Category: Investment Committee

Last week, Blackrock CEO Larry Fink wrote a letter to CEOs calling for them to “serve a social purpose”. A key phrase reads:

“Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”

He explicitly tied financial performance to meeting sustainability objectives:

“Your company’s strategy must articulate a path to achieve financial performance. To sustain that performance, however, you must also understand the societal impact of your business as well as the ways that broad, structural trends – from slow wage growth to rising automation to climate change – affect your potential for growth.”

When the man who oversees $6trn in assets says sustainability matters, the theme cannot really be regarded as a purely ethical activity.

I was in Zürich last week for the 2nd FINEXUS conference on Financial Networks and Sustainability, attended by leading practitioners, policy makers and academics. The purpose of the conference was to assess how sustainability criteria can be better integrated into the policies of central banks and development banks, the lending decisions of retail banks, and the portfolio decisions of asset managers.

If the forecasts for climate change are right, we are currently on course for irreversible environmental damage. We all know what this means: coastal flooding, water shortages, and lower crop yields; not to mention the effects on our oceans and for biodiversity. As the impacts of climate change will be concentrated in the Global South, we can expect huge intercontinental migrations that make the 2015 Syrian refugee crisis look like the tip of an iceberg.

The 2015 Paris Agreement commits countries to take action to limit the amount of global warming to 1.5C by 2100.

As Stanislas Dupre – member of the High Level Expert Group on the EU’s sustainable finance taskforce – explained at the event, the investment industry is funding a path that leads to warming of 4-6 degrees on the basis of its current choices, financing infrastructure that locks in emissions for decades to come.

Putting these two facts together means that investment managers who do not take sustainability seriously are likely to find themselves on the wrong side of transition risk in the coming decade. This is because commitments to the Paris Agreement make it highly likely that governments will regulate their economies to discourage and penalise carbon-intensive activities. It has almost nothing to do with the moral case for unilateral action and everything to do with the future tax, regulatory and legal changes made by governments which have committed to going green.

Asset managers who hold securities tied to carbon-intensive firms may therefore face significant losses. Huge amounts of capital need to be mobilised into green investments, and states committed to the Paris Agreement will take steps to facilitate this process. The ultimate risk that firms and investors face during the transition is being left holding stranded assets that have lost their value by either regulatory or technical changes.

There are other kinds of transition risk – such as the risk of a bubble in green assets – but the one that is immediately relevant for industry is the risk of stranded assets. This could plausibly arise in a number of ways:

• An announcement on a global (or national/regional) price for carbon
• New technological breakthroughs in the low-carbon sector
• The achievement of a price parity between renewables and fossil fuels
• Changes in legislation reflecting the legality of GHG emissions
• The forced nationalisation of selected assets
• An increase in pressure from shareholders, employees and activists to limit GHG
• Commitments to reduce implicit subsidies of fossil fuels (which are very large)
• An increase in accuracy in the monitoring and measurement of emissions for attribution to firms
• An increase in social awareness of the risk of GHG emissions

Any of these factors could affect the long-term return from carbon assets in portfolios.

The conference also hosted panels that discussed the need for stress-testing for climate and transition risk. This would be an activity that would help asset managers, central banks and development banks understand the possible consequences of the renewable energy transition.

This is a new area of research that could inform the policy of central banks in the future, especially when it comes to QE. If it is understood that carbon assets present a threat to financial stability as the effects of climate change on the economy take hold, central banks could make the case to favour ‘green’ assets (such as green bonds and companies that have low carbon intensity) when engaging in asset purchases.

A future Basel IV agreement could see rules that impose stricter capital requirements on banks that lend significantly to carbon-intensive activities. These policies could therefore reduce the cost of capital and increase its availability for green companies.

Other policies could have a similar effect. Mafalda Duerte from the World Bank’s Climate Investment Funds explained how state development banks could further raise the NPV of green activity by issuing green bonds that pay for subsidies and ‘credit enhancements’ to green firms.

Further, tax benefits could be offered to issuers of and investors in green assets, again with the aim of lowering the cost of capital as well as increasing the depth and liquidity of green asset markets.

These policies and others create transition risk for firms and investors, and they need to be assessed and quantified.

There is no immediate threat to existing portfolios but the message from the conference was that the status-quo will be costly in one way or another, and quite soon. Companies that invest for the long-term need to consider the issue of sustainability. There are opportunities as well as risks, and there will be returns for being on top of both.

