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Navigating Negative Rates In 2017

We are facing a world where ‘safe assets’ pay nothing or even charge you to own them, yield can only be found at higher risk levels and markets which have benefited from falling yields are vulnerable to a change in direction. The question for investors is: what to do? We believe there are opportunities worth pursuing, along with risks that require careful mitigation.

Despite these difficulties, we believe a thoughtful approach can help investors to meet these income challenges, by applying six simple rules:

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Identify your objectives

You need to clearly define your investment objectives and use these to guide all portfolio decisions. What yield or return do you need? What level of risk tolerance is acceptable? Are

you sensitive to short or longer term capital risk? How much liquidity do you require? If all of these things are broadly realistic, they can guide you in building an appropriate portfolio.

However, if you try to push any of these objectives too far, the balance of outcomes may be unattainable. For example, if you try to chase yield too far, it may increase the risk to capital loss. If you try to push volatility down too low, you may not be able to generate yield or a suitable return.

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Diversify your portfolio

Diversification is one of the most powerful tenets of portfolio construction. Assets with different characteristics will often offset each other in terms of risk, but can all still contribute towards performance, thereby improving the return achievable for a given level of risk. This is incredibly useful when trying to balance the need for yield against a limited appetite for volatility.

The key issue here is implementation. We think asset class labels can be highly misleading. For example, we think there is a much closer relationship between equities and high yield bonds than high yield and government bonds. Their respective labels say they are different asset classes, while their underlying performance driver, essentially corporate profitability, is the same for both.

We believe investors need to consider asset behaviour, when building portfolios. This is why we think of assets as exhibiting either ‘growth’, ‘defensive’ or ‘uncorrelated’ characteristics, regardless of the traditional labels. A truly diversified portfolio will have a blend of all three, which is critical to achieving proper portfolio diversification.

Adapt to changing market conditions

What is attractive today will change over time as markets move and economies evolve. Adapting exposure to re ect these changes, and rotating out of asset classes as they become less attractive can help towards achieving the stated objective.

In particular, certain types of assets will typically do well in times of economic expansion, such as equities and high yield bonds, and do poorly in recession, whereas other assets normally exhibit more defensive qualities, such as high quality government bonds. So a fundamentally different mix of exposures makes sense at different stages of the business cycle. It is, however, important to take account of value, as assets tend to go from cheap to expensive and back again, and the cyclical behaviour of assets may change in response to these valuations changes. Assets, for example, like government bonds, may have lost some of their defensive characteristics as they have become more expensive, making them less useful in negative economic periods.

Build exposure from the bottom up

Building portfolios from the bottom-up seeks to ensure that positions are consistent with the desired outcome, rather than just exhibiting broad market characteristics. The market will

contain many securities which may not help towards meeting your objectives. It will contain expensive assets, as well as ones that don’t provide much income. It will also contain assets with signi cant quality or capital risks. As a result, it is important to tailor the underlying portfolio to re ect the desired outcome and, again, to allow this mix to evolve over time.

Think holistically

Building from the bottom-up also allows a holistic approach across asset classes and capital structures. For example, given the many challenges faced by the banking sector, we have felt

that it is generally better to lend to banks as a senior bond holder than to own their equity. Regulatory change is designed to make harder for banks to make money for their equity holders, but conversely regulation is designed to make banks safer for their bond holders.

Similarly, earlier this year when oil prices collapsed, a lot of energy-related assets ended up at relatively cheap levels across their capital structures. We looked to see whether there were interesting opportunities that could do well, even if oil prices remained low, and which would benefit from any recovery in the oil price. Reviewing the opportunity set, we found that some of the best opportunities were within US high yield energy sector bonds, but selectivity would be key, because of the risk of default.

Hope for the best, but prepare for the worst

Financial markets are always hostage to events. One way to guard against this is to think about which events are worth worrying about, and then analyse their potential consequences

for markets, and the implications for your portfolio. This can be looked at alongside how probable the event appears to be, to decide whether to hedge exposed areas within the portfolio. This kind of approach worked particularly well in advance of the UK’s EU referendum, a discrete risk event with an uncertain binary outcome.

Rather than taking a view on how the vote would go, we believed that a more prudent course was to seek to reduce risk to limit the possible downside, in return for perhaps foregoing some of the upside. It can be very useful to manage exposure around future referenda or elections in a similar way.

Open-ended event-based risks offer a different challenge, such as the risk of a ‘hard landing’ in China, the risk of an oil price spike, or the risk of a bond yield spike. With these, it is worth examining exposure levels to see whether it makes sense to hedge certain risks while still maintaining core strategic positions.

John Stopford is Co-Head of Multi-Asset at Investec.

