The Ups and Downs of Markets Affect Long-Term Institutional Investors like Afores

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Los altibajos en los mercados afectan a los inversionistas institucionales de largo plazo como las Afores
Photo: Keviinbarrios1993. The Ups and Downs of Markets Affect Long-Term Institutional Investors like Afores

Assets under management of the Afore smaller and larger in Mexico are between 2 and 32 billion dollars (bd). This is the case of Afore Azteca and Afore XXI-Banorte respectively. Managing these portfolios, with turmoil in financial markets, it is not easy and requires focusing on the horizon and making decisions with a cool head and fluctuations that can act in favor or against the portfolio.

In the first half year, high volatility in financial markets was observed and everything indicates that the second half will prevail. In international markets the S & P index had a variation of 16% in dollars between its lowest and highest level and the return in the period was 4%; while the QQQ (ETF technology stocks) 15% in dollars between low and high and -2% in the period.

In Mexico, the Mexican stock Exchange index moved 15% in pesos, while the peso dollar exchange rate was fluctuating between its lowest and highest level of -12% and increase 7% in the first half of 2016. In the case of interest rates, the long-term rates moved 60 basis points between its highest and lowest so government bond (mbono) that matures in 22 years (2038), had a change in its price of 6%.

These strong fluctuations some long-term investors have been able to exploit the situation and others not.

Afores have 74% in debt securities in local currency (54% in government debt and 20% in corporate); 19% in equities (7% in local and 12% foreign) and 7% in others (6% in alternatives as CKDs an mexican REITs known as Fibras and 1% in international debt).

The observed volatility was reflected in the results of the Siefores that for the first half of 2016 had a direct average yield in pesos of 3.52% at the aggregate level where the results of last June explained one third (1.23% in pesos).

Reviewing cumulative returns for the first half of the Siefores, you can see contrasting results. The basic Siefore 2 (SB2) that is the one that has the largest amount of assets under management (AUM) by concentrating 36% (50 bd), has workers in the age range between 46 and 59 years and have 17% in equity (at May); yields were between 2.07% paid by the Siefore of Afore SURA and 5.34% direct performance in six months in pesos of Afore Coppel. The average return was 3.52%.

In the case of sb3 which is the second biggest having 32% of assets (45 bd), aged between 37 and 45 years and have 20% in equity, direct yields to six months Siefore in pesos they were between 1.76% of Afore SURA and 5.46% of Afore Coppel. The average return was 3.55%.

For sb4 which has 28% of assets under management (39.8 bd), ages are less than 36 years and have 26% in equity, ranges were from 0.82% of Sura to 5.46% of Afore Coppel. The increased presence of equities in this Siefore originated yields with more variation between the highest and lowest. The average return for this Siefore was 3.40%.

As for the sb1 which has only 4% of assets under management (6.3 bd), has workers above 60 years of age (where remember that retirement is at age 65) and 4% in equity, returns ranges fluctuated between 3.16% of Afore Banamex and 4.60% Afore Coppel. The average return for this Siefore was 3.79%.

It is interesting to note that the three largest Afores are XXI-Banorte (23% of AUMs), Banamex (18%) and Sura (15%) are in the last places of performance in sb2, sb3 and sb4,while some of the small and médium Afores are located at the top as in the case of Coppel (5%), Azteca (2%) and Principal (6%).

What contrasts these yields in the first half is that in long-term yields presenting CONSAR 3, 5, 7 and 7 years for SB1, SB2, SB3 and SB4 respectively, the Afores that are now at the top in six months, are not those in the first places in the long term and vice versa. SURA for example that appears in the last places in the first half, is in the top two places in long-term yields in the 4 Siefores and counterpart COPPEL contained in the first places in yields in the first half is in places 8 and 10 long-term returns in its 4 siefores.

There are few opportunities given to markets to change long-term positions, where the important thing is to know when to approach a competitor or maintain a different strategy for leaders.