 

The growth of passive investment products such as index tracking funds over the past few years has been significant as investors are attracted by low fees and the premise that the majority of active managers will not outperform the market over time. Passive investing, or indexing, involves buying a basket of assets that have been included in an index, such as the FTSE 100 Index or the S&P500, or sectors thereof without having to undertake the research and due diligence associated with an active investment decision as performance will mirror the overall movement of the market.

However, some investors argue that the increase in passively allocated money risks distorting the price discovery process. Active investors look to invest in companies whose shares and bonds look cheap and sell those that look expensive, thereby holding management to account by basing decisions on fundamental factors such as earnings growth; competitive prospects and management performance. Price agnostic or passive investors reduce the proportion of share price movements that are based on fundamentals, creating serious market anomalies by being obliged to buy already over weighted and overpriced assets.

This situation is more serious in the less liquid markets of corporate and high yield bonds where passive funds offer total liquidity in an index such as the Citi World Government Bond Index where the level of liquidity of the underlying index components may not compare. Furthermore, the more indebted a company, the more bonds it is likely to have issued, the greater its weight in the index meaning that a passive bond fund will effectively hold a high weighting of bonds in the less credit worthy members of the market place.

The use of passive products in less diverse markets could further contribute to overvaluation and provide a destabilising effect. For example buying sector specific exchange traded funds (ETF) such as the technology sector where market capitalisation may be skewed to a small number of very large companies that would risk breaking some basic investment rules regarding insufficient diversification and exposure to large individual holdings. The performance of the technology sector since Trump’s presidential win has seen Facebook, Apple, Google, Microsoft, and Amazon become over 40% of the Nasdaq 100 Index, which would be in breach of European fund rules if an active manager was to follow the same asset allocation.

Modern portfolio theory would argue that the primary driver of portfolio returns is asset allocation, which is the process of combining various asset groups with different risk and return characteristics (e.g. equities, bonds, cash, private equity, hedge funds, real estate) into one portfolio that will produce optimal, risk adjusted returns. An active investor believes he can outperform a set benchmark by using his skills in market timing, stock selection or style tilt. Smart-beta strategies are semi-active products that reweight on a regular basis in order to maintain an allocation that historical back testing would suggest has been the optimal mix over time. This blurs the boundaries between active and passive by offering the investor one asset allocation remedy based on past performance that any standard market disclaimer would state may not guarantee future success.

There has been a long debate over the relative merits of active and passive approaches to investment when both approaches probably deserve a place in a diversified portfolio. Recent opinion concludes that the ability of active management to generate alpha is probably cyclical;  underperforming when returns are overly concentrated or highly correlated such as times when interest rates are low, and, outperforming as economic growth improves, interest rates normalise and market inefficiencies increase. Active managers also have the benefit of making the decision not to be fully invested by holding cash in difficult times which should provide significant downside protection.

In our latest Global Insights publication we stated that the uncertainty surrounding potential US policy leaves US equity valuations priced for perfection whereas we believe European equities are under-estimating the strength of the eurozone economy and over-estimating the political risk. Since the French Presidential victory by Emmanuel Macron populist fears have largely been priced out of equity markets with European equities hitting a year’s high the following day coinciding with the VIX volatility index on the CBOE, known as the markets fear gauge, dropping below the psychological 10.00 level despite the chaos emanating from the White House.

 

The VIX Volatility Index Year-to-Date

Source: Bloomberg

 

This highlights that highly liquid conditions created by the different levels of quantitative easing implemented by Central Banks have been highly supportive of equity markets. Central Banks have been big buyers of financial assets creating more predictable markets and altering long standing asset class correlations. This has made portfolio diversification more difficult for long term investors and created an environment where macro-driven hedge funds have struggled to make the risk-adjusted returns that made them so popular. Furthermore, it could be argued that the increasing use of the $4tn passive investment market through exchange traded funds has created further indexation of investments and under-pinned many over-valued sectors of markets through blind investing.

Companies have accumulated significant cash on their balance sheets, which has been steadily returned to shareholders through share buybacks, dividends and M&A. As a generalisation, this wealth has accrued to the better-off members of society with a lower propensity to consume meaning it has been re-invested into financial markets creating worsening inequality and seemingly a de-coupling of financial markets from the real economy that seems to have coincided with the rise in populism.

According to Absolute Strategy Research (ASR), in their Equity Strategy Weekly publication dated May,18 2017, over the last 111 years major market corrections have often had part of their origin in inappropriate rate rises which removed liquidity from equity markets. This time the risk of raising headline rates is with the US Federal Reserve and China is also tightening policy but further the reduction in the pace of QE in particular the potential for ECB tapering. ASR attributes much of the rally in risk assets in 2016 to growth in both US and Chinese M1 money supply rather than political events and M1 money growth has decelerated as policy has tightened in 2017.

