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Don’t Cry Over the New Politics: Price it In, and Address its Real Concerns

If you want a picture to sum up how the politics of globalization have changed since the financial crisis, watch Canada’s trade minister, Chrystia Freeland, holding back tears last week as the Parliament of Wallonia refused to ratify the Comprehensive Economic and Trade Agreement between her country and the European Union.

CETA had its origins in October 2008. Back then, the executive European Commission would have expected to pass this agreement unilaterally. They felt the need to seek ratification from national parliaments because, since 2008, we’ve had the Great Recession, the Eurozone crisis, controversy over a similar E.U.-U.S. trade deal, Brexit, and the rise of Donald Trump. Belgium couldn’t ratify until all of its regions were onboard, the Wallonians weren’t having it—and so 75 lawmakers held the interests of 500 million Europeans and seven years of painstaking negotiation in the balance.

It’s tempting to dismiss the Wallonians as benighted protectionists blind to the wider benefits of trade and globalization. The more sober response is to acknowledge the very real difficulties globalization has created for working people in the developed world, and the very real controversies surrounding the new arbitration tribunals created by these new trade agreements, which some argue undermine democracy in favor of big business.

Investors need to acknowledge and understand these issues because debate around them will establish the context against which capital operates over the next generation.

Polarized Debate Obscures Real Issues

In the immediate aftermath of the Brexit vote and the run-up to next week’s U.S. presidential election, those debates around sovereignty, trade, globalization and immigration have not been very helpful. It’s difficult to make a reasoned contribution. Positions get simplified and polarized. You’re either for or against immigration. You’re asked to vote to leave or remain in the E.U.

When I travel through Europe today I tend to get asked, “When did Americans become so anti-trade and anti-immigration?” And of course the answer is they didn’t. But working and middle-class Americans have started asking whether the trade deals struck by their political representatives really benefit them, how such a vast number of undocumented workers get through the immigration system, and whether business still offers them and their children opportunity, rather than just exploitation.

These are perfectly reasonable questions. The share of GDP going to labor has declined relentlessly this century. Over the same period the number of “breadwinner” jobs paying at least $45,000 fell from 73 million to 70 million, while those paying $20,000 or less have grown from 35 million to 40 million. If it’s reasonable to ask these questions, they won’t go away after next week’s election, regardless of the result.

Less Technocracy, More Democracy

If anything, these concerns will receive more mainstream attention once the electoral temperature has cooled. That’s partly because the mainstream is learning that, when they don’t get a hearing, many voters will back populists despite knowing their solutions are as likely to hurt as to help them. It’s also because politicians recognize that they need to do more now that central banks are at the limits of their effectiveness—and perceived to be part of the problem, into the bargain.

This is relevant for investors in two big ways, one short-term and one longer-term.

First, the transition from economies being driven by central-bank technocrats with their forward guidance, to economies being driven by politicians with their restless constituents, represents a meaningful increase in market risk. The Wallonia incident shows how a little extra democracy can throw a lot of extra sand into the wheels of global capitalism, and the premium for that kind of risk is already starting to be priced into markets.

Second, it’s worth remembering that addressing these concerns may be painful for providers of capital today, but real solutions to them are essential to capital, trade and globalization in the longer term. Disappointment with opportunity in today’s economy will continue to drive the debate around trade and immigration for years to come. These are complex issues requiring thoughtful and balanced solutions, not rancor and hyperbole.

It makes sense to “turn the channel” on the current political noise and focus on economic fundamentals, as Joe Amato has advocated in recent posts. But as you do, keep in mind the real issues behind the sound and fury—issues that require real solutions, which will have a real impact on the economy and your investments over the coming years.

Neuberger Berman’s CIO insight

Diagnosing the Health Care Selloff

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Health care stocks have suffered as political rhetoric heats up around health care reform. Heidi suggests the sector may have been over-penalized.

No sector has been a victim of election antics and volatility like health care, the third-largest sector weight in the S&P 500 Index. The S&P 500 Health Care Index is down a little more than 2% this year and the S&P Biotechnology Select Industry Index has plummeted over 15%, while the S&P 500 has notched a decent 6% gain, according to Bloomberg data.

This should come as no surprise: A key factor in the recent selloff has been investor concerns that new regulations could impact the prices of drugs. These concerns are exacerbated by political rhetoric connected to the presidential election, and we think the likelihood of significant reform remains low. Although both U.S. presidential candidates have very different approaches to health care, each has proposed significant changes to the current system. And as politicians suggest plans to rectify an imperfect system, many health care companies feel the heat, particularly biotechnology companies, which then see weakened stock prices.

However, despite the potential for near-term political headwinds, there are positive fundamental and structural factors that suggest some health care companies are being over-penalized.

In recent years, U.S. equities overall have generally seen their stock prices gain from multiple expansion, rather than significant earnings growth. In other words, investors have been willing to pay more for the same dollar of earnings. But the health care sector is an exception; its earnings have been overlooked. The cheaper the stock prices get, the less the stocks are loved. See the chart below.

Ampliar

Reform talk could just be talk

So why have health care and biotech stocks been left out in the cold? The market selloff in biotech began last year when Hilary Clinton commented on drug price gouging and the need for increased regulation. In a single day, the Nasdaq Biotech Index dropped almost 5% (source: Bloomberg).

I think this is a classic example of investor behavior driving stock prices rather than investment fundamentals. For now, this reform talk is all rhetoric. Actual reform measures affecting drug pricing would likely take years to legislate and implement. I won’t speculate on whether Congress would remain under Republican control, or which candidate would become president, but I believe that there is a strong likelihood of continued political divisions and gridlock. This suggests that the power to push through major reforms will be limited.