Column by Arturo Hanono

Brexit: Outlook for Global Fixed Income & Credit

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Brexit: Perspectivas para la renta fija global y el crédito
CC-BY-SA-2.0, FlickrPhoto: Rob Brewer. Brexit: Outlook for Global Fixed Income & Credit

Following the initial shock of the Brexit, the critical issues for markets will now be the path that the UK will choose for exit and how the vote will affect the political backdrop in other European countries. We expect to see a continued ‘flight to quality’ in the fixed income market while uncertainty prevails. Risk premiums will likely remain high while the uncertainty of leadership in the UK remains an overhang. In the shorter term, emerging market debt seems relatively insulated; however, there are concerns over the potential for longer term problems. Global credit markets have reacted negatively, as might be expected, but this may provide investors with attractive buying opportunities.

UK growth likely to weaken, with interest rate cuts expected

In terms of the UK economy, until there is confidence in the UK’s position, there will be a drag on business confidence. This will see business investment and employment slow, which will inevitably be a drag on UK growth. As a result, we expect economic data in the UK to weaken in coming quarters. The Bank of England could react to this by reducing interest rates from 0.50% to possibly as low as 0%, but it will likely need some concrete evidence that the economy is being negatively affected before acting.

Most forecasters are still in the process of reassessing their outlooks, but Bank of America now expects the UK to have a mild contraction lasting three quarters, reducing its forecasts for UK growth to 1.4% in 2016 and 0.2% in 2017. Inflation will be affected by the move in British pound sterling, but further falls would be needed to increase inflation to a level where the Bank of England would potentially worry given the very low current levels.

Flight to quality in developed fixed income markets

We expect the uncertainty premium to persist for some time as the exit process will be negotiated over an indeterminate period. Overall, we have observed an initial flight to quality, with Gilts leading the bond market on an over 30 basis point (bp) rally in yields, while US Treasuries were a close second, rallying over 20 bps on the day after the vote. Gilts have continued to rally despite the indication that S&P will likely downgrade the UK’s credit rating. The European periphery was the hardest hit on the news, with Spanish and Italian government bonds selling off more than 15 bps.

A July rate hike for the US Federal Reserve (Fed) now seems very unlikely, with market implied expectations of a rate cut now exceeding the probability of a rise. The Bank of England will likely remain on the sidelines until the dust settles, but remains in play with increased market implied expectations for a rate cut within the next several meetings.

In currency markets, the British pound fell over 7% as of mid-day trading on June 24, and is off more than 3% mid-day on June 25, while the broader foreign exchange (FX) market sold off versus the US dollar. The Yen remained the top performer on the day, up over 3.5%.

Emerging market debt relatively insulated 

The impact on external debt has been limited so far. Spreads are 30 bps wider but US Treasuries are 20 bps tighter and overall the JP Morgan Emerging Markets Bond Global Diversified Index lost only 0.6% on 24 June. Local rates were 10 bps tighter in Asia and 10 to 20 bps wider in Latin America and Central & Eastern Europe, the Middle East and Africa (CEEMEA).

Most of the initial risk aversion shock was felt in the FX market and EM currencies are on average 2.75% weaker versus the US dollar.

Overall, as an asset class, emerging market debt has been relatively insulated from the initial Brexit surprise. However, in the long term, Brexit could have an impact on EM fundamentals through other channels, particularly for central and eastern European countries. Indeed, the UK is a significant trading partner and foreign direct investor in the region. Romania is the most exposed when we consider exports to the UK, while Russia, Poland, Czech Republic and Romania are exposed in terms of imports from the UK.

Beyond trade and financial considerations, we can also envision a rise of political risk in the region. Poland and Slovakia are already openly criticising the EU and the anti-EU rhetoric is likely to increase further. The Euro adoption process will likely be stalled as well. Ultimately, increased political risk may further delay the absorption of EU funds and Poland, Hungary and Romania are the biggest net beneficiaries from the EU budget.

