Top 10 ideas for 2017
Idea 1: US equities
Despite a huge rally from the low of 2009, we believe US equities remain well-posi-tioned to continue to rise in 2017.
Equity bull markets don’t die of old age; rather, they typically end when the econo-my enters a recession. The good news is that we do not believe an economic con-traction is on the horizon in the near term, and potential pro-growth policies from a Trump administration, such as tax reform, infrastructure investment, defense spend-ing, and regulatory reform, should sustain the expansion.
Economic growth has further room to run
Leading indicators in the manufacturing and services sectors imply increased activity ahead, and the US consumer remains in very good shape. This should mean higher revenue and earnings growth for US corpo-rations, especially as the headwinds from the oil price collapse and strong US dollar diminish. CIO expects US earnings per share to rise 8% in 2017. The Trump admin-istration’s policy priorities suggest there could be some upside to this estimate, es-pecially from the repatriation of overseas cash.
Monetary policy will likely remain accommodative
Inflation is firming, but remains comfortably below the US Federal Reserve’s target. While the Fed will likely raise borrowing costs (CIO expects a hike in December, and two more next year), it is under no pressure to hike rates aggressively and put the ex-pansion at risk. Financial conditions for businesses and consumers look set to re-main accommodative, suggesting that in-terest rate-sensitive segments of the econo-my, such as housing, will continue to be well-supported, especially in the context of continued labor market gains.
Valuations are not stretched
While absolute valuations for US stocks, such as price-to-earnings (P/E) multiples, are slightly higher than average, they are not stretched and are justified by low infla-tion and durable growth. Stocks currently trade at a forward P/E 16.5x versus a long-term average of 15x. Also, bear in mind that historically, P/E multiples tend to rise when interest rates increase from low levels. Finally, equity valuations contin-ue to look attractive relative to bonds.
Idea 2: Sector preferences
Among the sectors we favor in the US equity market, we high-light those that have above-average, near-term earnings growth (healthcare and finan-cials) or strong secular growth drivers (technology).
US Financials
In the days following the US election, finan-cials were the best-performing sector. The prospect of a more favorable regulatory en-vironment and the fairly rapid backup in in-terest rates were the primary drivers of the strong gains. We believe these trends will persist, suggesting that the outlook for fi-nancials remains favorable.
Interest rates look poised to grind higher as the Trump administration pursues policies that will boost US economic growth and in-flation. Even before the election result, in-flation was beginning to firm, and the Fed looked poised to raise interest rates at its December meeting. We expect two more rate hikes in 2017.
While a Trump administration will not likely be able to change most of the financial re-forms that were put in place in the wake of the financial crisis without some Democrat-ic support in the Senate, the risk of further adverse legislation has clearly diminished. In addition, the regulators will have some lee-way to offer more favorable interpretations of existing regulations.
US Healthcare
We expect the sector to advance as fears of stricter drug pricing regulation abate after the US election. However, until the market gains some clarity about what will replace Obamacare, some uncertainty may linger. Pharmaceutical stocks should benefit from better product pipelines, diverse revenue sources, and attractive valuations that do not reflect our expectations for mid-to-high single-digit percentage earnings growth. The sector could be a key beneficiary of the repatriation of overseas cash.
US Technology
Secular drivers (cloud computing, e-com-merce, internet advertising, security) remain in place, and enterprise spending should remain resilient as corporate profits improve. In addition, the outlook for smartphone end-market demand is bright-ening due to pent-up demand as the em-bedded base ages and expectations grow that more substantial enhancements to the next generation of smartphones will be rolled out in 2017.
Valuations appear attractive, and the sector continues to aggressively return capital to shareholders, which could get a further boost from the Trump administration’s plans to encourage the repatriation of over-seas cash.
Idea 3: EM equities
After years of underperfor-mance versus developed markets, equities have outperformed so far in 2016. Political uncertainty could drive short-term volatility. But CIO thinks EM stocks can continue to perform next year.
Regional growth rates should speed up next year.
Leading indicators of economic activity, such as purchasing managers’ indices, have reflected four months of EM expansion to October 2016.
The EM growth pickup is not just a func-tion of middle-class domestic demand growth. Terms of trade have improved and commodity producers should benefit from stable or rising commodity prices – CIO forecasts Brent prices climbing to USD 60/ bbl next year.