The Road to Retirement is as Important as the Destination

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El camino a la jubilación es tan importante como el destino — CC-BY-SA-2.0, FlickrPhoto: DD. The Road to Retirement is as Important as the Destination

If you use the GPS map application Waze then you know that there are usually multiple routes to a destination, and that each could provide an experience remarkably different than the others. You could follow the easiest route and make it to your location on time and without stress, but you could also get stuck in heavy traffic, because you choose “shortest route” on the app instead of “fastest route.” Or, seeking to save time, you could choose the fastest route but find yourself in a confusing maze of one-way side streets littered with potholes.

Employees participating in defined contribution retirement plans also take different routes to a common destination — retirement — and have different investment experiences along the way. A primary driver of a plan participant’s experiences is asset allocation, and the widespread adoption of target date and other default strategies used for that purpose is well documented. What is surprising, however, is that even with the proliferation of Target Date Funds (TDFs), more than three- quarters of retirement plan assets are still invested in individual core menu options, as shown below in Exhibit 1.

This has motivated some plan sponsors to enlist “white label” strategies for help. White label strategies contain one or more funds that are stripped of company and fund brands and replaced with generic asset class names or investment objectives such as “income” or “capital preservation,” among others. These solutions aim to improve core allocations (by making plan choices simpler), create more diversified portfolios and be more cost effective.

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Aligning white label solutions with participant DNA

You can take a white label strategy a step further by aligning the type of investment experience the strategy will deliver with factors like participant perceptions of investing and plan demographics. In other words, you can build investment strategies that make the journey to retirement a bit more pleasant. The general characteristics, or “DNA,” of participant bases can vary greatly. Many DC plans, for example, have growing numbers of millennial workers (those born between 1980 and 2000) among their ranks. Having started their savings years with the bursting of the tech bubble followed by the global financial crisis, millennials tend to be conservative investors and concerned about losing money despite their long-term investment horizons. They have the same amount invested in cash and fixed income assets as older generations do. Plans with a significant millennial participant population should consider options that aim to limit losses in challenging market environments while still providing the growth opportunities critical for younger investors, given their long journey to retirement ahead.

By tailoring white label investment options to the characteristics and unique needs of a particular demographic or work force, the solutions can be optimized to deliver an investment experience that can drive better long-term outcomes for participants.

How can you determine what type of investment experience is most appropriate for a given population? Exhibit 2 provides some examples of factors plan sponsors can consider when evaluating the best approach for their plan. White label solutions incorporating these factors may help participants stay invested through various market conditions.

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Don’t ignore the journey

For most, there isn’t a perfect route to retirement. There are inevitable bumps and detours along the way. You can find ways to make the ride easier and less anxiety-provoking, however. Since plan demographics, behavioral beliefs and investment committee dynamics vary from plan to plan, these factors can play a role in determining the appropriate investment experience for a group of participants.

Demographic considerations such as age, employee turnover and the presence of a Defined Benefit (DB) plan are important drivers, while behavioral factors including loss aversion, engagement and professional profile are also important. Additionally, you should consider investment committee beliefs around expressing investment views and the role of a core menu. Taking all of these factors into consideration can help you optimize white label portfolios for your participants. While getting participants to their retirement destination is critically important, you can’t ignore the journey they will take to get there.

Kristen Colvin is a director of consultant relations at MFS Institutional Advisors, Inc., the institutional asset management subsidiary of MFS Investment Management® (MFS®).

A Mixed Bag, Not A Game Changer

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Amundi lanza el primer ETF con exposición a bonos flotantes denominados en dólares — Pixabay CC0 Public Domain. A Mixed Bag, Not A Game Changer

In recent weeks, the market has been abuzz with talk about a rotation in the equity markets from more defensive sectors like utilities, REITS and large-cap multinationals to “riskier,” cyclical sectors. While a rotation is clearly underway, I question the durability of the current trend.

This rotation began in September, when economic data began to confirm an upturn in the pace of US growth, and picked up after the US presidential election. The election gave the market a shot of adrenalin, with investors anticipating lower taxes, less onerous government regulations and a significant increase in infrastructure spending, which theoretically should improve the pace of economic growth. In the post-election environment, beaten-down, lower quality sectors such as banks and industrials — owing to higher debt levels and less-certain cash flow generation abilities — took on market leadership roles.

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Let’s put the recent price action into context. Historically, there is a bias for stocks to rise in the fourth quarter of the year, the so-called “Santa Claus” rally. In addition, stocks tend to rise for three to four months immediately following the quadrennial US presidential elections. However, the rotation we are seeing from growth to value this year is atypical.

Sustainably in question

Given all the buzz, it is natural to ask if the so-called Trump rally is sustainable. I doubt it. Here are a few reasons why:

Hedge funds, which have on average badly underperformed their benchmarks in recent years, have been largely responsible for the much of the recent market movement, stepping on the gas in an attempt to improve their performance figures and setting off a highly leveraged momentum-driven trade into cyclicals and riskier companies.