Markets in autumn have historically seen an uptick in volatility, according to Bloomberg data. Given that we are in the final weeks before the election, we expect volatility to continue in the health care sector. In fact, the issue is top of mind for voters. In a 2016 national survey of registered voters, health care ranked number four on the list of importance behind the economy, terrorism, and foreign policy. With so much focus on the sector, health care companies could continue to pay the price for political rhetoric in the near term.

The need for health care

But it’s important to remember that in addition to valuations and earnings, lifestyle and demographic factors support health care over the long term. First, while we can postpone discretionary purchases like a car or new appliances in dire times, health care is one thing we cannot live without. Meanwhile, an aging baby boomer population means demand for health care services will likely continue to grow. And as advancements in technology ensue, so will the average age in life expectancy, thus furthering the need for health care.

Some options to think about

Stocks in the biotech industry have a history of volatility, and given the election, nothing is certain. Yet, the industry is experiencing a wave of innovation. Within this context, it may make sense for some long-term investors to consider how biotech stocks may fit into their portfolio. Investors with a higher risk tolerance and/or a longer-term investment horizon may want to think about taking advantage of market volatility to find select opportunities in health care and biotech. To gain exposure to health care or biotech companies, investors may want to take a look at the iShares Nasdaq Biotechnology ETF (IBB) or the iShares U.S. Healthcare ETF (IYH).

Build on Insight, by BlackRock written by Heidi Richardson

Investing in the Age of Populism: a European Equities View

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Populism is on the march. The unexpected UK vote to leave the EU, rising support for right-wing politicians in several other European countries, and the surprisingly strong showing by politicians such as Donald Trump are starting to cause jitters amongst investors. Not least because several of these politicians and political movements support ideas that range from mildly damaging to economically illiterate, such as greater government intervention in business, criticism of central bankers and restrictions on immigration and protectionism.

Despite increasing popular support for these unattractive ideas, equity markets have so far held up reasonably well, with the US market still trading near record levels. European markets have also snapped back from their post-Brexit vote blues, but is this stance complacent? And what are the potential investment implications of this populist movement?

Discontent with the status quo

First we should consider what is behind these votes and polls. Popular dissatisfaction with general economic development since the global financial crisis is palpable, caused by stagnation or falls in real disposable income for middle or lower earners. And discontent has been further sharpened by the realisation that almost all of the economic rewards go to a tiny elite. Mostly, these are the failings of globalism, which has delivered cheaper goods but also a deflationary impact on the bargaining power of semi-skilled and unskilled labour in developed countries, as products and services are moved offshore.

But the key point is that this discontent is being directed at national governments, because of the belief that politicians can ‘do something’. More unscrupulous politicians have realised that they can exploit these discontents to further their careers, even if they have no clue how to solve the underlying problems. Remember how prominent Brexiteers in the UK promised that the UK could control immigration and retain full access to the single market – a false claim that was exposed fairly quickly after the vote.

Thankfully, no politician has the power to roll back the effects of globalism – otherwise someone might propose that we all buy locally made clothes or rear our own chickens. Perhaps that sounds like a lovely idea. But on a more serious note, there is still a risk that politicians could come up with increasingly outrageous ideas to try to appeal to voters and to make a difference in a low-growth world. The Brexit debate is a case in point. Is the UK really likely to be a more prosperous place if it becomes significantly less attractive to foreign investors?

The politics of pragmatism

So the key task is to identify politicians who might do real damage and to assess if they really will be in a position to do that damage. The resilience of markets in the face of Brexit and other factors is explained by the expectation (or hope) that relatively sensible people are likely to end up taking decisions, or that the most foolish ideas will not actually be enacted.

In the case of the UK, the finance ministry is being run by the first man to have some actual business experience in at least a generation. And although much of the public rhetoric in the UK seems to be anti-business, a good part of this is probably pre-Brexit negotiation tactics aimed at securing a good deal. There is a difference between what politicians feel they need to say to justify their positions to discontented voters and what they are likely to enact in practice. It is also overlooked that the UK could well remain inside the European customs union – even if it leaves the single market.

If you work on the basis that the most extreme politicians will not get their hands on the controls and that mildly daft ones will be reined in by bureaucrats, then the current market view looks more realistic. There are risks that relatively sensible politicians could try and spend their way out of low growth, especially because we seem to be close to the limits of what central banks can do via quantitative easing (QE) and negative interest rates.

But it is more likely that a few high-profile infrastructure projects or housing schemes will be announced (maximum publicity for the least money) and that much riskier ideas such as ‘helicopter money’ – an alternative to QE that could be anything from payments to citizens to monetising debt – will be avoided. Fears that the EU will fall apart because of Brexit also seem misplaced: history means that other European countries have a completely different view of the institution.

Why pay for nothing?

Back to investment. If you want to get a return on your capital, no-one likes the idea of paying to lend money to a company (thanks for the offer, Henkel and Sanofi, which have both offered debt at negative rates). This only makes sense if you think someone else will buy the debt for an even more negative return.