Ideally excess liquidity leads to improving economic fundamentals and constructive government policies to justify higher asset prices. We are currently focusing on three medium term possible headwinds for markets, the clearest being the US political environment raising doubts over the implementation of the President Trump pro-growth agenda.

Equally, Beijing will continue to try and cool the housing market and run the economy at the official target growth rate of 6.5%.  This was reflected in the significant slowdown in PMI and Industrial Production readings in April along with a marked deceleration in Private investment growth to 6.9% from 7.7% in April, all consistent with moderating growth momentum.

Thirdly, a European government bond taper tantrum in H2 17 along the lines of the US taper tantrum in 2015 would be significant with so many European issue trading in negative territory. Interestingly the market seems to have more confidence that hard data will eventually mirror sentiment in Europe. Eurozone PMI’s hit their highest levels for 6 years in April with business expectations the main driver showing broad based positive sentiment across the Eurozone. President Draghi is questioned at every ECB meeting Q&A session to comment on the potential for changes in monetary policy as the European economy shows signs of continued recovery.

Unusually low interest rates and quantitative easing have boosted market liquidity and supported financial markets and as this liquidity is constrained there is a reasonable possibility that risk assets will moderate.

Global equity markets finished April strongly, with the Eurozone now assuming a relatively benign outcome of a Macron victory to the French election. MSCI World rose 1.4% over the month and 7.2% year-to-date in dollar terms. The Eurozone was the best performing region up 2.04% enjoying both a strongly rising equity market and Euro; political pressures in the Netherlands, France and Germany have weighed on the eurozone so far in 2017 but stronger growth and falling unemployment are supporting real wages and consumer spending. Eurozone equity markets have gained 6.8% so far this year despite the uncertainty of Brexit negotiations. Rising inflation expectations, loose monetary conditions and markets priced for bad news all help us to prefer European equities at present. We believe European equities are under-estimating the strength of the eurozone economy and over-estimating the political risk.

The other clear winner over the month was Emerging Markets with the MSCI Emerging Index also up 2.04% in dollar terms. The weaker dollar environment (the Dollar Index -1.3% in April) complements the robust company, bank and country balance sheets that lead us to favour Asian markets. We think that emerging economies stand in good stead to withstand any shocks delivered from developed economies where the main uncertainties currently lie particularly while the reflation trade is allowed to run.

Japan was also a strong performer during April up 1.52%, but that was largely currency related as indicated by the weakness of Euro/Yen down 2.4% on the month. Japan is still struggling to make economic headway despite its massive quantitative easing programme but there are still many opportunities amongst Japanese equities and signs that inflation is picking up giving us hope that optimism will be realised.

The UK is feeling the pressure of BREXIT as inflation is beginning to affect spending plans and the realisation that a hard result seems more likely. The triggering of Article 50 has created clarity and as such allowed the pound, which had discounted the worse case scenario of the UK crashing out with no deal, to appreciate approximately 1% vs. EUR and 3.25% vs. USD.

GBP vs. USD Year-to-date

 

Source data: Bloomberg

This obviously had a detrimental effect on the long running overseas earnings trade and consequently the FTSE 100 fell -1.62% whereas the more domestically orientated All Share index only fell -0.69%. The forthcoming election on June 8 will mostly likely see a larger Conservative majority but the outlook will remain uncertain so the financial markets are now left to react to media feedback on the progress of negotiations and the reality of economic statistics.

The first 100 days of the Trump administration have been dominated by the failure of the attempt to reverse Obamacare and its effect on the ability of the government to successfully implement its other plans. There now exists a level of caution over the continuance of the reflation trade, although stocks are currently buoyed by the quarterly reporting season, they are priced for perfection so the uncertainty surrounding US policy will cause a negative reaction if there is a perceived threat to the boost to global growth that has already been accounted for by investors.

After five years of uninspiring relative returns, will Asia ex Japan equities crow loudest in the Year of the Rooster? The Asian markets beat global equities comfortably during the 2000s but have lagged since late 2010. However, on a medium term view, this may be about to change.

Improving Economics. China is of course the biggest player in the region and changes in the Chinese economy help to explain strong equity returns in the 2000s and weaker ones since. The Chinese authorities have deliberately slowed the economy, seeking more sustainable growth led by consumer demand and services output. The markets doubted whether China would succeed but may be changing their minds.

The IMF said last month that it expects Asia’s emerging economies to grow by 6.4% this year. China will slow a little to 6.5% and India pick up to 7.2%. Private sector forecasters are pencilling in 6.4% and 7.4%. Despite large error bands around any economic forecast, Asian growth looks impressive.