Day traders are back in force. After sitting out much of the nearly seven-year-old bull market, day trading volumes have increased substantially in recent weeks, lately exceeding institutional volume, according to trading volumes reported by discount brokers.

Retail participation has picked up too. That tends to be a late-cycle phenomenon, as the average investor tends to buy during periods of euphoria and sell during times of despair.

The recent modest earnings rebound witnessed in the third quarter is unlikely to last. Higher energy prices, the dramatically strengthening dollar and rising interest rates are all headwinds to earnings and economic growth. These factors could work to offset any fiscal stimulus from Washington next year. Plus, given the advanced age of the present business cycle, history suggests that it would be prudent to expect a potential recession at some point during Trump’s first term.

Beware of narratives

Market narratives can be powerful, but they can also be misleading. Recall the narrative in early 2009, at the trough of the global financial crisis. The economy was too fragile and the financial system was under too much strain. It was thought that in such an environment earnings growth going forward would be anemic, if not impossible. Investors ran scared and many did not return until recently.

That was precisely the wrong approach. Had investors looked past the gloom, they would have realized that policymakers around the world were making an extraordinary effort to heal financial markets and economies. And heal them they did. We experienced incredible earnings growth as markets recovered from the crisis.

Now, years later, the narrative is somewhat euphoric. But I was skeptical of the negative narrative after the crisis, and I am skeptical of today’s euphoria. And euphoria is often a late-cycle phenomenon.

In my view, it is important to keep an eye on several inhibitors to growth that could prove the euphoric market narrative premature, if not wrong. The global economy continues to face a mountain of debt, and depending on the policy mix embraced by the new administration, that mountain could grow more quickly. We face the substantial demographic challenge of an aging, less productive work force.

While lower personal and corporate taxes and a boost to infrastructure spending will likely be accelerants to growth, they are not enough, in my view, to offset the factors that have constrained both US and global GDP for nearly a decade. Perhaps government actions will extend the present cycle for a while longer, but it is unlikely to shift it into a higher gear. For example, given the recent experience with tumbling energy prices, it is unclear that tax cuts will lead to increased consumption. The so-called energy dividend ended up being spent on things like health care rather than on other goods and services. Tax cuts will likely be treated similarly, in my view.

Quality wins in the end

To be sure, some of the recent rotation makes good sense and will likely endure. Bank stocks are likely beneficiaries of a looser regulatory regime and higher interest rates that fatten net interest margins. Energy companies, particularly coal producers, will like find life easier in the new environment.

In my view, what lays ahead is a mixed bag, but not a game changer. I do not see a dramatic uptick in economic growth from the new administration’s policies. Against this backdrop, I continue to prefer high-quality companies with track records of solid cash flow growth, strong balance sheets and high returns on equity. They have a long history of beating market averages over time. I think they will still win out in the long run.

James Swanson is Investment Officer at MFS.

Let’s Stick To The Knitting

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Política y renta variable no siempre van de la mano — CC-BY-SA-2.0, FlickrPhoto: Steve Snodgrass . Let’s Stick To The Knitting

Sometimes politics influences economic factors, sometimes it does not. Former President Ronald Reagan was a great champion of supply-side economics, using the work of leading economists such as Friedrich Hayek to provide theoretical justifications for his political actions. But I have to admit to a sense of frustration that has been growing steadily all year whenever anyone starts to talk to me in the workplace about politics.

Remind me, at what point did we all become self-styled experts, ready to voice our opinions on issues ranging from Brexit, Trump, the Italian referendum, and the likely fortunes of Marine Le Pen in next spring’s French presidential elections? At what point did stock market chatter over corporate earnings, valuation multiples, and a hearty debate on a company’s outlook make way for the latest opinion-poll gazing?

Up until very recently, when Mariano Rajoy was returned as prime minister of Spain, the country was without a government for over 10 months. In that time, Spanish GDP growth did not stop, registering 0.8% in the first two quarters of 2016 and marginally lower growth of 0.7% in the third quarter. A prime example, if ever there was one, of there often being no link whatsoever between politics and economics.

Nor is the correlation between underlying economic growth and the performance of equities clear-cut. A company’s earnings are not analogous to GDP growth. Just because an economy is doing well, or badly, does not necessarily mean stock markets should follow the same fortunes.

Just to reinforce the point when looking at smaller companies, here’s how it works in practice. The profitability of Prosegur, the Spanish securities and cash management business, is dependent on the growth in the European alarm market and the cash-in-transit market in Latin America. Revenues for another Spanish group, Viscofan, the sausage skin casings’ manufacturer, are driven solely by the global demand for protein. Get the picture?

Irrespective of the economic landscape, our investment strategy, a blend of value and growth styles, favours companies benefiting from structural growth situations, turnaround positions and cyclical businesses; admittedly the latter are more related to the fortunes of the economy.

