Monthly Investment Letter - Planning is everything

Monthly Investment Letter

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In last month’s letter, “Dealing with Disaster,” we looked at how to allocate and diversify portfolios for long-term success. We showed how global diversification and equities can help protect and grow your wealth over the long run.

Yet many of you asked how we’re thinking about the assets and strategies that can help portfolios if the current economic upturn rolls over.

“Plans are worthless, but planning is everything.” –Dwight D. Eisenhower

Although we consider a downturn unlikely over our six-month House View, it’s something we think about a lot. The answer is not to sell out of risk assets completely or to overpay for insurance at this time: we know our risk scenarios will probably not transpire as we expect, or in the time frame we predict. The goal is to develop strategies that might help protect wealth if our downside scenarios come true, yet will incur only minimal cost if they do not.

In this letter, I review three of the negative scenarios we’re considering, detail the signposts we’re watching to understand if the risks are increasing, and outline what investors can do today to prepare.

In our tactical asset allocation, we keep an overweight in global equities – economic and earnings data have remained promising over the past month. We adjust our FX strategy positioning, closing our underweight in the Swiss franc in favor of an underweight in the Norwegian krone against an overweight in the Swedish krona. We also close our underweight in the Australian dollar in favor of an underweight in the US dollar against an overweight in the Canadian dollar.

Scenario 1: Much higher US interest rates

A first risk we’re monitoring is higher-than-expected US inflation translating into an aggressive Federal Reserve rate hike cycle. Each of the six recessions the US has experienced over the past 45 years occurred after hiking cycles. These downturns were preceded, on average, by 20% corrections in the S&P 500, with similar effects on equities globally.

Inflationary pressure is currently relatively low. Average hourly earnings growth is running at just 2.4% year on year – versus a long-term average of 4.2% (Fig. 1). But with unemployment close to all-time lows, companies could soon face sufficient difficulty hiring that they are forced to raise wages more rapidly. This could lead the Fed to hike interest rates aggressively in an effort to constrain demand and avert a wage-price hike cycle.

While rapid inflation is not our base case, we will grow more concerned if: hourly earnings growth rises toward the 4% level seen ahead of the 2007 financial crisis; 5-year/5-year breakevens (a market measure of medium-term inflation expectations) climb above 3% from 2.2% at present; the yield curve inverts, with 2-year Treasury yields surpassing the 10-year yield; or core personal consumption expenditure (PCE) inflation breaches 2%, from 1.3% today.

We believe a number of strategies could perform relatively well in such an environment, while also performing adequately if the threat does not materialize:

• Hedge funds have historically outperformed other asset classes during periods of tighter monetary policy, averaging 11.4% annualized returns versus 7.6% for the S&P 500 during the 1994–95, 1999–2000, and 2004–06 hiking cycles (Fig. 2).

• Long-duration government bonds could provide another defense, as part of a well-diversified portfolio. Although buying bonds to protect against inflation and rising rates seems counter-intuitive if the Fed is hiking rates to reduce inflation, long-term bonds could even rally on the expectation that growth might slow. This was the case in the 2004–06 hiking cycle (termed the “Greenspan conundrum”).
• Regional diversification. Europe, the US, and Asia are all at different points in their economic cycles, making it unlikely that inflation will soar in all three at the same time. The 1970s bout of high inflation was largely contained to US and the UK; continental Europe did not suffer as badly. German stocks outpaced US equities during the decade, with the DAX returning an average of 10% annually, compared with 6% for the S&P 500, in USD terms.
• Risk-parity strategies could also be effective at hedging inflation risks, especially if the latter emerge gradually. Risk-parity strategies aim for the same level of risk contribution from different clusters of assets. Some strategies include an inflation-risk cluster, including such assets as commodities, precious metals, and inflation-linked bonds.

Scenario 2: Local debt crisis in China

A second risk is rising leverage in China, where non-financial debt has increased from 145% in 2007 to about 270% of GDP last year, according to the Bank of International Settlements (Fig. 3). The “debt threat” led outgoing People’s Bank of China Governor Zhou Xiaochuan to recently warn that “if we’re too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a Minsky Moment*.”

In previous China debt panics, the best strategy has been to stay invested. Global investors have consistently underestimated the Chinese government’s ability to control events through regulation. In August 2015 and early last year, US stocks recovered their losses within three months of Chinese capital controls helping to stem the decline in foreign exchange reserves.

Our base case is that China’s debt accumulation is manageable. External debt-to-GDP is around 13%, quite low relative to, say, the US’s 98%. And even if capital starts to leak, the country has USD 3.1trn of foreign exchange reserves.

But we will be monitoring several key indicators of distress. Higher government bond yields or interbank borrowing rates would indicate rising financial stress and increased potential for defaults. Meanwhile, a renewed decline in foreign exchange reserves could indicate that capital is again fleeing China, reducing the government’s ability to manage its currency and debt.

Debt crises in Asia have historically rewarded diversification. During the Asian financial crisis, the MSCI World Index declined by 2% while Asian markets fell by 48%. And in more recent worries Asia ex-Japan equities fell 14% versus a 10% peak-to-trough decline for global equities in August 2015. Although diversification out of Asia can be costly in good years (this year Asia is up 27% versus a 18% return for the MSCI World Index), we believe it is worthwhile to mitigate risks.