Global credit has reacted negatively, but could provide opportunities for investors

Credit markets reacted negatively to the UK’s decision to leave the EU. It started with Asian credit, but European markets soon followed suit, with credit default swaps (CDS) as well as cash and bonds trading down. Sterling credit issuers were most affected, while price effects for Euro credit were more muted, given the ECB’s bond buying programme. The basic resource sector and banks suffered heavily. We expect trading in US credit to take its lead from European markets. In our view, the correction in valuations and market volatility could provide buying opportunities in some fundamentally strong credits.

Andre Severino is Co-Head of Global Fixed Income at Nikko AM.

Interdependence Day

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¿Va a frenar la Fed la subida de tipos por el Brexit?
CC-BY-SA-2.0, Flickr. Interdependence Day

It has been a lousy few years for the relationship between economic data and financial markets. Whether data is strong or weak, the markets have pretty much ignored it. All the market seems to really care about is what the central banks are going to do. But at least the economic data has company to share its misery: the market now seems to be ignoring geopolitical events as well.

The UK’s vote to leave the EU was seen as bad news for the market. Just as with other negative events, the market expects the central bank to step in with a monetary stimulus to make everyone feel better. So, if the result of a geopolitical event is positive then risk assets rally, and if the result is negative the central bank can offset any downside for risk assets. Heads you win, tails you don’t lose.

Towards the end of last year the market had been expecting the Bank of England (BOE) to hike rates by 2016 at least and then proceed with about one hike a year (chart 1a). When worries about the global economy worsened at the beginning of the year, the probability of rate hikes was reduced. But in February, when the date of the referendum was announced, the market decided that monetary policy would most likely remain on hold for another three years. Following the surprise result to leave, the market is now fully pricing in one rate cut by the BOE this year. Probably the only reason the market is not pricing in more cuts is because the BOE is averse to zero or negative rates. But there could still be an expansion of quantitative easing.

So much so sensible: this is a UK-specific shock and in the absence of fiscal policy the BOE has to deal with the shock. But the market has also decided that the Federal Reserve (Fed) is going to be on hold for another couple of years as well (chart 1b). The Fed has been striking a more dovish tone of late, but there was still a substantial drop in rate expectations following the UK referendum result. For example, there was about a 50% probability of a rate hike priced in for 2016, which was wiped out overnight. Now the first rate hike is not fully priced in until the end of 2018.

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This impact on the Federal Reserve looks a little bit surprising. The trade channel between the UK and the US is significant but hardly large enough to affect the Fed. The GBP fell a lot against the USD, but the broader index of USD strength is little changed. That only leaves financial contagion channels, but if anything the market reaction has been much more restrained than almost anyone expected beforehand. There looks to be something inconsistent between the UK financial markets and the expected need for the Fed to react.

Take for example the FTSE 100, which is above its pre- referendum levels (chart 2). Of course, the FTSE 100 is not really a UK index; the vast majority of revenues come from overseas. A weaker currency increases the GBP value of those foreign earnings. The more domestic-oriented FTSE 250 has fared worse, but still recovered a lot of the ground that was lost when the referendum result was announced.

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The currency impact is not just important for revenues, it is also important for foreign buyers. If you are sitting outside the UK, then you don’t care about the GBP value of the FTSE; you care about the value in your currency. So BOE rate cuts help you less because rate cuts push down the currency. Even if existing holders are mostly hedged, the marginal buyer will look at the FTSE and decide if it is worth buying. For example, on a USD-basis both the FTSE 100 and FTSE 250 have fallen substantially but not recovered. In other words, foreign investors are not attracted to buy UK equity despite the fact that it is now cheaper to them.

Over in the rest of the EU, many in the market expected a pretty harsh risk off reaction in the Eurozone. Sure enough, on the day both Italy and Spain sold off by 20 basis point and Germany rallied by the same amount (chart 3). But soon after Spain started to rally (their election was relatively market friendly) and even Italy rallied. Now Spain trades tighter to Germany than it did before the UK referendum, and Italy has the same spread – but at a lower absolute rate.