A good example of the structural growth theme is in the area of European outsourcing. Large companies, constrained by red tape, have achieved greater flexibility using this method across a wide range of industries, including IT, engineering, software and automotive systems.

Turnaround situations are a particular feature of European building material manufacturers. An industry known for its operational gearing, companies have continued to pare down costs since the global financial crisis. When sales eventually reach levels more akin to their long-term average, bottom line growth should be significant.

At the start of each year analysts tend to start with optimistic forecasts for European earnings growth, only for them to be continuously downgraded in subsequent months. So when I say that growth for European smaller companies for 2017 should be around mid-teens, colleagues start to look sceptical.

But here’s the mathematics. Rising employment is continuing to propel the eurozone region towards 2% growth. Add 1% inflation, the effect of prior year acquisitions, and the general growth premium of smaller companies gets us to around 6% revenue growth. Then add in falling input costs, some acquisition benefits and a dollop of operational gearing and there you have it. An asset class which, despite all the political shenanigans going on around it, is managing decent growth.

So, next time you are tempted to talk politics, opinion polls, and the vagaries of the US Electoral College system, try restraining yourself, however tempting. No one knows how key political events are going to transpire, just as much as no one knows what the stock market’s reaction to those events is likely to be. As investors, let’s try to stick to the knitting and focus on company fundamentals.

Ian Ormiston is a manager, Old Mutual Europe (ex-UK) Smaller Companies Fund.

Dynamiting the Log Jam

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As Bob Dylan wrote way back when, “The Times They Are A-Changin’.” With the election of Donald Trump to the White House, they surely have. But perhaps not quite as dramatically as some commentators believe. If I look back over the CIO Weekly Perspectives written by myself and my colleagues over the past nine months, many of the current market trends were in plain view. In fact, much of what just happened in the U.S. is simply the amplification of a series of global trends that were already in place.

For evidence, look at the central banks piece written back in March: Central Banks Just Pulled Back from the Abyss. This described the growing recognition that central banks had reached the limits of policy intervention. And, as a result, the consensus was moving away from the aggressive pursuit of negative rates in the realization that central banks had done all they could, and that the burden of lifting growth and opportunity needed to shift to political leaders and legislators.

As the summer unfolded, my colleague, Joe Amato, President and Chief Investment Officer – Equities, wrote a piece on infrastructure entitled The World Turned Upside Down. Joe’s piece also referred to the end of central bank dominance and the need for political leadership to embrace the concept of structural reform and pro-growth policies. In some ways, Joe’s words back in July were prophetic: “The more unified the political control [in the U.S.] and the worse the economy is doing, the more likely we are to see a deal [on infrastructure].”

Turning Japanese

This August, I wrote about Japan in a piece entitled Lost in Translation.

This examined Prime Minister Shinzo Abe’s latest economic stimulus package and how it was focused on fundamental labor market reform. His proposals included increasing wages for educators, changing the laws to encourage two-earner households, and improving the economics and availability of childcare. I concluded that some of the policies that Abe was pursuing would be emulated by other parts of the developed world.

Markets have been reflecting these changes for a while. Forward inflation indicators and interest rates bottomed in July and have been moving up for the past four months. Since July, bank stocks have outperformed utilities by nearly 50%, with nearly half the gain taking place through October. Commodities turned the corner even earlier, bottoming out in February.

This change in sentiment partly reflects the better growth story, but it also lends support to how fearful the market had become over the prospect of even lower rates. Indeed, the corrosive economic effects of negative interest rates probably won’t be fully appreciated for some years.

End of an Era?

Back to the present. The rapid lift in interest rates following the U.S. election has of course coincided with a much more optimistic re-pricing of risk assets in the U.S., namely stocks and credit spreads. We believe it reflects a dramatic shift in the markets’ views with respect to growth and inflation. It has happened fast and is barely reflected in any economists’ forecasts at this point. As such, it may be the “dynamite” required to blow up the log jam of the lingering aftereffects of zero interest rate policy. It provides the U.S. Federal Reserve the air cover they seem to need to continue raising rates. “ZIRP” has lost its punch, just as former Fed Chairman Ben Bernanke long ago predicted it would, and it needs to be left behind. We believe this is the beginning of the end of an era.

It may seem odd to hear a career bond man crowing about rising rates but remember, over the long term, bond market returns are all about income and, more importantly, about real income. We’ve spent a number of years struggling to find either in the higher quality bond markets. We believe the persistence of negative real rates in short to intermediate high grade fixed income is simply a recipe for losing money. For a long-term investor, the end of this era is coming none too soon.