So it seems that equities are one of the few places that can offer the potential of a real return. And within equities, there are some sensible steps to follow that can help to identify the types of company that should be able to ride out the next few years in a resilient way:

Look for basic products and services (tyres, lubricant, shampoo, food)
Look for recurring revenues or long-term contracts
Don’t overpay for growth – it might disappoint!
Find niche products with pricing power
Avoid regulatory/tax risk
Avoid dependence on a few products or countries
Identify beneficiaries of low interest rates (infrastructure)
Look for contractors with specialist infrastructure skills (tunnels, bridges)
Locate ‘self-help’ stories

Although valuations in Europe are significantly higher than they were two years ago, it is still possible to find solid businesses capable of delivering a cash yield of 6–7% and with opportunities to grow. Unless the political situation really deteriorates, those prospects are some of the best available in a world where low growth and negative rates are likely to continue for some time to come.

Simon Rowe is a fund manager in the Henderson European Equities team.

The Hedge Fund Allocation Is Dead. Long Live Total Return!

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La asignación a los hedge funds ha muerto. ¡Larga vida al Total Return! — CC-BY-SA-2.0, FlickrPhoto: Concepción Muñoz. The Hedge Fund Allocation Is Dead. Long Live Total Return!

Outflows from hedge funds are accelerating. Hedge funds are now finding themselves on the defensive from poor performance, high fees, unfriendly legal structures, and an onslaught of negative publicity. Investors were already becoming more conscious of fees amid low nominal returns. Now a new dynamic is setting in: fear.

Those who are still invested in hedge funds are right to worry about whether today’s flood of outflows will induce tomorrow’s lowering of the portcullis, with hedge funds invoking gates to prevent investors from running en masse. Runs on banks can happen very suddenly, hence the time-tested maxim: “If you are going to panic, panic first.”

But here’s a more benign view of hedge funds’ future.

Five years from now, there will be no hedge fund allocation. In its place will be the total return allocation. This will consist of a whittled down group – in numbers and fees – of surviving, talented hedge funds that tear down their gates and earn their keep net of fees, blended with managers of liquid alternatives. Just as multi-strategy hedge funds eclipsed their single-strategy counterparts, so too will multi-asset strategies incorporate and push aside single-strategy liquid alts. This new and improved allocation will have lower overall fees, boost transparency, and deliver better and more differentiated riskadjusted returns (Sharpe ratios).

Within most portfolios, we’ll see differing blends of total return. At one end of the spectrum will be total return blends that focus more on seeking a capital appreciation outcome. Here, more growth-oriented multi-asset liquid alts will be teamed with long-biased multi-strategy hedge funds. Together, they will cannibalize equity and private markets to deliver returns based on capital appreciation while taming volatility – without the need to tie up capital for up to a decade at very high fees. On the other end of the spectrum will be blends that deliver capital conservation, with multiasset liquid alts focused on absolute return teamed with multi-strategy hedge funds focused on relative value. As interest rates start to rise, investors will increasingly see these blends as a more stable and steady source of capital preservation. Most portfolios will blend strategies focused on capital appreciation and capital conservation depending on the client’s objective.

The total return allocation will grow to help constituencies achieve outcomes that are important to them. With lower nominal returns and rising volatility, blending and increasing the size of the total return allocation – an outcome-based strategy – will be the order of the day for most portfolios. Outcomes include compounding money in real terms over inflation by certain hurdles over defined time frames. For example, an outcome could be exceeding inflation by 3% per year over rolling three years, or by 5% per year over rolling five years. This allocation will be more of a talent pool than an asset class, focused on achieving higher Sharpe ratios than those of traditional asset classes.

Today’s 10% allocations to hedge funds will give way to 20% allocations to total return. Within US institutional portfolios, hedge funds will shrink from a 10% allocation to 5%, while liquid alt forms of multi-asset will grow to 15% to lower fees while enhancing liquidity and transparency. Of course, this will differ by region. The UK has already evolved toward 10%-15% multi-asset (which they call diversified growth). This will keep growing to 30%. Australia is furthest along in eliminating hedge funds, owing to unseemly fees.

Comparable talent found in liquid alts will have the edge. This is because of their lower fees, higher liquidity, and greater transparency. Liquid alts also tend to be attached to more formidable and buttoned-down marketing and compliance organizations than hedge funds are – an important consideration in the post-Bernie-Madoff world.

Relative return has worked well for asset managers, yet only in secular booming markets. Gone is the 30-year disinflationary tailwind that enabled booming markets with shrinking volatility. The total return allocation will manage to objectives, not benchmarks, gradually weaning away the overall portfolio from relative return investing. As regimes evolve, so too must portfolios.

Michael J. Kelly, is Managing Director, Global Head of Multi-Asset at PineBridge.

This information is for educational purposes only and is not intended to serve as investment advice. This is not an offer to sell or solicitation of an offer to purchase any investment product or security. Any opinions provided should not be relied upon for investment decisions. Any opinions, projections, forecasts and forward-looking statements are speculative in nature; valid only as of the date hereof and are subject to change. PineBridge Investments is not soliciting or recommending any action based on this information.

Why Voter Anger is Positive for Emerging Market Debt

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Por qué la ira de los votantes es positiva para la deuda de los mercados emergentes — CC-BY-SA-2.0, FlickrPhoto: Kirilos. Why Voter Anger is Positive for Emerging Market Debt

Political risk almost always features prominently on the list of concerns for investors in emerging market debt, as the countries in which they invest are prone to occasional bouts of instability, unrest and even revolution.

Recently, though, upheaval in the politics of a number of key emerging economies has been something to welcome, rather than fret about, as it is the result of voters demanding better economic stewardship.

The trend complements a shift in other factors that were previously bearish for emerging market bonds, and have now become bullish, helping the asset class to generate some of the best returns of 2016. These factors are economic growth, where the prospects have improved in emerging versus developed economies; commodity prices, which have rebounded strongly; China’s economy and financial markets, which have stabilised; and the outlook for US monetary policy, where rates are now expected to remain lower for even longer.