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The market seems very blasé about the consequences for the rest of the Eurozone of the UK’s departure. Once again there is an expectation that the central bank will step in to make everything better. But the European Central Bank is finding it more and more difficult to conduct monetary policy (largely due to its own rules), so this may turn out to be too optimistic. And the market is also implying that if anything the UK leaving will drive the Eurozone closer together, rather than further apart. Given opinion polls in many countries, that also looks dangerously optimistic.

In a globalised world, the interdependence of major economies and their central banks is both strong and complicated. But if anything it looks like the market may be expecting too big an impact on the US, and too little of one on the remainder of the EU.

Joshua McCallum is Head of Fixed Income Economics UBS Asset Management.

Brexit… Pursued by a Bear?

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Brexit… Pursued by a Bear?

Early “Brexit” impact was localized, but tail risk persists.

When the U.K. voted to leave the European Union, I happened to be in the thick of it, on a business visit to London. When I turned in on the night of 23 June, the opinion polls showed the race to be neck-and-neck, but financial markets were increasingly confident that a “Remain” vote would be returned. The comment we published the next morning was not the one we’d anticipated.

You had to be there to get a good sense of the shock the “Leave” vote caused. It has set off the U.K.’s biggest political and constitutional upheaval in 70 years. But what do markets make of it all?

Large-Cap Equities Erase Losses
Our initial response was to convey our view that fears of a “Lehman moment” were overblown. The vote hadn’t changed the fact that we are in a slow-growth, low-inflation, low-interest rate environment. Sure enough, the FTSE 100 Index powered back through its pre-Brexit level at the end of last week. The S&P 500 Index has also been reversing its losses. Global risk assets were recovering even before Bank of England Governor Mark Carney boosted them by hinting, last Thursday, at “some monetary policy easing” over the summer. It looks like our first instinct was a good one.

We have now experienced a handful of these V-shaped moves in markets over the past two years, over which time both the price and the earnings of the S&P 500 have remained virtually unchanged. Indeed, it’s the “slow, low, low” background that is both stagnating earnings and allowing specific or localized shocks to cause outsized short-term volatility; it makes the margin of error for investors so thin.

And there is no shortage of additional potential shocks coming our way. The U.S. still has to choose between two (at least publicly) anti-trade Presidential candidates in November, and Spain’s latest general election kicked off an 18-month cycle that will include Germany, France, Italy and the Netherlands. But as long as the underlying fundamentals remain unchanged, volatility from these events can create opportunity, which is why we stress the importance of focusing on fundamentals rather than news headlines. Amid the noise of last week, for example, the Atlanta Fed raised its forecast for U.S. Q2 real GDP growth to 2.7%, while the Eurozone printed a positive headline inflation number and its lowest unemployment in five years.

The Impact Has Been Localized
This is not to say that the vote hasn’t inflicted damage. At the end of last week, the FTSE 250 Index, which better represents the U.K. economy than the global, often U.S. dollar-earning companies of the FTSE 100, was still some 5% short of pre-Brexit levels. European stocks remained down by a similar amount. This is as challenging for the E.U. as for the U.K. itself: Standard & Poor’s downgraded both entities last week.

And then of course there is the pound sterling. Its 8% one-day drop against the U.S. dollar on 24 June was the biggest since the end of Bretton Woods. A recovery last week was stopped in its tracks by those comments from Mark Carney.

So far, so rational. Global markets in general have recovered, with those most exposed to the longer-term implications of “Brexit” re-priced for weaker performance.

Still “Slow, Low, Low”—But More So
Where the vote has had a broader impact, it’s “more of the same”. “Brexit” hasn’t changed the “slow, low, low” dynamic, but may have amplified it. Fed Funds futures now forecast that the U.S. central bank will be on hold at least into next year. The prospect of monetary tightening disappearing over the horizon has driven bond yields lower. The two-year U.K. Gilt yield went negative for the first time last week, the entire Swiss curve is dipping in and out of negative territory and the German Bund yield has sunk to uncharted depths. And now the 10-year U.S. Treasury yield is also flirting with historic lows.