Spain Is Open for Business: Politics Aside, Spain Offers an Appetizing Opportunity for Investors

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España atrae a los inversores: las empresas de private equity identifican oportunidades tentadoras — Pixabay CC0 Public DomainPhoto: AnaGuzzo, Flickr, Creative Commons.. Spain Is Open for Business: Politics Aside, Spain Offers an Appetizing Opportunity for Investors

2016 has been a tough year for Spain. After two elections and 10 months without a government, the center-right People’s Party, led by Mariano Rajoy, was finally able to grab the reins of power, albeit without a majority of seats in parliament. Another election could be in the offing as early as May. Beneath the political tumult, however, the economy is quietly humming along. The IMF has lifted its estimate of Spain’s economic growth to 3.1 percent for 2016, making it the envy of the developed world.

The recovering economy, which is playing catch-up after a deep recession brought on by the 2008 financial crisis, has given a strong boost to Spain’s private equity market. The country saw a record 72 private equity deals in 2015, totaling $2 billion, according to research service Preqin.

But while the number of deals hit an all-time high, the dollar volume was the lowest in five years, reflecting a shift in private equity investment to small and medium-size enterprises. It’s those companies that now provide the most inviting growth opportunities.

Investors are starting to pay attention. A record 1.27 billion euros was raised in nine private equity fund closings in 2015, according to Preqin. Spain now has 25 private equity funds with a combined 3.6 billion euros of targeted capital.

Still, the market is small compared to its potential, with those 3.6 billion euros accounting for just 0.3 percent of Spain’s gross domestic product (GDP). That compares to $1.34 trillion in the US, or roughly 7 percent of GDP.

So where are the most promising private equity investments? The list starts with disruptive companies that are bringing new products and new ways of doing things, of which Spain has its fair share.

The companies that are most likely to be disruptive are the smaller and more agile firms. In addition to their growth prospects, smaller firms often offer more attractive valuations than their larger brethren and there is often less competition among investment funds to garner a stake in these companies.

The sectors of the Spanish economy with this kind of appeal include telecommunications, transportation, medical technology, biotechnology, education and real estate.

When it comes to telecommunications, I see opportunities in young companies providing services that complement traditional offerings from telecom, cable and satellite incumbents.

On the medical technology front, two overriding factors are driving innovation in the provision of healthcare services. First is the issue of rising costs for medical care. Second is a concern for patient safety. Technology plays a key role in both areas.

Recent examples of private equity investments in disruptive small- and medium-size Spanish enterprises include the following

· GPF Capital acquired a majority share of telecommunications company Acuntia, which engages in the design, integration and maintenance of communication networks, including network architecture, video collaboration, security and mobility, and data centers;

· Magnum Capital took an equity stake in Orliman, a manufacturer and distributor of non-invasive orthopedic devices for the limbs and torso, with its products being used in the prevention of injury, treatment of chronic conditions and for recovery after surgery or injury; and

· Eneas Alternatives Investments, of which I am a partner, acquired control of Lug Healthcare Technology, a medical technology company that has developed a unique error-free process to manage the prescription, administration and inventory of single-dose drugs in hospitals.

Spain is full of similar disruptive companies in growing industries. Many of these companies are starved for capital after a prolonged recession. And there is far less competition among private equity firms in Spain than in the US.

Combine that with the fact that its population of nearly 50 million is well-educated and larger than California’s, that its $1.4 trillion GDP is the fourth largest in Europe, that it’s home to some of the world’s top-ranked business schools, and you have an attractive playing field for private equity.

As my partners and I have discovered, Spain is most definitely open for business.

Opinion column by Ed Morata, partner and co-founder of Eneas Alternative Investments.

Japan Stands To Benefit From Trump Policies

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Los novedosos planes de Japón no atajan los problemas subyacentes — Pixabay CC0 Public Domain. Japan Stands To Benefit From Trump Policies

Watching the Japanese equity market on 8 November 2016, we had a sense of déjà vu from the Brexit vote that shocked the world in June. But as the poll results for the US Senate and House of Representatives became clearer, we were encouraged by the emergence of a new Republican president who will benefit from full Republican control of Congress.

Other than the US itself, we believe that the country which will benefit most from the policies to be implemented by the incoming Trump Administration would be Japan. The three pillars of Trump’s policies are: tax reform, deregulation and infrastructure spending. We think that these measures are highly likely to be implemented—in particular the tax reform—given that there will be an absence of political gridlock in Washington.

These policies are expected to boost US GDP growth over the next few years, and, given Japan’s dependence on the US, which is the largest economic partner for Japan (20% of total exports, valued at JPY 15 trillion in 2015, and outbound direct investment into the US totaling USD 419 billion as of end 2015), it stands to benefit a great deal from the policies’ implementation.

Changing policy mix in US to drive yen lower

Looking at US monetary policy, the Federal Reserve has been in a rate hike cycle since December 2015, implying that the US economy is recovering steadily. The job market is also tightening, as evidenced by the unemployment rate dropping to 4.6% in November 2016 – its lowest level since 2007 (before the Global Financial Crisis).