In this note, we discuss four high-profile emerging markets that suffered both from matters beyond their control, before the areas listed above turned from headwinds to tailwinds, and from matters within their control – and which they are now in the process of confronting.

Brazil

The presidency of Luiz Inácio Lula da Silva, a founding member of the left-wing Workers’ Party, or PT, from 2003 to 2011 coincided with a period of rising commodity prices, stoked in large part by demand from China. Unfortunately for his successor, Dilma Rousseff, this important prop for the economy was gradually removed during her tenure.

Rousseff also took a different approach to economic policy from Lula, who had managed the economy well over his two terms. She adopted a number of misguided policies that weakened the country’s fiscal credibility and undermined the independence of its central bank. Recession struck; investors dumped Brazilian assets; and the country lost its cherished investment-grade credit rating.

Over this period, a corruption scandal known as the ‘Car Wash’ affair erupted, over a kickback scheme at the state oil company, Petrobras. While Rousseff was not directly implicated, many of her party members were – including Lula. Ultimately, the economic crisis and public rage against alleged widespread graft undercut Rousseff’s popularity and derailed her government. She was ousted from office this year and replaced by her former vice president, Michel Temer, who appointed figures regarded highly by investors to lead the finance ministry and central bank.

It is unclear whether Temer will manage to enact all of his plans to steer Brazil out of its current quagmire, but investors are optimistic.

Argentina

The Kirchners – first husband Néstor, then wife Cristina Fernández – governed Argentina from 2003 to 2015, over which period they pursued largely populist and investor-unfriendly policies, such as giving sizable energy subsidies to consumers and forcing the central bank to fund the government. These policies stoked inflation – which the government tried to hide by manipulating the official data.

The difficult global backdrop only worsened the country’s economic malaise. But in December, Fernández was replaced by Mauricio Macri, the centre-right mayor of Buenos Aires, who beat the government-backed candidate in a general election.

Macri won on a pro-business platform that included pledges to reduce subsidies and export taxes, and normalise economic reporting. He also helped Argentina end a standoff with ‘holdout’ creditors, who had prevented the country from paying other investors to whom it had sold debt. These measures enabled Argentina to return to the bond market earlier this year with a US$16.5bn debt sale, a sign of renewed investor confidence.

Venezuela

Home to the largest proven oil reserves in the world, Venezuela is another South American country that experienced a sudden reversal of fortunes when commodity prices slumped.

During the good years, Hugo Chávez, its socialist president who held office from 1999-2013, borrowed heavily and used profits from oil exports to spend lavishly on his constituents. At the end of his presidency, these policies proved unsustainable: poverty, inflation and crime spiked; investors fled Venezuelan assets.

The social and economic crisis worsened after Chávez’s death in 2013, as his successor, Nicolás Maduro, continued the former president’s policies but without his charisma, while oil prices fell precipitously. This year, large numbers of Venezuelans have pressed the authorities to allow a recall referendum to remove Maduro – a process that has so far been stymied by the government-influenced electoral council.

While the outlook remains highly uncertain, it is clear that the military will be key to how the situation plays out, given its grip on many areas of the economy.

South Africa

After the end of apartheid, South Africa was well run for many years: its institutions remained strong; its financial markets, first-class. The government was fiscally prudent, keeping the country’s debt-to-GDP ratio low.

But as power passed from Nelson Mandela, to Thabo Mbeki, to Kgalema Motlanthe and most recently to Jacob Zuma, economic policy-making deteriorated, while issues such as high unemployment persisted. This became more problematic following the slowdown in Chinese growth and collapse in commodity prices, especially as the government did little to change course.

Zuma has presided over a host of corruption scandals, and an ill-fated attempt to replace South Africa’s highly respected finance minister, Nhlanhla Nene, with a little-known politician. The latter move sapped investor confidence in the country, triggering a bout of market stress that only dissipated when Pravin Gordhan, a former finance minister, was reappointed to the position.

In South Africa, too, the electorate has recently voiced its displeasure with the government’s economic stewardship: in local elections in August, the ruling African National Congress party in August suffered its worst election result since coming to power in 1994.

Favourable outlook

Clearly some of these countries are closer than others to achieving the better economic stewardship that their electorates are demanding. There will doubtless be further moments of drama as voters press their case against governments and vested interests. But the important thing is that while the process is noisy and messy, it is democracy at work. And it shows that these countries are moving in the right direction, however fitfully.

Looking ahead, we expect the clamour for reform across emerging markets to support the asset class, alongside the improvement in growth prospects, bounce in commodity prices, stability in China’s outlook and a still-accommodative US Federal Reserve.

In this context, we expect the appeal of emerging market debt to grow as more investors seek out the attractive sources of return offered by the asset class, especially in light of the low-to-negative yields on offer by developed market government bonds.

John Peta is Head of Emerging Market Debt at OMGI.

Don’t Let a Busy Fall Calendar Distract You from Longer-Term Fundamentals

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Regular readers of the CIO Weekly Perspectives know that we try to relate our observations on topical news to our medium-term investment outlook. Yet a “weekly” commentary inevitably gets a little caught up in current headlines.

So this week we try to dig beneath the surface of the headlines that are dominating current markets. There are already plenty of deeper indicators of what the world might look like in 2017-18.