Low global interest rates mean abundant liquidity in EM
Despite the back up in interest rates after the US election, global interest rates look set to stay low next year. CIO does expect the US Federal Reserve to hike rates twice and the European Central Bank to reduce the scale of its bond-buying programs. But loose monetary policy will be tightened only gradually. And the premium that EM firms pay to issue investment grade debt re-mains close to two-year lows.
CIO also expects the US dollar to fade in value as investors price in a gradual pace of US interest rate increases. That matters for EM companies, many of whom generate sales in local currencies but service debt in dollars. A softer USD next year would effec-tively cheapen debt and offer a potential boost to corporate earnings.
Earnings per share growth is rising, backed by sustainable fundamental drivers.
The earnings of developing market firms are finally growing again, after falling by one-third since 2012. From the trough in February, EM profits had climbed by 8%. And the revisions ratio (a measure of earnings upgrades versus downgrades from company analysts) has rebounded from –40% to a balance of positive and negative revisions.
Investors should monitor the evolution of US trade policy under the new government, but at this stage we believe that EM funda-mentals are strong enough to win out against uncertainty.
Idea 4: EM FX basket
Emerging market (EM) currencies were among the big winners in 2016. Yet we believe the coming year is set to be another positive one for select EM foreign exchange.
Political uncertainty could create volatility for emerging market currencies in the near term. But the low-yield environment remains supportive, and valuations are attractive. We favor a basket of EM currencies – including the Brazilian real, the Indian rupee, the Rus-sian ruble, and the South African rand, equally weighted – versus a basket of equally weighted developed market (DM) currencies – the Australian dollar, Canadian dollar, and Swedish krona.
Our selected EM currencies offer a substantial interest rate carry.
At the time of writing, this rate advantage is around eight percentage points. Brazil has the highest yield in our group, with three-month rates at 12%, while even the lowest rate – in India – is 6%. In contrast, DM rates are still ultra-low. For our DM funding basket, the yield is just 0.6%.
The risk of a significant depreciation for these EM currencies is contained.
While these currencies rallied in 2016, they are still significantly down over the past five and 10 years. Since 2006, our EM basket has depreciated 60% versus the US dollar. That has left these currencies close to what CIO believes is fair value. Meanwhile, they are benefiting from a turnaround in the economic outlook. In 2016, purchasing managers’ indices climbed above the 50 mark separating expansion from contrac-tion. Commodity prices also moved higher, helping the outlook for growth. We expect both the Russian and Brazilian economies to expand again in 2017 after deep reces-sions.
Diversification limits the risk that politics will get in the way.
In The end game? we highlight-ed the influence that policy can have on markets. Russia, Brazil, and South Africa have all been prone to political turbulence in recent years. But the chances of setbacks hitting all of these countries simultaneously is lower. As ever, diversifi-cation is a prime investor tool.
Relative trade: Investors can protect against EM volatility by pairing with select DM currencies.
EM currencies would likely decline if commodity prices and/or global growth declined, but so would the currencies of commodity-reliant developed nations such as Canada and Australia. Sweden’s krona, meanwhile, is highly correlated to global growth. As a result, using this select basket of developed market currencies to fund the trade should reduce the overall risk of the position.
What’s more, we expect the central banks of these countries to be sensitive to a strong appreciation of their currencies, reducing the potential downside of the position even more.
Investing in emerging markets is risky. EM currencies would face risks if global growth slows, or protectionism rises. But through this currency basket pairing we have attempted to reduce downside, and we expect 2017 to be another positive year for EM currencies.
Idea 5: Municipal securities
Although politics will create headwinds for US municipal bonds, we believe that munis still play an important role within a portfolio.
Municipal bond investors have been amply rewarded for taking both credit risk and du-ration risk in recent years. The technical en-vironment in which tax-exempt investors must operate has now changed. We advo-cate defensive positioning for municipal portfolios.
1) Politics will create headwinds for US municipal bonds. First, broad-based tax cuts would reduce the value of munici-pal bond tax-exemption, thereby placing some downward pressure on prices. Sec-ond, larger deficits based on more federal spending will lead to a steeper yield curve and higher rates that will have a spillover ef-fect on munis. Third, higher long-term yields often lead to a sharp reversal in muni mutual fund flows. And, finally, we antici-pate that more infrastructure spending will push muni new issuance higher, represent-ing another headwind for the municipal bond market.