Fiscal stimulus under the leadership of the incoming US president in the current environment is likely to cause interest rates to rise, resulting in the US dollar strengthening against all other major currencies. If investors make decisions based on fundamentals (i.e. if the currency market is driven by interest rate differentials), we think that the currency likely to see its value drop the most is the Japanese yen.

This is because the differential between US and Japan interest rates will widen as the US rate rises and that of Japan remains anchored at a low level due to the Bank of Japan (BOJ)’s new policy framework. Under the framework, introduced in September 2016, the central bank commits itself to keeping the 10-year JGB yield around 0% through its “yield curve control” policy.

As an excessively strong US dollar may dampen US exporter earnings, “one-sided” strength in the greenback could trigger a political intervention. Having said that, the US already has a large trade deficit, and a stronger US dollar will result in lower import prices, boosting disposable income. This will likely have a positive impact on US GDP growth.

Outlook for Japan equities

Looking at the corporate earnings trend for Japan, revenues and profits fell year-on-year in the first half of the fiscal year (April through September 2016) for the first time in five years due to the yen’s strengthening from USD/JPY=112.57 to USD/JPY=101.35.

However, despite the stronger yen, net profit margin is on the rise and is poised to surpass market expectations by reaching an all-time high this fiscal year (ending March 2017) thanks to companies’ aggressive cost-cutting efforts. As major companies are still assuming a USD/JPY of around 100-105, if the yen remains weaker than what these firms expect (with the USD/JPY above 110), we expect EPS growth to accelerate, driving the equity market higher. We believe this is especially likely given that recent currency movements have been very rapid and have yet to be priced in by the equity market.

Valuation-wise, the price-to-earnings (P/E) multiple for the broad market TOPIX is attractive. In fact, multiples had been driven down by foreign investors through the end of September 2016 (see Chart 3), as a strengthening of the yen triggered skepticism of the government’s “Abenomics” economic policies. Foreign investors have sold a net JPY 6 trillion worth of Japanese equities year to date through the end of September, the largest amount of foreign investor selling since the Tokyo Stock Exchange started collecting such data in 1982.

However, with yields bottoming out globally and the yen now weakening against the US dollar, foreign investors have come back to buy a net JPY 2 trillion in October and November alone. The supply/demand conditions in the market are clearly improving. The BOJ’s program for purchasing ETFs was expanded to JPY 6 trillion per year last July and we are also expecting about JPY 6 trillion in corporate buybacks this fiscal year.

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Lastly, we believe that further improvement in corporate governance at Japanese companies will translate into higher stock prices. Among the significant successes of Abenomics has been the implementation of Japan’s Stewardship Code in 2014 and of Japan’s Corporate Governance Code in 2015. A few years following the introduction of the codes, we are seeing a significantly positive change in the way corporate managers are engaging with shareholders. We believe this trend will only accelerate from here on in. The Stewardship Code is expected to be revised in 2017 to enhance asset management firms’ monitoring of and engagement with portfolio companies in order to help enhance shareholder value.

In conclusion, we believe that in an increasingly uncertain world, Japan’s less uncertain market will provide a compelling opportunity for serious investors.

Hiroki TsujimuraChief Investment Officer, Japan at Nikko Asset Management.

The Themes (and Risks) That Will Shape Markets in 2017

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Each year BlackRock strategists and portfolio team members assemble to discuss the outlook for the coming 12 months. The major takeaway from our discussions this year: We believe three major themes—and a few key risks—are poised to shape markets in 2017, as we write in our new Global Investment Outlook 2017.

Theme 1: Reflation

We expect U.S.-led reflation—rising nominal growth, wages and inflation—to accelerate. Yield curves globally are liable to recalibrate to reflect this “reflationary” dynamic, and we see steeper yield curves and higher long-term yields ahead in 2017. We believe we have seen the low in bond yields—barring any big shock. Steepening yield curves suggest investors should consider pivoting toward shorter-duration bonds less sensitive to rising rates.

Expectations for global reflation are also driving a rotation within equities. See the chart below. Bond-like equities such as utilities dramatically undershot the broader market in the second half of 2016. Global banks, by contrast, have outperformed along with other value equities on expectations that steeper yield curves might boost their net interest margins—the gap between lending and deposit rates. We see this trend running further in the medium term, albeit with the potential for short-term pullbacks. We could see beneficiaries of the post-crisis low-rate environment—bond proxies and low-volatility shares—underperforming. We see dividend growers—companies with sustainable free cash flow and the ability to raise their payouts over time—as most resilient in a rising-rate environment. Our research suggests they perform well when inflation drives rates higher.

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Theme 2: Low returns ahead

We see structural changes to the global economy—aging populations, weak productivity and excess savings—limiting growth and capping rate rises. Still-low rates and a relatively subdued economic growth trend are taking a toll on prospective asset returns, especially for government bonds.