An Eventful and Uncertain Fall Ahead

For sure, there’s a lot to dig through between now and the end of the year: quarterly earnings, GDP growth, employment figures, and, of course, central bank policy decisions. After 20 weeks of corporate bond purchases, last Thursday Mario Draghi’s pronouncements left markets looking to December 8 for more hints about whether QE would be extended or “tapered”. Six days later we will have a Federal Reserve announcement likely to increase short-term rates. And, if you haven’t heard, the U.S. has a big vote on November 8, Italy has a tricky referendum to get through on December 4 and Spain may be forced into yet another general election before the end of the year.

These events are likely to move markets—understandably. Some will undoubtedly feature in forthcoming CIO Perspectives. But, as investors become consumed with these current events, storm clouds seem to be gathering and recession risks rising.

Recession Risks Are Rising

Near term economic data looks decent enough. U.S. GDP for the second half of the year will likely show an improvement on the first half and, while it’s early days in the Q3 earnings season, it looks like S&P 500 earnings, while nothing to write home about, will have modestly improved.

Nonetheless, that only brings us to flat earnings growth, year-on-year, and it marks six straight quarters of weak reports. Moreover, the Bureau of Economic Analysis’s National Economic Accounts reveals this to be a problem across U.S. businesses, not just among the S&P 500 elite group of companies.

Housing starts have slowed, retail sales and consumer confidence are softening and employment growth seems to be peaking. The inflation we are experiencing is not benign: non-discretionary costs such as energy, housing and healthcare are rising, but not discretionary costs—a characteristic of recessions, historically. Wages are rising, which will put pressure on companies’ margins. And of greatest concern, credit conditions appear to be tightening: recent editions of the Federal Reserve Board’s Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) report tightening lending standards for all companies, but especially smaller firms.

We Are Late Into an Elongated Cycle

These are all late-cycle indicators. We should not turn a blind eye to them just because GDP and earnings have ticked up slightly on a weak first half of the year.

Let’s be clear: I’m not calling for a recession to start on January 1, or for investors to sell all their risk assets. Indeed, this has been an elongated business cycle and there is a good chance that it can be elongated still further. Even casual observers of this economic cycle will conclude it has been quite unique. What might lead us to get more optimistic in our outlook? Political leadership doing their job: corporate tax reform, infrastructure investment, and a more sensible regulatory environment.

We have written a lot over recent weeks about the growing probability of extra fiscal stimulus around the world, for example. Central banks have been keeping things afloat for years and will continue to try to do so.

But it’s also true that central banks are conceding the limits of their influence and that politics can easily get in the way of fiscal plans and structural reforms. Even in the best-case scenario, no central bank or government has ever been able to legislate the business cycle out of existence.

So this is just a timely reminder that the cycle will turn at some point, and that a couple of quarters’ headlines can obscure late-cycle dynamics that are appearing in the data. Digging down to these underlying dynamics keeps us relatively cautious on risky assets.

Neuberger Berman’s CIO insight by Joseph V. Amato

The Two-Track U.S. Economy

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Las dos vías de la economía estadounidense — CC-BY-SA-2.0, FlickrPhoto: Ron Cogswell. The Two-Track U.S. Economy

Many market watchers interpreted the September U.S. jobs report as a bit of a disappointment, as jobs growth came in slightly weaker than expected. But I think it was a decent report, fairly in line with where I expect the U.S. economy to be given that it’s moving on two tracks.

What do I mean by that? We’re currently witnessing a U.S. economy in which both consumption and employment in the services sectors have been amazingly robust, while expenditures and employment in good-producing segments remain softer. The September report showed this longstanding trend is continuing, with strong employment growth in service sectors, such as health care and education, and especially in professional business services (up a strong 67,000 last month). In contrast, the manufacturing sector lost another 13,000 jobs, continuing short-term and long-term trends. In fact, manufacturing employment peaked in June 1979, roughly four decades ago, with nearly 20 million jobs in the sector (or 1 in every 5 employees). At its trough in 2010, there were only 11.4 million manufacturing jobs in the U.S. (or less than 1 in 10 employees).

There are both demographic and technological underpinnings behind this two-track trend, as an aging population and innovations in technology boost employment in service industries that tend to be much more labor intensive.

September’s labor force participation rate numbers are another sign of the trend, showing strong demand for human capital in today’s new economy is sending more people back into the workforce. Indeed, the participation rate has rebounded from 2015 lows, and is now back around 63%. See the chart below. The recent uptick in labor force participation is even more impressive when judged alongside an aging population, as many more people are exiting the workforce today (i.e., retiring) than we’ve experienced in prior decades.

Enlarge

The U.S. economy is also running along two separate tracks in another sense. We’ve seen strong employment growth in recent years, but merely decent levels of reported gross domestic product growth. Some say the incredible employment numbers reflect a poor-productivity economy. These arguments suggest that we have needed to hire many more people to produce a relatively smaller amount of goods, as if production and labor output were diminished in their ability to generate aggregate output. I believe this is a misguided interpretation of the economic landscape due to the fact that traditional productivity and output numbers don’t capture the downward influence of new technologies on prices.

The bottom line: The two-track trends evident in the September jobs report are just more signs that the U.S. economy is doing better than headline numbers may imply. So where does this leave us from a monetary policy perspective? The Federal Reserve can, and will likely, move policy rates at its December meeting, barring an unexpected shock to the economy or markets.

Build on Insight, by BlackRock written by Rick Rieder.

Think Globally on Political Risk

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A couple of weeks ago, Joe Amato pleaded to be allowed to turn the channel on the U.S. presidential election debates. I sympathize.

“What all this focus on personality obscures are the actual issues the country faces,” he wrote. And that was before the lurid disclosures before the second debate and all the tabloid noise engulfing it.