2) Manage duration risk. From a maturity standpoint, we recommend bonds with ma-turity terms in the 6- to 10-year portion of the curve. We believe bonds with a shorter duration segment will hold up better than longer-dated debt as talk of tax reform and higher federal budget deficits dominates the news cycle. We maintain our preference for high-coupon bonds versus those with low coupons to help minimize price volatili-ty. We also continue to favor floating-rate securities that are better insulated from interest rate changes because the income distributions are reset periodically based on a particular reference rate.
3) Focus on higher-rated credits. We prefer higher-rated investment grade paper over high yield bonds. Lower-rated munis have underperformed their investment grade counterparts in recent months as the technical environment for tax-exempt obli-gations has weakened. Mutual fund manag-ers are likely to be more discriminating in what they choose to purchase in a volatile market, so municipal credits with better credit profiles will prove more resilient.
Despite our shift to a cautious view on mu-nicipals, we believe that tax-exempt bonds continue to play an important role in an overall well-diversified portfolio. Many indi-vidual investors buy munis for two basic reasons: income and safety of principal. That has not changed.
Against this backdrop, we prefer utility en-terprise debt and bonds issued by estab-lished transportation agencies and selected institutions of higher education. We are less constructive on the state and local govern-ment sector, and recommend that investors avoid obligations where repayment is sub-ject to discretionary annual appropriations. Careful credit selection will be imperative. We also take a more cautious stance on non-profit healthcare. The repeal and re-placement of the Affordable Care Act cre-ates uncertainty and may cause the sector to underperform in the near term.
Idea 6: Master limited partnerships
With an improving outlook for the broader energy industry and the need for additional US energy infrastructure, we be-lieve that Master Limited Part-nerships (MLPs) are well-posi-tioned for 2017.
Increasing oil and natural gas production activity, particularly in the Permian and the Marcellus shale formations, as well as growing demand for natural gas and natural gas liquids in the US, will drive the need for additional energy infrastructure expansion over the next several years. This is supported by the potential for improving oil and natural gas commodity prices in 2017 and 2018. Further, we believe US President-elect Trump‘s energy policies could encourage energy infrastructure investment. Combining the improving fundamentals and the attractive yield leaves MLPs well-positioned for 2017.
Infrastructure expansion will drive MLP growth. Expansion of US oil and natural gas production and consumption is driving the need for additional energy infrastruc-ture. The production activity is evident in the most prolific and economic production basins, like the Permian and the Marcellus, where new gathering, processing, and transportation infrastructure is necessary.
As domestic demand for natural gas rises and crude oil exports grow, additional pipelines and logistics infrastructure will be necessary.
Improving production and prices should support the expansion. For crude oil, as global supply and demand rebalances in 2017, there will be fundamental support for higher prices that will drive additional drilling activity, driving higher utilization of existing midstream energy assets and promoting the need for additional infra-structure capacity.
For natural gas, rising demand in the US, coupled with new supply resources, is driving the need for additional gas pipeline and processing capacity. Additionally, rising demand for ethane and other natural gas liquids will drive additional fractionation and pipeline capacity investments. All of this supports cash flow and distribution growth for MLPs.
Yield looks attractive relative to high yield equity and fixed income alterna-tives. MLPs have an attractive yield and are poised to grow cash flow and distributions as energy infrastructure investments grow. The MLP distribution yield is particularly attractive in a low interest rate environ-ment. Combining the yield with attractive distribution growth offers the prospect of a low double-digit total return for 2017 at current valuation and growth levels, which have more upside potential than downside on a risk-adjusted basis.
Idea 7: US senior loans
Amid decent economic growth, inflation picking up, and the Fed likely to increase rates, we believe US senior loans are among the most appealing segments of fixed income in 2017.
A standout performer in fixed income markets for 2016 was US high yield, which appreciated 13% in the first 10 months of the year. This impressive run has left these assets looking less attractive. Senior loans appear more likely to shine in 2017.
Senior loans are attractive in an envi-ronment of low fixed income yields.
Ranging 5–6%, the yield on senior loans constitutes a pickup of 4% over short-matu-rity investment grade corporate bonds. Even if we assume a rise in default rates from the current 2% toward the long-term average of 3%, we see senior loans delivering total re-turns of 3-5%.
Coupons can adjust upward, providing protection against higher base rates.
