value ratio could revert to the historical average of 1.15x versus 0.85x currently, thus leading to substantial returns over the next 12 months. After a 30 per cent underperformance in 2017, we see room for an H1 2018 "catch up" rally.
In South-east Asia, strong recoveries in the regional macro economy, trade momentum and infrastructure-related demand in some countries will likely support a revival in credit growth for banks across markets. This, together with lower provisions and better interest margins (owing to higher interest rates), should propel a double-digit earnings growth in 2018. On the whole, we see South-east Asian banks outperforming in their respective markets.
Michael: Finding sustainable and attractive yields has become more important than ever for investors worldwide. We expect today's "lower for longer" interest rate environment to persist. With traditional fixed income yields typically at half their pre-crisis level or lower, finding attractive income is no longer as easy as it once was. We have seen investors meaningfully increase their allocations to traditional income-producing asset classes such as dividend-paying stocks and high yield bonds over the past few years, potentially leading investors to take on more risk to maintain similar levels of yield. As such, we recommend investors to widen their pursuit of income outside of the typical sources. These complimentary income-generating asset classes are often more difficult to access and may not be well known, hence are less commonly held in portfolios. Asset classes such as mortgage-backed securities, floating rate loans, preferred stock and equity covered call writing offer compelling opportunities to investors today. Not only can investors potentially earn attractive levels of income but we also see the potential for capital appreciation and diversification.
The theme of reduced reward for risk taking is especially relevant in fixed income. Investor demand for yield has driven high-yield bond spreads and prices to less attractive levels. However, high-yield bonds are well supported, in our opinion. Improving corporate fundamentals, low default rates, and the global demand for yield provide an attractive backdrop for the asset class. Upside may be limited, and high-yield investors should not get overly excited about returns much higher than a bond's coupon. Furthermore, while there is a good level of dispersion and active bond pickers may be able to identify the potential winners and losers, we would not recommend reaching for yield in the credit markets at this stage of the cycle. Similarly, loans remain attractive given the rising path of Libor (the global benchmark for floating rate instruments). However, strong demand has resulted in higher prices.
We also like preferred stock - it has been one of the strongest performing income oriented asset classes - as such, prices have increased materially. Furthermore, tax reform in the US and higher interest rates should benefit the financial sector, the key issuer of preferred stock. We continue to view preferred stock as a relatively attractive place to source yield and return given the continued positive broader macro backdrop, and believe bottoms-up, active security selection is important to potentially identify more attractive opportunities.
Diversification is another crucial element in today's investment environment. Non-agency mortgages continue to offer attractive diversification benefits and relatively attractive yields for the amount of risk being taken. We believe the outlook of non-agency mortgages will continue to be supported by improving housing data and large institutional investors driving asset flows. Similar to most areas of fixed income, however, spreads have tightened meaningfully over a long period of strong performance and forward-looking opportunities look less attractive. It is important to keep monitoring opportunities to capture profits on certain positions while tactically moving up or down in quality where we believe there may be better yield opportunities. Lastly, price dispersion within commercial real estate has created some selective opportunity.
Bhaskar: We have experienced a multi-decade run in yield markets. We have seen 30-year bonds beat equities. So it is only natural that hunger for yield is well entrenched in investor psyche. There are pockets of opportunity that still exist in the bond-yield space. To some extent those with a local currency and emerging market bias could continue to have access to higher coupons and yield. Corporate Asian hard currency paper still looks resilient.
Genevieve: What major risks could ruin the party, and how may investors hedge against these risks?
- Inflation unexpectedly surges.
We believe price pressures will ultimately remain contained in 2018 and even into 2019, but there is scope for inflation expectations to rise sharply as growth continues apace. As rising inflation would present a significant risk to our economic and financial market assumptions, we currently still see moderate long-term inflation expectations as an appealing entry point for inflation linked bonds (ILBs). Despite the recent rise in the so-called breakeven rates, valuations remain reasonable in our view. As such, we view ILBs as safer than nominal government bonds to gain duration exposure in USD.
- Tightening financial conditions
The erstwhile sanguine attitude that most global central banks have maintained amid the fairly benign inflation environment could turn hawkish if latent inflation pressures start to manifest or fiscal expansion is suddenly perceived to be more inflationary. Changes in personnel at the various central banks could be another catalyst for such a shift in attitude.