Although it appears that Hillary Clinton has opened up a meaningful lead in national polls and has a clear path to the Electoral College votes she needs to win the presidency, extreme outcomes, ranging from a Democratic “sweep” of Congress to a surprise October comeback for Donald Trump despite an increasingly fractured Republican party, cannot be discounted.

Sour Politics Across the Developed World

At least we Americans can take comfort that some of our friends are more than matching us in the political-turmoil stakes. We could start with the French and German establishment battling to keep the far right at bay ahead of general elections next year, or Italy’s Matteo Renzi betting the credibility of the euro on a too-close-to-call referendum on constitutional process in December. But the real action has come from the U.K., and its brutal punishment in foreign exchange markets.

Sterling traded in a tight range since its immediate pummeling post-Brexit. The annual conference of the ruling Conservative Party changed all that.

Prime Minister Theresa May outlined a surprisingly interventionist plan with a distinctly economic-nationalist flavor that would preclude membership in the single market. But then finance minister Philip Hammond insisted that continued membership was not ruled out. The mixed messages sent sterling on a 7% tumble to $1.21, complete with a “flash crash” on October 6.

A Different Direction of Travel in Emerging Markets

Since returning from the Annual Meeting of the International Monetary Fund and World Bank Group last week, Brad Tank has been talking about the contrasting moods of the (upbeat) central bankers of the emerging world and their (exhausted) peers in the developed world. That raises a question: With all this souring of politics going on in the developed world, perhaps investors should look again at emerging markets?

We expect these markets to suffer political uncertainty, and they don’t disappoint. Hotheads talk of an attempted coup in the U.K., but Turkey had a real one. Rodrigo Duterte of the Philippines reminds us that the emerging world has its share of interesting political characters. Vladimir Putin is hardly a friend of the post-Cold War settlement. The death of King Bhumibol Adulyadej last week could exacerbate tensions in Thailand.

But it’s the starting point and the direction of travel that counts. In some of the most important markets, new reforming leaders such as Narendra Modi, Michel Temer and Mauricio Macri are changing the narrative.

I drew attention to some of these trends back in April, when we were still edging cautiously into emerging markets and waiting for fundamentals to prove themselves. Since then, emerging-world growth has continued to outstrip that of the developed world, commodity prices have stabilized and currencies have recovered.

Emerging Markets Still Offer a Risk Premium

Despite this, the emerging world is still valued as if it were the riskier destination for your capital.

The forward price-to-earnings ratio on the MSCI Emerging Markets Index is currently around 13 times, compared to 17 times for large-cap U.S. equities. In bond markets, nominal yields have started to rise in the developed world but could go much further—real yields still average just 0.5%. In the emerging world, the average real yield is 3%. Relatively high risk is still priced into nominal yields even as currencies recover and inflation eases.

It’s this combination of easing financial conditions and increasing policy latitude that has the emerging world’s central bankers feeling upbeat. It’s a long way from the dilemma facing the Federal Reserve and its peers—and it provides a solid macroeconomic foundation for investors in emerging market assets.

To be sure, if toxic politics lead to toxic economics in the developed world, the fact that the emerging world increasingly trades with itself will likely provide only partial shelter. Moreover, intra-emerging market demand may be weaker than we all thought, if the 10% year-over-year drop in China’s exports revealed last Thursday is any guide. Overall, however, the direction of travel in politics, governance and economic fundamentals, paired with the high degree of risk still being priced into valuations, builds a compelling case for emerging country stock and bond markets over those of the developed world.

Neuberger Berman’s CIO insight by Erik Knutzen

Earnings Stability, a Positive Sign for Asian Equities

| For Fórmate a Fondo | 0 Comentarios

After five years of steep earnings downgrades in Asian equities, we are now seeing encouraging signs that this trend is abating. While this might partially be a reset of prior expectations that were unrealistically high (be it in the form of reform potential in India, or the take-off of Chinese internet companies), it has also been a welcome indication that companies are starting to be more disciplined around capital expenditure and returns on equity. Coupled with early signs of a pickup in demand, it makes us more optimistic that we will reach a more balanced supply/demand environment, which should translate to an improved Asian corporates’ pricing power in the long run.

While capacity has been abundant due to over-optimism regarding Asia and in particular China’s growth leading to years of ramp up in capital expenditure, we are starting to see signs of better capital discipline. For the past few years, when China seemed like a growth engine that could not be stopped, companies significantly increased capacity. The dramatic increase in supply outpaced demand, leading to a period of deflation as prices were under pressure and earnings downgraded as a result of margin compression. Coming from such elevated supply, Asian companies spent the recent years reducing capital expenditure. This can be seen through supply side reform and regional industry consolidations in China which is pushing local corporations to focus on margins and returns rather than topline volume growth. With reducing competition and excess capacity, we are starting to see signs of price tension come back into the system helping companies regain pricing power.

On the demand side, as companies lack conviction around future demand, they have held on to cash instead of investing in their businesses despite historically low interest rates. Recently though, we have noticed a turnaround, where Asian corporates have started to reduce their cash through share buybacks and increased dividend payments. We have also been encouraged by early signs of an increase in demand as leading indicators such as cement demand, construction, and property sales have started to pick up.

We think Asia is currently on the cusp of a turning point and that better capital management, more stringent capacity controls and early signs of revival in demand should provide a solid platform for better, more sustainable equity returns in the region.