This is one reason we believe investors need to have a global mindset and consider moving further out on the risk spectrum into equities, credit and alternative asset classes. U.S.-dollar-based investors should consider owning more non-U.S. equities and emerging market (EM) assets over a five-year time horizon while reducing exposure to government bonds, our work suggests.

Theme 3: Dispersion

The gap between winners and losers in the stock market is likely to widen from the depressed levels of recent years as the baton is passed from monetary to fiscal policy. Under extraordinary monetary easing during the post-crisis years, a rising tide lifted all boats. Fiscal and regulatory changes, by contrast, are likely to favor some sectors at the expense of others. The dispersion of S&P 500 weekly stock returns—the gap between the top and bottom quartile—recently hit its highest level since 2008. Other markets are likely to mirror the U.S. trend as major central banks approach the limits of monetary easing. Rising asset price dispersion creates opportunities for security selection. Yet the risk of sharp and sudden momentum reversals in sector leadership highlights the need to be nimble while staying focused on long-term goals.

At the same time, we are seeing a regime change in cross-asset correlations that challenges traditional diversification. Long-held relationships between asset classes appear to be breaking down as rising yields have led to a shakeup across asset classes. Bond prices are no longer moving as reliably in the opposite direction of equity prices. Similarly, asset pairs that have historically moved in near lockstep—U.S. equities and oil, for example—have become less correlated. This means traditional methods of portfolio diversification, which use historical correlations and returns to derive an optimum asset mix, may be less effective. Bonds are still useful portfolio buffers against “risk-off” market movements, we believe. Yet we see an increasing role for equities, style factors and alternatives such as private markets in portfolio diversification.

Key risks

2017 is dotted with political and policy risks that have the potential to shake up longstanding economic and security arrangements. There is uncertainty about U.S. President-elect Donald Trump’s agenda, its implementation and the timing. The UK has vowed to trigger its exit from the European Union (EU) by the end of March, while elections in the Netherlands, France and Germany will show to what extent populist forces hostile to the EU and euro are gaining sway. At the same time, expectations are building for the Federal Reserve to step up the pace of rate increases after a stop-and-go-slow start, and China’s Communist Party will hold its 19th National Congress, at which Xi is expected to consolidate power.

China’s capital outflows and falling yuan are also worries, as the trade-weighted U.S. dollar’s surge to near-record highs raises the risk of tighter global financial conditions. Rapid dollar gains tend to cause EM currency depreciation, apply downward pressure on commodity prices and raise the risk of capital outflows from China.

For more on these themes and risks, as well as a detailed outlook for sovereign debt, credit and equity markets, read the full Global Investment Outlook 2017 in the following link.

Build on Insight, by BlackRock, written by Richard Turnill

Too Much, Too Little, Too Late?

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El ciclo entra en su fase madura y hay que estar atentos — CC-BY-SA-2.0, FlickrPhoto: Joao Caram. Too Much, Too Little, Too Late?

Business cycles don’t typically die of old age. More often than not, some outside force, such as higher interest rates, snuffs out the expansion. Surely the US Federal Reserve’s intent is not to bring the economic cycle to a close, but that is often the end result of trying to rid the system of risks like excessive financial leverage or runaway inflation. Sometimes the Fed has an accomplice or two, such as an oil shock or a currency dislocation. Whatever the cause, recessions are unwelcome, bringing with them rising job losses, falling financial markets and even bankruptcies.

The end of a business cycle can be tough on investors. Stock and high-yield bond portfolios typically tumble. The average decline in the S&P 500 Index during a recession is 26%, and during the global financial crisis, the index declined nearly 50%. Recessions can be particularly damaging to Main Street investors, as they typically exit the markets after most of the harm has been done and often do not reenter markets until well into the subsequent expansion, when confidence abounds. Poorly timed exit and entry points mean the average investor does not achieve anything like the returns of the major indices. For instance, only now, with markets up 230% from their March 2009 lows, are Main Street investors reentering the market. This begs the question, are they too late again?

Alive and kicking, for now

We’re in the midst of the third-longest business cycle in the post–World War II era. At the moment, even though the cycle is showing signs of fraying, there are no obvious threats to its continued well-being. However, it may pay to be wary of entering the market at this late stage, as risk/reward ratios tend to become unfavorably skewed late in a cycle.

With that in mind, let’s look at our late-cycle checklist.