This floating rate feature reduces the dura-tion risk of senior loans. The standard senior loan is benchmarked against three-month USD LIBOR, and its coupon rate is reset every 45 to 60 days on average. There is a minimum floor for resetting – on average at 98 basis points on LIBOR. Once that level is breached, however, senior loan coupons track interest rates higher. With the Fed foreseen to increase interest rates in December and twice in 2017, we expect demand for this asset class to increase.
Credit risk is lower than for high yield bonds.
Overall, we are upbeat about the outlook for the US economy and corporations. Our forecast is for S&P 500 earnings per share to grow by 8% in 2017, up from an esti-mated 1% in 2016. Even so, the US credit cycle is relatively mature, so investors should monitor the risk of higher defaults. While the direction of default rates for senior loans have historically mirrored those of high yield bonds, recovery rates are higher, since senior loans are often secured against a firm’s assets and rank senior in the capital structure. Over the past 20 years, the aver-age annual credit loss on senior loans was 1.3%, less than half the 2.8% loss on high yield bonds.
Idea 8: TIPS
There are signs that inflation is rising. The inflation-protected securities market is underpricing the risk of further increases, in our view.
Investors typically view inflation as a threat that erodes the real value of their assets. But we believe that it will be possible to profit from accelerating inflation in 2017.
Here’s why:
There is limited slack left in the US jobs market, which should presage higher wage growth.
US unemployment is now back to pre-finan-cial crisis levels, with average hourly earnings already having started to rise more quickly in the summer of 2016. Along with higher salaries, such wage increases typi-cally translate into higher discretionary spending and promote a broader increase in prices.
The oil price appears to have stabi-lized, removing a key downward force on inflation.
The value of a barrel of Brent fell 75% from mid-2014 to its low point in February 2016. This plunge contributed to repeated downside surprises in consumer price index (CPI) readings. While oil only accounts for around 6% of the overall price index in the US, it has an outsized effect on inflation perceptions. Through 2017 we expect the global glut in oil supplies to clear, allowing the price of Brent to rise modestly to USD 60/bbl over the coming 12 months. The base effects of steadier oil are likely to push inflation up in the coming months.
Donald Trump’s platform has an infla-tionary bias.
His fiscal policy is likely to be expansion-ary, and he leans toward protectionism, which is inflationary due to the effects of tariffs and curtailed immigration.
We expect a weaker dollar to boost import prices, an additional spur for price rises.
The dollar has climbed by 25% since mid- 2014, according to the Bloomberg Dollar Spot Index. This currency strength has been dragging down the price of imports. As the US dollar has stabilized recently, import prices have started to climb. CIO expects dollar weakening in 2017 given the current overvaluation of the US dollar.
In addition, statements from top Federal Reserve officials, including Chair Janet Yel-len, suggest that the Fed is willing to toler-ate inflation slightly above its 2% target. In late 2016 Yellen indicated that the Fed could consider running a “high-pressure economy” for a while to draw more discour-aged workers back into the labor force.
CIO believes that the best returns from this trade can be achieved by focusing on TIPS with a duration between three and seven years. Inflation expectations embedded in shorter-duration securities tend to be more volatile and are already pricing in a more significant uptick in inflation. The long end of the yield curve, by contrast, is less liquid.
Idea 9: Alternatives
Hedge funds and private markets can play a critical role for investor portfolios in 2017. Traditional asset class returns are likely to be mod-erate, and uncorrelated ex-posure will be more valu-able than ever.
Hedge funds
We believe that hedge funds represent a crucial part of well-balanced portfolios. In an environment where low yields will likely mean that returns for bonds are low, we ex-pect hedge funds to provide an attractive al-ternative, with low correlation, higher re-turns, downside protection, and only moderate risk.
In 2017 we expect performance to be boosted by:
1. Steady increases in US interest rates. Hedge fund strategies have historically performed well during periods of rising interest rates. The HFRI Fund Weighted Composite Index returned close to 12% annually on average during the past three US rate-hike cycles. Although this kind of performance is unlikely to repeat itself, it demonstrates that hedge funds are capa-ble of strong absolute and relative perfor-mance during periods of rising rates.
2. Rising equity markets. Hedge funds have a small positive beta to equity markets, and should stand to gain if the equity market moves higher, as we expect.