Scenario 3: Geopolitics - Middle East and Korea

Middle East

Recent Middle East events have raised political tensions in the region. In instigating a crackdown on alleged corruption, Crown Prince Mohammad bin Salman has taken a political risk. Our base case is that the move enhances the prince’s ability to push through reforms. But it could unleash opposition and undermine political stability in the Kingdom. Meanwhile, tensions between Saudi Arabia and Iran intensified after the interception of a missile allegedly launched by Iranian-backed Yemeni Houthi rebels toward Riyadh. Lebanon’s Prime Minister Saad Hariri also resigned, blaming Iran’s influence over his nation.

The main transmission mechanism between Middle East political instability and the global economy would be through a sustained increase in oil prices. Oil inventories are 10% above historical norms, which provide a short-term buffer, and US shale production could increase over the medium term should prices climb. But we are watching a number of factors to assess if the risk is rising.

In terms of positioning, an overweight in energy stocks could help protect investors from uncertainty in the region.

A political backlash against King Salman or the crown prince would raise concerns about political stability in the world’s largest oil exporter and swing producer. The Kingdom controls most of the world’s 2.5–3 million barrels a day of spare capacity. Red flags would also be raised by an escalation of the conflict in Yemen, or in tensions in Iraq or Qatar. The worst-case scenario would be the outbreak of regional proxy wars leading to a direct confrontation between Saudi Arabia and Iran.

In terms of positioning, an overweight in energy stocks could help protect investors from uncertainty in the region. The sector could be expected to benefit if oil prices rise. And, even if tensions calm, the average dividend yield of 6% offered by European energy firms is both attractive and well supported in our view. Meanwhile, the valuation of US energy firms is near a 40-year low, both on a price-to-book and a relative cyclically adjusted price-earnings basis (Fig. 4).

Our other observation, based on recent oil price spikes, would be to avoid hasty selling of stocks. Since 2000, the maximum drawdown on global stocks during oil-price spikes has averaged just 6%, and stocks were back in positive territory even before oil prices peaked, which on average was three months later.

Korea

North Korea’s steps toward creating a nuclear-enabled intercontinental ballistic missile have increased the risk and consequences of mishaps or miscalculations. Various “near-misses” during the Cold War resulting from miscalculations show how conflicts can break out even if neither side is incentivized to start them.

We see a couple of positions that could perform relatively well in both our base case and Korean tail-risk scenario:

1. We believe gold and silver could outperform industrial metals in both our base case (due to low real interest rates and weak demand for industrial metals) and in the case of rising tensions, when gold could be seen as a “safe haven."
2. Chinese stocks could outperform Taiwanese stocks in either scenario. If concerns about conflict increase, we see Taiwan’s market is more vulnerable to disruptions to global supply chains than China’s. And even in our base case, we expect China’s economy to outperform Taiwan’s.

Worry about the downside and the upside usually takes care of itself. The world today faces upside and downside risks. While we think on balance markets are supportive of risk assets into the end of 2017, tracking risks and how to mitigate them is where we spend considerable time.

Worry about the downside and the upside usually takes care of itself.

Tactical asset allocation

This month we leave our tactical asset allocation positioning unchanged.

We remain overweight global equities. Data this month showed that the US economy enjoyed its best back-to-back quarterly growth since 2014, expanding at a brisk 3% pace in the third quarter. And US earnings per share were up around 7% in the third quarter, with a particularly strong performance by technology firms. The Eurozone, meanwhile, is on track for the fastest annual growth rate in a decade this year. We don’t expect global equities to return another 20% this coming year, and equity valuations are now close to or above their 20-year averages in most regions. But we believe strong earnings growth should help stocks continue to have positive returns.

Within Europe we prefer Eurozone equities over UK stocks. Excluding financials (which include the drag from US hurricane damage on the Eurozone’s large reinsurance industry), earnings rose by around 12% in the third quarter. In contrast, high UK inflation is reducing consumer spending power, Brexit uncertainty is likely to contribute to slower investment spending, and the tailwind from a weaker pound has ebbed.

In our FX strategy, we close our underweight Swiss franc (CHF) and open an underweight in the Norwegian krone (NOK) versus the Swedish krona (SEK). We see greater potential for weakness in the NOK than in the CHF, which has already weakened by 8% against the euro this year. Norway’s inflation has been falling toward 1%, and a declining housing market looks likely to undermine consumer spending (Fig. 5). We underweight the NOK relative to the SEK. Swedish growth and inflation indicators point to overheating, with consumer prices rising faster than the central bank’s 2% target in three of the last four months. This is likely to require the Riksbank to make a more hawkish shift.

We also close our underweight AUD and open an underweight in the US dollar relative to the Canadian dollar. Downward pressure on the AUD should be reduced going forward, with both business confidence and the labor market holding up well, while the US dollar could face longer-term challenges from its twin fiscal and current account deficits. We remain upbeat on the CAD. The Canadian economy has recovered from a 2015 slowdown and growth is now running above potential.

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*During a “Minsky Moment” the realization dawns that debt built up to fund speculative investments is unsustainable. Lenders call in their loans and investors are forced to sell, causing a collapse in asset prices. Hyman Minsky was a US economist whose research sought to explain the characteristics of financial crises.