Looking at more timely indicators, Asia’s purchasing managers’ indices are mainly above the key 50 level: South Korea is the key exception. More interestingly, Citi’s economic surprise index for Asia Pacific recently hit a six-year high. The markets did not anticipate the better figures.

At an industry level, DRAM prices are rising sharply. In fact, they have doubled over the past eight months. Meanwhile, the International Air Transport Association noted late last year that shipments of components for consumer electronics, a regional strength, are rising. It also reckons that total freight volumes rose 9.8% yoy in December.

Cheap Equity Markets. After a long period of weak equity returns, it is no surprise that valuations are attractive. As of 31st January, MSCI calculated a forward P/E ratio of 12.7x for Asia ex Japan equities versus 15.7x for MSCI World and a price-to-book ratio of 1.5 compared with 2.2. This is despite a strong rally in Asia ex Japan stocks in January. Today’s valuations also compare favourably with those over the past decade.

Under-valued Currencies. Foreign investors can also take heart from generous currency levels. Over the past couple of years, the Korean won has depreciated by 5%, the Indian rupee by 8% and the Chinese renminbi by 9% versus the US dollar. As trading nations, these currency declines have given exporters an edge and also reduced the risks for overseas equity investors.

Investment Conclusion. Leaving aside active funds, many investors will seek to invest via an MSCI Asia ex Japan ETF rather than pick individual stocks. 85% of the index covers five economies (China, South Korea, Taiwan, Hong Kong and India) and over 60% is in three sectors (information technology, financials and consumer discretionary). Thus, exposure is concentrated in a few economies and industries.

True, there remain concerns over how China handles its transition and also rising private sector debt ratios. There are also worries over US-China relations in the Donald Trump era. However, the fundamentals seem good and both equities and currencies offer fair value. The only caveat is the 8% rally for sterling investors since Christmas. It may be wise to wait for a setback.

The major US stock indices and the film La La Land both broke records this month. The S&P 500, Dow Jones and Nasdaq hit all-time highs and La La Land won seven Golden Globe awards. But the question for investors is whether US equities are now in La La Land.

The Positives. Let us round up the reasons to be cheerful under three headings. First, animal spirits. President-elect Donald Trump has given US corporate morale the feel-good factor without actually doing much. However, importantly, he has nominated a business-friendly senior team. Ray Dalio of Bridgwater reckons that the key eight personnel have just 55 years’ experience of public office (mostly in the military) but 83 years in business. The equivalent figures for Barack Obama were 117 and five(!) respectively.

Second, fiscal stimulus. While artfully avoiding specific numbers, Trump has promised lower taxes and more infrastructure spending, which will give the economy a budget boost. We should get a sense of how big next month when the White House delivers its draft budget to Congress.

Third, micro measures. Mr Trump has dangled a raft of measures before the public and the markets. His proposals include a corporate tax rate cut from 35% to 15%, reducing the personal income tax bands from seven to three, a bonfire of regulations and a shake-up of energy policy. These plans could be partly paid for by getting rid of tax breaks and widening the tax base and also by a one-off 10% repatriation tax on firms’ overseas earnings.

The Negatives. However, there are also reasons to be gloomy. Here are a few:

The pre-election reasons for caution – a sluggish economy and expensive valuations – are still there. This economic recovery has been lacklustre at best. And, while equity valuation is an imprecise art, the chart shows that both the forward price/earnings and price-to-book ratios are around cyclical highs.

Furthermore, President Trump is not guaranteed to get his agenda through Congress. Trump has been talking in terms of tax cuts and spending increases but Congress prefers fiscally neutral programmes.

Also, part of the Trump package is trade barriers and immigration curbs. These were popular on the campaign trail but may not be good for either the economy or the corporate sector.

Even if Donald Trump does deliver a sizable fiscal lift, it may result in more inflation rather than more growth as the economy over-heats. And the latest FOMC minutes openly suggest that rising inflation would be offset by faster interest rate increases.

And, finally, a policy mix of easier fiscal but tighter monetary policy is a recipe for a stronger US dollar. The dollar has risen by a manageable 5% over the past six months but further appreciation will put downward pressure on corporate earnings.

Conclusion. We think the best explanation of the post-election rally is the prospect of corporate tax cuts. There is a fair chance that Donald Trump will push this initiative and that it will get through Congress. The result may be higher after-tax earnings for years ahead which discount to higher equity prices now.

However, all the good news may now be in the price and the markets could be entering La La Land. Could Inauguration Day on Friday be the start of the next downturn?