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Investors may want to take heed of the increasingly worrisome signs indicated above. However, these should be taken as cautionary signs, not a call to retreat. There are also some positive signs afoot. For example, inflation has been late to arrive this cycle, which should allow the Fed to tighten monetary policy much more gradually than would normally be the case. Also, the US labor market continues to slowly improve, suggesting this business cycle will be prolonged. However, there is the risk that the cycle could suffer a slow fade-out. While US personal incomes are rising, health care costs are rising faster, taking away purchasing power, which is impacting consumer-facing sectors such as restaurants and retailers. US business spending remains very weak, and credit conditions are already tightening for certain borrowers. Several market sectors are experiencing profit erosion, which contrasts with the first six years of this business cycle, when margins and profits rose in tandem. US worker productivity is falling, as well, as unit labor costs rise.

Aging expansion vulnerable

While we’re not yet in bubble territory, I’d caution investors that US and European markets are historically expensive on both a price-to-earnings and price-to-sales basis. For example, the Russell 2000® Index is now at a price/earnings multiple of 27. However, I don’t foresee a quick or violent end to this cycle, as we saw in 2008. But I am concerned that late-cycle entrants into risk assets like stocks and high-yield bonds are taking a leap of faith at a time when there is less room for markets to move up and growing risks of them falling back. I do foresee this cycle coming to an end, but not as suddenly or brutally as in prior episodes. This aging expansion, now in its eighth year, weakened by faltering profits, is becoming more vulnerable due to slowly rising interest rates, sluggish consumer spending, shrinking profit margins and rebounding energy costs. Gone are its youthful days of mid-cycle strength.

In the wake of the US election, the retail investor has come back to life. But history tells us that changes in political regimes have relatively modest impacts on the real economy, which obeys only the laws of supply and demand. The signals being sent by the real economy are much more sobering than the signals being sent by a euphoric market. In my view, the odds of a reacceleration in economic growth are minimal at this late stage of the cycle. Retreating slowly from risk is one way to manage today’s ecstatic environment, perhaps by lightening up on historically expensive assets and shifting over time into high-quality corporate bonds or shorter-term fixed income vehicles.

James Swanson is Chief Investment Strategist at MFS.

European Retail – Having to Adapt to Digital Disruption

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El sector minorista europeo frente a la invasión digital — Wikimedia CommonsPhoto: Pixabay, Creative Commons CCO.. European Retail – Having to Adapt to Digital Disruption

All business has to respond to change. For the retail sector they have to cope with annual changes in fashion and at least in northern Europe the weather. Structural changes in shopping habits and property have moved much of the consumer activity from the high street to out of town shopping centres but now digital disruption is creating a huge challenge for the sector. Traditional store portfolios with large fixed costs associated with long leases on property are no longer as attractive. The competitive landscape is changing with competition from the likes of Amazon, who with huge buying power puts deflationary pressure on prices. Many traditional retailers are suffering and struggling to refine their business model to cope with these challenges in an overall weak environment where overall fashion retail is barely growing.

As is often the case challenges also present opportunities reflected here in market share changes. Location of sales outlets remains an important selling point but now the location includes websites and social media. This has profound implications for capital allocation, stock control, supply chain logistics, brand, advertising and promotion and most aspects of the business. Many of the key elements of success – a clear identity with customers and a value proposition remain important but these now have to be fused with a digital offer and the logistics to support this distribution channel. For many this means a radical change in the store portfolio to fewer larger flagship stores and less small stores. The impulse purchase once made via the store on the way home can now be made as easily by flicking through the web on a smartphone on the train home.

Several European businesses have taken advantage of these changes to boost their own position and find new areas of growth. Inditex is a successful traditional retail company headquartered in Spain, offering affordable fashion that has adapted while keeping several distinctive aspects. Unlike many who focus extensively on cost in the supply chain, Inditex has sacrificed some cost for proximity of supply and with that faster turnaround times to respond to fashion changes. This model results in fewer discounts, faster moving lines, as well as a good combination of central information, control and local store manager autonomy. They have extended this to the internet and integration with the physical store portfolio in the way they have incentivised staff and collection options for customers. Having taken their time to consider and launch their digital offering, they can now reduce investment in physical stores and with that capital intensity while still driving top line growth.

Zalando is a new challenger, based in Germany, created for the digital age. They grasped the importance of logistics and a scalable platform to create the network effect so common with digital offers. Their offer is all via the web and they host others’ products where they can literally deliver both the products and the shop windows in a better manner than many established brands. According to Zalando, they can deliver to over 80% of Europe within two days. For a sector with little overall growth they are growing sales in excess of 20% pa.

In Germany, Deutsche Poste has grown out of the postal service in the country into a broad logistics and delivery company. The mix of businesses face challenges – most obviously traditional delivery of letters is in decline but they also deliver parcels and have a strong infrastructure to do so. All these internet purchases have to find their way to the end consumer and this offers a solidly growing business that is strong enough in their own territory to compete with Amazon.

Companies are the place where we see adoption of new technology and techniques to run their business and to meet customer needs and wants. They have to adopt and change to survive but this remains part of the life blood of a growing dynamic economy.

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Column by Stan Pearson, Head of European Equities, Standard Life Investments