To guard against this risk, we would avoid the lowest-yielding government bond and generally prefer shorter-duration exposure. High-yield bond spreads are also narrow by historic standards and we thus see little value in weaker credits, preferring to stick with investment grade, particularly financials. Having favoured long-dated USD investment grade corporate bonds for most part of 2017, we now prefer floating rate exposure with the 1-10 year segment offering, for instance, a decent yield of close to 3 per cent.
- Eurozone political risks
The Italian general election has been set for March 4, 2018, presenting what is likely to be the political event risk of the year for the Euro area. From the current pricing, Italian bonds have priced in a high degree of economic and monetary union stability. Additionally, the recovery in the economic growth momentum in Italy may already be peaking.
- Trade war, China slowdown, geopolitics
Any threats to the growth of the Chinese economy or its stability could create contagion risks for global equity markets. Policy errors or a credit bubble burst could risk a deeper-than-expected slowdown, inflicting material damage to global growth. Similarly, a trade war between the USA and China, cancellation of North American Free Trade Agreement without replacement, or a critical escalation of tensions around North Korea or in the Middle East could negatively impact growth expectations and risk assets. Mitigating these risks could involve switching some cash equity exposure to simple index call option-based strategies, or protecting positions with put options to hedge these risks while volatility is low.
Michael: Although equity valuations are fairly high compared to history, the healthy economic growth backdrop should result in even stronger rates of earnings growth. In the US, tax reform is an additional positive earnings catalyst. However, if the US economy grows too quickly and inflation starts to pick up we could see interest rates rise more quickly than what's priced into markets today. A big move higher in interest rates could upset both fixed income and equity markets. We continue to favour single-stock covered calls on more cyclically oriented names which can offer a compelling mix of yield and capital appreciation, while being less exposed to drawdowns than equities alone. Lower levels of volatility have reduced premiums, which makes it all the more important to focus on individual names rather than indices where volatility is typically 8-10 points higher on average.
Looking at the big picture, we see a strong global economy and somewhat elevated market valuations. We are probably closer to the end of the cycle than the beginning and are carefully managing the overall level of risk in our pursuit of income. We believe investors should be looking to increase diversification and avoid popular, crowded trades. We intend to keep our currency risk to a minimum, especially around the uncertain nature of currency markets and high sensitivity to a variety of domestic and international drivers.
Finally, although our interest rate exposure remains modest, we have been seeking opportunities to slowly add duration. While we are not expecting a sell-off, should market volatility pick-up, duration may help mitigate downside loss. The current environment is positive for investors, though we are keeping a close eye on risks to our outlook. Geopolitical risks, a growth slowdown in China, central bank policy normalisation, and dramatically higher interest rates in the US could potentially pause or end the markets' upward trajectory.
In order to generate attractive returns and consistent levels of yield, our portfolios focus on assets with attractive cash flow and potential capital appreciation to generate return. We believe this combination of high income and portfolio diversification is exactly what many investors are looking for today.
Bhaskar: Any shock to liquidity would be a big threat to asset prices. The current pace of rate normalisation is potentially baked into prices but any change to this schedule will have an impact.
Genevieve: Currency exposures can make or break a portfolio. What trends do you see here, and for Asian investors, which currencies might offer the most attractive carry and risk-adjusted returns?
John: The USD has weakened broadly against other major currencies in 2017 and this trend looks set to continue. In spite of improving growth, persistently low inflation in the US has tempered rate hike expectations and weighed on the USD. While we have a neutral stance on the EUR in the short-term, we see upside risks for the currency especially if the ECB were to change its tone and drive higher expectations of earlier than expected tapering/rate hikes.
Among the currency majors, we are most constructive on the GBP in view of the supportive valuation and technical momentum. Expected progress toward a Brexit transition deal could underpin the undervalued GBP. The BoE may also turn more hawkish relative to current market expectations should growth and inflation pick up.
We are positive on EM FX as a whole on the back of attractive EM real rates and an expanding EM growth differential over the developed markets. Asian currencies should remain supported in 2018 given our expectations of healthy growth and external fundamentals for the region.
Markets have demonstrated a high degree of capriciousness when it comes to the USD trend so investors should brace for potential swings at various points in the year. Investors would thus do well to consider hedging where relevant.
Bhaskar: We remain biased towards a leg-up in the dollar but do believe that reference currency is critical to portfolio construction. We see value in tilting the portfolio to regions - be it the Americas, Europe or Asia - and then look for pure alpha or risk diversification strategies that are layered on top. Hedging the diversification bets or alpha enhancers would be a dynamic and active decision.