This puts banking-sector profits under more pressure: at the end of last week European banks were still down 15%-20% since the vote, but U.S. banks remained down 4%-5%, too. But does it forecast similar gloom for non-financial corporate earnings? This is something Joe Amato discussed a couple of weeks ago, and we still think bonds are being pushed by technical pressures rather than fear of an outright collapse in growth and earnings—and so far equity markets appear to agree.

Nonetheless, we believe this is a time for caution, not complacency. If the U.K.’s voters have articulated a cry of rage against trade and globalization that is heard and echoed further afield, we could see more than a localized effect on growth prospects. In Spain a week ago the electorate responded to “Brexit” by moving back towards the center, but there are still many more occasions for political risks to spill into global economic fundamentals—and for markets to hit bumps that are much harder to overcome.

Neuberger Berman’s CIO insight column by Erik L. Knutzen

A Fork in the Road for Europe: Investing Post-Brexit

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A Fork in the Road for Europe: Investing Post-Brexit

“Every new beginning comes from some other beginning’s end” – Seneca

A few days after the Brexit vote, which caught most people by surprise, us included, we believe that there are two questions which really matter for investors:

  1. Will policymakers succeed in stabilizing a violent, negative market reaction in the short-term?
  2. What will happen to the process of European integration and to the European Union, as we got to know it, in the medium to long-term?

There is no doubt that the vote opens a new period of uncertainty for the future of the European Union’s original design, but it is extremely difficult at this stage to make any prediction on the likely path that European leaders will take in order to repair the damage done to the EU (ie, the new idea, after the vote, that European integration project could become reversible).

So let’s start with the first question. The consensus view – that a long Brexit process could result in two or more years of difficult negotiations between a new UK political leadership and Brussels – may increase the probability of recession in both Europe and the UK. In fact, uncertainty around the UK’s future trading relationships could affect economic activity, reduce investment and hurt consumer confidence. The sterling devaluation could continue as uncertainty could lead to an interruption of the flow of capital to the UK and eventually lead to lower growth.

Are We Facing a New “Lehman Event”?
We do not believe so, for a simple reason: leverage. By 2008, a massive amount of leverage had been accumulated in the private sector, based on the assumption (subsequently proven false) of risk spreading in a myriad of structured products. Post-Lehman it was the subsequent chaotic unwinding of the positions that lead the global financial system to a sudden stop.

Nothing like this has ever happened with reference to the European integration project, and if anything, any major exposure to European assets has been based on the assumption that the Euro, as a common currency, will always have the backing of the ECB, especially after the famous “whatever it takes” speech from ECB president, Mario Draghi.

Therefore the real question is whether financial markets, in risk-off mood, will continue to have the backing and support of Central Banks’ action and whether this will continue to be considered credible by investors. We believe that Central Banks (like the ECB) currently engaged in Quantitative Easing could make adjustments to their purchasing programs, while others (like the Fed) which have started a path of policy normalization could delay expected rates hikes, and so on.

In other words, the activity of supporting financial assets through massive injections of cash and with zero/negative interest rates could be prolonged.

However, markets may question the efficacy of additional monetary policy, putting the credibility of Central Banks’ action under scrutiny. Meanwhile the political impasse could still impede the articulation and implementation of effective fiscal policies and long-needed incentives to private investments in the “real” sector.

What is important to note is that the policies implemented in the years after the Great Financial Crisis, while absolutely necessary to save the sound functioning of the financial system in the immediate aftermath of the crisis, have ended up contributing to the current problems distorting liquidity and valuations on major segments of financial markets (government bonds, credit). They have added further divisions to the long-term trends of wealth and income inequality and sluggish growth with disappointing progress in employment, which have been in place for many years, and which electorates are starting to rebel against, not only in the UK, but also in the rest of Europe and the US.