Bull:

The pace of earnings downgrades in Asia has been declining as companies are more disciplined around capital expenditure and as we are seeing early signs of a pickup in demand
A more balanced demand and supply environment offer an attractive buying opportunity for Asian equities

Bear:

As top line growth resumes, companies and government alike could revert to the bad habits of the past and over expand
Demand remains weak and requires further supply cuts which would have a negative impact on employment and by extension, consumer trends

Column by Andrew Swan, Head of Asian Equities for the Fundamental Equity division of BlackRock’s Alpha Strategies Group

The End of Dollar Dominance?

| For Gabriela Huerta | 0 Comentarios

The end of U.S. dollar dominance may be unfolding in front of our eyes. No, we don’t think China’s ascent is the key threat; instead, key to understanding the U.S. dollar may be to understand the money market fund you might hold. Let me explain what’s unfolding in front of our eyes, and what it might mean for the U.S. dollar and global markets.

Typically, when we think about potential threats to the dollar, we think a different reserve currency might take over; or that foreigners might dump their dollar holdings. I will touch on these, but then dive into what may be a much bigger elephant in the room. Bear with me.

Foreigners holding U.S. debt

Yes, foreigners hold trillions in U.S. debt, and if they were to dump all their debt, borrowing cost in the U.S. might rise. Except it hasn’t happened: in our analysis, as foreigners have been selling U.S. Treasuries, the dollar has neither plunged, nor have U.S. borrowing costs skyrocketed. Why is that? As we will discuss below, we believe, in the short-term, other market forces have been even stronger.

That said, the recent decision by Congress to override President Obama’s veto to allow private citizens to sue Saudi Arabia should get our attention. Saudi Arabia has threatened to sell its U.S. assets in case this law passes, as it doesn’t want a judge to freeze their assets. As this chart below shows, this may not be an empty threat:

I write “may be” because there might be other reasons for the Saudis to sell U.S. Treasuries, such as a need to raise cash to deal with the fiscal challenges that have resulted from lower oil prices.

Some say the inclusion of China’s currency into the official basket of reserve currencies (SDRs) by the International Monetary Fund (IMF) is a clear sign that we have the beginning of the end of dollar dominance. In our assessment, this change is mostly symbolic. First of all, the new SDR basket barely changes the U.S. dollar weighting (other currencies were reduced to make space for the yuan); second, no large country manages its reserves according to the formula provided by the SDR; instead we allege that they manage them according to what they believe to be in their perceived self-interest. Where SDRs come into play is when the IMF provides a loan, as those are typically denominated in SDR. A belief in this theory suggests a great belief in the power of the IMF, an institution that has, ever since its inception, looked for reasons to be relevant. I’m not trying to discredit this theory, but am a firm believer that market forces playing out may well overwhelm the bureaucrats at the IMF for a long time.

It turns out, though, that those that predict the end of the dollar dominance might still be right; not because of the IMF, though, but because of what we believe are massive changes underway in how anyone from foreign governments to foreign banks to foreign and domestic corporations fund themselves.

Understanding Money Market Funds

At the peak of the Eurozone debt crisis in 2011, we cautioned that U.S. investors weren’t immune from potential fallouts because prime money market funds, i.e. the typical money market fund that doesn’t exclusively invest in U.S. government securities, at the time had incredible exposure to European banks. It turns out European banks historically have had great funding needs in U.S. dollars because they extended U.S. dollar denominated loans in emerging markets, amongst others. At the time, we calculated that the average prime money market fund had half of its investment in U.S. dollar denominated commercial paper issued by (often weak) European banks; our analysis showed one money market fund of a major brokerage firm had 75% of its holdings in such paper. We weren’t the only ones warning about this, and, within months, we gauged that the overall quality of investments held by money market funds improved. Sure enough, though, “everyone” appears to be chasing yield, and your money market fund portfolio manager may not have been immune from it, either.

It turns out that this month, new rules for certain money market funds are being phased in. The regulations focus on institutional money market funds – you might not hold them in your retail brokerage account, but could be invested in one through your 401(k) plan. The new rules make it far less attractive for money market funds to invest in anything that’s not U.S. government paper. Amongst others, institutional money market funds that invest in securities other than U.S. government paper must have a floating Net Asset Value rather than a fixed value of $1; they also must caution investors that their money might be held hostage for a few days in case of a panic in the market. Aside from a shift on how portfolio managers manage money market funds, investors are also thinking twice whether it’s worthwhile to stuff money into money market funds when the returns are near zero, yet the risks are now higher (a floating NAV is riskier than a fixed one; so is the potential inability to withdraw money) than they used to be.

As money market funds have been preparing for the new rules, we have seen seismic shifts in the world of global finance. Basically, until 2008, we believe there was a perception that money market funds were safe. The ‘breaking of the buck’ of a money market fund in 2008 threw cold water on that theory, but what few noticed is that it wasn’t just an illusion for investors. For issuers of debt, it was what might be considered an implicit government guarantee (because the government set the rules on stable net asset value and liquidity), thus allowing issuers to access funding at what we believe was a subsidized rate. Think about it: a world where there’s one place where funding is cheaper. Wouldn’t you want to access that cheap pool of money if you were in need of cash? Well, you may not be large enough, but municipal and U.S. corporate issuers are large enough; so are foreign corporates, foreign banks and foreign sovereigns.