3. Higher stock dispersion and normalizing volatility. As the equity market rally matures, stock fundamentals are becoming more import-ant for price performance, providing equity long-short managers opportunities to generate alpha.
We view well-diversified portfolio investing in a range of managers and styles as the best approach to hedge fund investing. For instance, in 2016, diversifying a hedge fund portfolio using systematic traders would have significantly improved risk/return characteristics as the strategy performed positively when other hedge fund styles suffered. As a stand-alone investment, however, the strategy ranks among 2016’s low-tier performers.
The hedge fund industry has suffered out-flows recently, partly because of fund-of-fund redemptions and partly due to the rise of smart beta exchange-traded funds. We think the outflows create a unique oppor-tunity for private investors to increase their allocation to hedge funds and to put it in the hands of top-tier managers.
Private markets
For investors with a limited near-term need for capital, 2017 could also be a good year to explore private market strategies.
Public equity listings seem to be going out of fashion: the number of US-listed companies has roughly halved since its peak in 1996. Firms, in particular many of the fastest grow-ing technology companies, are staying private for longer. Globally, there are now 177 pri-vate companies valued at USD 1bn or more, according to CB Insights. Gaining diversified exposure to the firms driving the global econ-omy now requires investors to have at least some exposure to private markets.
These strategies also provide investors with additional potential sources of return, including an illiquidity premium for locking up capital, which are important in a low yield environment. They expand the num-ber of investment options available to include illiquid companies and assets: managers of private market funds can capitalize more easily on mispriced assets thanks to their long-term perspective, locked-up investment capital, and ability to uncover relevant information not as readily available to average investors.
In a low-return world, manager selection is particularly important, given that the per-formance difference between the top and bottom quartile of private equity funds is far wider than it is for equities and bond funds, and can exceed 20%. Access to top-tier private equity managers is equally import-ant, since they can create significant value in their portfolios’ companies by utilizing industry knowledge, optimizing capital structures, and sharing best practices across those companies.
Idea 10: Sell Treasuries
The global economy is strength-ening and US Treasury positions are rising. Investors could consid-er replicating some of the insur-ance features of the asset class with other assets or approaches.
Although “Sell Treasuries” appears in our Top 10 ideas for 2017, we should be clear that we see a sharp sell-off in US Treasury yields in 2017 as unlikely. In spite of increas-ing growth in the US, prospects for expan-sionary fiscal policy, and signs of recovery abroad, the ECB’s quantitative easing (i.e. central banks buying government debt) is taking place at the fastest pace since the height of the financial crisis. Given the cor-relation of global interest rates, we do not anticipate a large rise in US Treasury yields as foreign demand remains high.
That said, the risks to US Treasury holdings are rising. Inflation is starting to pick up, and is now at a two-year high in the US and Europe. If economic growth surprises to the upside there is an outside risk that the US Federal Reserve will be forced to raise rates more aggressively than we cur-rently expect. The European Central Bank might also have to taper its quantitative easing program which would trigger selling ins US Treasuries from foreign investors. With yields currently so low, US Treasuries offer little cushion against rising interest rates or longer-term inflation risks.
The alternatives to US Treasuries
Some allocation to Treasuries makes sense for most investors, but to prepare portfoli-os for the challenges of today, we see a number of potentially attractive alterna-tives:
1. Switching out of bonds with a high probability of negative return. It is important to hold US Treasuries in a port-folio. But investors shouldn’t hold bonds that have a very high probability of deliv-ering negative returns. They should look to switch out longer-duration bonds that are particularly vulnerable to interest rate rises.
2. US inflation-protected securities. In-flation presents an important risk to holders of US Treasury securities: it serves to lower the nominal value of the bonds’ principal and coupons while increasing the risk investors face from interest rate hikes. Anyone looking to mitigate infla-tion risk while remaining invested in high-quality bonds could consider infla-tion-protected bonds. Treasury Inflation Protected Securities are one of our Top 10 Ideas for 2017, as we be-lieve the market is under-pricing the risk of higher inflation.
3. Alternatives. Those with more risk ap-petite who seek return and portfolio di-versification could also consider alterna-tives, such as hedge funds, as a bond alternative. At turning points in monetary policy, correlations between bonds and equities can rise, reducing the diversifica-tion benefits provided by US Treasury bonds. Alternatives offer a third source of return that may be relatively less correlat-ed than bonds and equities during times of market uncertainty about monetary policy.
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