A Vote against Exclusion
The vote for a Brexit is better interpreted as a vote against exclusion (from the benefits of globalization, financialization of the economy, and so on) than a vote against Europe per se.

Seen in this light, the second question, about the long-term future of the European integration project, is not a question around the institutional mechanisms of “in” or “out” of Europe. It is a more existential question about the benefits, in terms of economic and social welfare, for European citizens, stemming from a more (or less, depending on the views) united Europe. It is the real question that European leaders and citizens will have to solve in the next few years, radically rethinking the “raison d’etre” of a European integration, and the consequent economic, social and security (both internal and external) policies.

A Historical Crossroads
We do not have any ambition to answer this question in these pages. We just observe that Europe currently stands at a historical turning point and we believe there (logically) are two possible, but opposite, outcomes:

  • The first is a move towards a broader fragmentation of the EU, resulting in the break-up of the free trade market and also in the failure of the long-term project of a political Union.
  • The second is to see a renewed effort towards a higher political integration, beyond the pure monetary and economic integration. Only in the next several months we will understand which of the two roads Europe will take.

Turning to the investment implications, in the immediate future political leaders (not just in Europe) have to face the growing discontent of their electorates, which underpins not only the increase of anti-EU sentiment, but of a more general rise of populism, anti-immigrant sentiment and so on.

As such, it is possible that part of the political agenda of “moderate” leaders will have to include a portion of the populist agenda such as: an increase in taxation of corporations and higher earners, protectionism (i.e. import tariffs), and an increase of welfare benefits for low earners (i.e. minimum wages). All this means less growth and downward pressure on corporate profitability, which is a negative factor for equity exposure.

On the other side, we believe that monetary policies engaged in negative rates and QE for a longer period mean that a larger part of the bond universe will remain in negative (or close to zero) yield territory.

Finally, it is quite likely the adjustment mechanisms during the phase of transition will take place through the exchange rate mechanism, especially if monetary policies of different areas remain, at least partially, divergent.

Opportunities for Active Managers
Consequently, the investment landscape is less than exciting. But it does not mean that long-term opportunities, that can be exploited though active management, will not exist. Actually, we think that active management will have an edge over passive in a world of zero or low beta , where most, if not all, total returns should come from alpha.

The current market dislocation may create opportunities for active managers to identify undervalued companies and sectors that may be unjustifiably penalized in this phase of market turmoil.

In the meantime, we remain committed to manage the risk side of the equation in order to preserve, as much as possible, the stability of our client portfolios and to take all the decisions needed to mitigate the current volatility.

Column by Giordano Lombardo.

Will China’s Debt Bubble Burst?

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¿Explotará la deuda china?
CC-BY-SA-2.0, FlickrFoto: Carlos ZGZ. Will China's Debt Bubble Burst?

China is the second-largest economy in the world, with growth more than twice most others, facilitated by its willingness to lever up while others were deleveraging. Last year, China abruptly pulled back its credit-fueled growth, inadvertently slowing its economy far more than desired. The resulting ripples inexplicably weakened economies everywhere. From fall 2015 until March 2016, China reversed course and revived its lending growth to get back into its comfort zone. Can it be sustained?

China’s all-inclusive debt/GDP has now risen tremendously to 250%, equal to that of the US. No warning flag there, yet its interest rates are far higher so its debt service is also higher and rising. Most others have lower and falling debt service ratios. China’s is now at a level where some countries, but not all, have run into sustainability issues. Those who did had large foreign ownership of their debt; foreign investors can be fickle. China’s foreign ownership is tiny. Outside of China, market participants are worried about the quality of China’s outstanding debt, which has overwhelmingly taken the form of bank loans instead of bonds. Nonperforming loans and the number of bond defaults are both rising. While China’s borrowing probably hasn’t gone too far yet, we believe a restructuring lies ahead to keep it that way.