If you have followed the markets since the financial crisis, you have probably heard of the LIBOR market. The U.S. dollar LIBOR rate reflects the cost of U.S. dollar funding outside of the U.S. It’s a benchmark for anyone who isn’t the U.S. government or a U.S. bank that can get financing from the Federal Reserve. If you look at this chart below, you will see that the funding cost has steadily been increasing:

In our assessment, the reason LIBOR has been increasing is because borrowers are no longer able to access U.S. money market funds as cheaply as they used to. With the new rules, I allege they have to pay closer to a true market rate rather than what used to be a subsidized rate. This doesn’t just affect European banks, but also US corporate and municipal issuers. If you want to know why the Fed didn’t raise rates in September, I believe the full phasing in of new money market fund rules is the main reason: the Fed wants to see how LIBOR rates behave.

We believe this additional cost in the LIBOR market may well be permanent. And it may also be ultimately healthy for global markets, as borrowers will have to pay interest at a rate that’s more reflective of their risk profile. However, that doesn’t mean that there aren’t major implications.

End of Dollar Dominance?

If our analysis is correct and there has been a massive subsidy to borrow in U.S. dollars through the old money market fund rules, then we believe this helps explain why so many borrowers wanted to get their funding in U.S. dollars. No wonder the U.S. dollar was so popular when you got a free lunch.

In today’s world, though, a European bank is no longer able to tap into U.S. dollar funding at the same favorable terms, as evidenced by the higher LIBOR rates. That means their clients won’t have access to the same embellished terms, either. Such clients may well decide to no longer seek a U.S. dollar loan, but instead a euro denominated loan, or a loan denominated in their home country’s currency. This trend might be accelerated by the fact that interest rates in the Eurozone are lower than in the U.S. As much as we love to hate the euro, this trend may let the euro rise as a formidable competitor to the U.S. dollar as a reserve currency.

What does it mean for the markets?

To me, there is no question that this has massive implications for the markets. What implications, however, isn’t quite as obvious. I’ll mention a few here:

Liquidity. When borrowing costs go up, liquidity might go down. When it comes to the foreign exchange markets, there’s been a glaring “violation” of a textbook equation that suggests that it is equivalent to buy a bond in a foreign currency or a foreign currency forward contract. It’s equivalent because there is an arbitrage opportunity. Well, not so anymore: covered interest rate parity, as this is referred to, has been broken. Basically, alleged arbitrage opportunities are not swept away. In our view, the increased funding costs are a key reason; the second reason may well be increased regulations that don’t allow banks to gear up their balance sheets anymore to eat what used to be considered a free lunch. For those that like to dig deeper into this topic, please see this report from the Bank of International Settlements for an interesting perspective. To us, this is a sign that liquidity isn’t what it used to be. Differently said, next time there’s a crisis, don’t expect markets to work as expected. Remember, the 1987 stock market crash may have been exacerbated when the link between the cash and futures markets failed, i.e. when liquidity providers could no longer arbitrage market inefficiencies away.
Dollar squeeze. If you think the dollar would crash because of these changes, slow down. There are lots of different reasons to issue U.S. dollar denominated debt, and different stakeholders may well act differently. Take the foreign issuer that wanted to get cheap dollar funding. That issuer may have been hedged or un-hedged. If un-hedged, such a borrower might have raised money in U.S. dollars, then sold the dollar to acquire, say, Chinese yuan. In essence, such a borrower is short U.S. dollar. When it is no longer attractive to borrow in U.S. dollar, the loan will be re-paid, causing a dollar squeeze (higher). We think we have seen this dollar squeeze play out until the end of last year. The force may continue to play out, but other forces might be stronger.
The example above mentions the Chinese yuan. Aside from the corporate issuer, the Chinese government sees someone buying yuan, but doesn’t like the yuan to appreciate. In this particular case, even if the corporation didn’t hedge, the Chinese government might jump in to gobble up the U.S. dollars, and acquire U.S. Treasuries in the process.
The world is complex and there are all kinds of reasons to issue U.S. dollar denominated debt. When positions are currency hedged, the phasing out of such a position might not have any impact at all on the currency.
We also see an uptick in U.S. corporate borrowers taking on euro denominated debt. To us, this trend is no co-incidence, as the euro may well become a more formidable competitor. And those of you that roll your eyes because there are issues in the Eurozone, I’m not suggesting that those issues will be solved, just as many U.S. challenges won’t be solved. We will discuss the euro implications in more depth in an upcoming MerkInsight.
In the medium term, we expect funding in local currencies to increase. We have already said years ago that this will ultimately create a more stable global financial system. But it has ripple effects to the U.S. With global fixed income markets developing, U.S. fixed income markets might become less relevant. The Chinese government, for example, might not have as a much of a need to purchase U.S. Treasuries. That, in turn, might increase the borrowing cost for all U.S. borrowers, including the U.S. government.

I use words like “may” and “might” not only because there are other scenarios. If I am not mistaken, for example, the U.S. cannot really afford much higher interest rates, especially if I look at the trajectory of U.S. deficits. As such, it’s quite possible that the Federal Reserve may keep borrowing rates low. But I am a firm believer that there will be a valve; that valve may well be the U.S. dollar, which may decline in the process. Have I mentioned that we believe the U.S. dollar isn’t exactly cheap right now? If you look at the chart below, you will see that we continue to be about two standard deviations above its longer-term moving average:

Some say that the dollar has to rise because U.S. rates may go up. In our analysis, real interest rates, i.e. those after inflation, may not go up as the Fed is at risk of falling further behind the curve; at the same time, interest rates in part of the rest of the world may have reached their lows. In this context, we see it is quite conceivable that the U.S. dollar could continue to weaken.

Alex Merk manages the Merk Hard Currency Fund (MERKX), a mutual fund that seeks to profit from a rise in hard currencies versus the U.S. dollar.