Policy will push a terming-out of loans into bonds, in our view. Extending duration will lower debt service, resulting in a much larger debt market and smaller loan market. When your interest rates are higher than the rest of the world’s, and policy actions connect your bond market to the outside, your interest rates are prone to coming down. The mutual recognition of Hong Kong and Shanghai registered funds will enable such connectivity. For those who can get comfortable with the yuan’s stability versus a basket of currencies, in today’s yield-starved world, inflows into China’s bond market should lower its rates as well as its debt service. If China’s bond indices become recognized in global indices (a current lobbying effort), this too will help connect its bond market. State-owned enterprises will also be encouraged to issue equity in Hong Kong and bring back those funds to pay down debt. The country cannot maintain rapid debt growth forever – but it can for several more years.

One also needs to consider whether debt is being incurred for consumption or to enable investments: If you generate a return on those investments above the cost of debt, your debt is inherently more sustainable than consumption-driven debt binges. Today, China is trying to bridge its old economy to carry enough growth until its newer economy becomes large enough to pick up the baton. We think the new consumer, services, and higher-technology industries will be strong enough three to five years down the road to do just that. In our eyes, China is building a bridge to a pier, not a bridge to a cliff.

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

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.

Brexit: Implications for Asia Stock Markets

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Implicaciones del Brexit para las bolsas asiáticas
CC-BY-SA-2.0, FlickrPhoto: Gilhem Vellut. Brexit: Implications for Asia Stock Markets

The recent announcement afirming the U.K.’s vote to exit the European Union has many ramifications—many of which affect millions of people in a negative way. Some refer to Friday’s announcement as a Black Swan event. Regardless of how the event is characterized, the fact is that the exact implications are largely unknown, the potential for a domino effect is real, governments and companies will need to re-think strategy and individuals will be impacted. Hopefully we will have more clarity in the days ahead, but it is always dificult to predict macro influences or investor sentiment. What is more apparent to us is that good businesses exist regardless of macro movements.

Reactions since Announcement

The FTSE 100, a cap-weighted index traded on the London Stock Exchange, has suffered signi cantly— down 15.79% in USD terms in two trading days since the announcement.

Initially, Japan certainly was Asia’s worst performing stock market with the Nikkei down the day after the announcement, almost 8% in local terms and 4.8% in USD terms. Japan was affected by worries that a stronger yen would negatively impact future earnings, especially for global exporters. The Japanese yen hit 100 vs. the U.S. dollar early in the trading session which sparked a stronger-than-anticipated equity reaction. The Nikkei recovered slightly overnight bringing its two day loss in USD terms to -2.10%.

The worst performing equity sectors within Asia ex Japan were energy, industrials and materials while the best performing sectors were consumer staples, health care and utilities. Asian currencies generally outperformed the Euro and GBP with export/commodity related currencies performing worst (Korean won, Australian dollar, and Malaysian ringgit). Interestingly, local Chinese shares, represented by the Shanghai Composite performed relatively well, down less than 1% in USD terms since the Brexit announcement.

Matthews Asia Investment Team Thoughts

A combination of an unexpected result not priced into markets and a likely prolonged period of uncertainty were the main negative drivers of markets across all asset classes. Risk-off sentiment could continue in the short term and because Brexit negotiations are expected to extend for many months, a period of ongoing uncertainty will keep markets unsettled for quite some time. That said, we also expect that global central bank coordination is ready to add stimulus as needed which should add liquidity— potentially mitigating market volatility.

In an already slow growth environment, added uncertainty will not help Europe’s fragile recovery. Prolonged uncertainty will cause a slow-down in investment, capex and European growth which in turn will increase the length of the current credit cycle, spur further central bank stimulus and liquidity, and ultimately drag out the “low growth for longer” thesis. In this scenario, we envision that cyclical sectors—especially those exposed to the EU—are most at risk. Winners could include defensive sectors and those that focus on domestic demand. Within Asia, we see both potential winners and losers if the turmoil in Europe continues to unfold.

Portfolio Implications

We believe successful investing in Asia includes an increased focus on domestic demand and regional growth— nding businesses that are less dependent on global growth and more dependent on regional growth of middle class consumers. And although growth may be increasingly dificult to find in Europe, our conviction for the long-term growth of Asia remains intact. We believe the ability to capture that growth—through domestic demand oriented businesses, attempting to mitigate macro influences wherever possible—have never been more important. While we don’t yet know what the long-term ramifications are for Europe and the U.K., we can be a little more certain about the future for Asia’s economy and its growing contribution to global growth.

David Dali is Client Portfolio Strategist at Matthews Asia.

Careful With The Brexit: Not To Confuse The Local Economy And Politics With Markets

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Brexit: Es importante no confundir la economía y la política local con los mercados
CC-BY-SA-2.0, FlickrPhoto: D Chris. Careful With The Brexit: Not To Confuse The Local Economy And Politics With Markets

The United Kingdom’s decision to leave the European Union has begun to reverberate around the world.

Prime Minister Cameron has announced he will resign in October, around the time of the next Conservative Party annual conference. Only after a new prime minister is in place will the UK trigger Article 50 of the Lisbon Treaty and start the two-year process of negotiating its exit from the E U.

From a credit perspective, the ratings agencies have made it known that the UK’s sovereign credit rating will be downgraded as a result of the decision to leave the European Union. Standard and Poor’s called the AAA credit rating ‘no longer tenable under the circumstances’. Moody’s called Brexit a credit negative for the UK and for other issuers in the country, citing a prolonged period of policy uncertainty that will likely dent investment flows and confidence. On an absolute basis, UK gilt yields may fall in the near term, but spreads could widen.

Central banks have made it clear that they stand ready to provide liquidity to financial institutions — and in some cases intervene in currency markets — amid volatile market conditions. Expect central banks to work together to suppress volatility. A rate cut by the Bank of England in July is increasingly likely, while the US Federal Reserve, as a result of the vote, is unlikely to hike short-term rates for the balance of the year.

Currency markets have borne the brunt of today’s volatility, with the pound falling by a record 11% against the dollar in the wake of the vote before stabilizing. Equity markets were hit hard at the open of trading on 24 June, with the FTSE 100 Index falling nearly 9%, but those losses moderated significantly as the session wore on. The moves have been relatively sensible, with the sectors most at risk in the short term — financial services and cyclicals — bearing the brunt of the pressure thus far. Ten-year UK gilts fell to a record 1% before stabilizing near 1.10% toward Friday’s close, while the 10-year US Treasury note tested record low yields, near 1.40%, this morning before rebounding to 1.57%.

This sort of environment can create opportunities for investors. We are long term in our focus, and we’re very careful not to confuse the local economy and politics with markets. We invest in international and global businesses, and stock prices act as a discounting mechanism. Some of the impacts of the Brexit vote may already be reflected in prices. Against this more volatile backdrop, long-term inefficiencies may emerge. There are great businesses that have been hit hard in the short term, and there are others where risks have increased substantially. This is the type of environment where long-term active managers would be expected to add value. After all, volatility should be our friend over the long term.

In fixed income, we continue to look for opportunities where valuations have become dislocated. We’re going through our names and sector exposures, deciding where we want to add or reduce risk. We’re not rushing, as we’re mindful of challenges around liquidity in the near term. We’re largely taking a wait-and-see approach, awaiting improved liquidity. We have already identified specific credits and sectors, so we can move quickly when the environment is conducive to adjusting portfolios appropriately.

Politically, it’s not over

As Michael Gove said during the Brexit campaign, many ‘have had enough of experts’. That sentiment is being felt far beyond the UK’s shores, notably within Europe and the United States. While the Brexit vote has brought a slight bit of clarity to the UK’s future relationship with the EU, it opens the door for a potential domino effect across Europe as populist movements gather strength. Investors wonder which countries will be next in the queue for an EU referendum of their own.

To sum up, it looks as though the UK’s decision to leave the EU could be the beginning of a large, protracted process in which dissatisfaction with the effects of three decades of globalisation is being expressed in ever more impactful ways. It bears watching to see if the trend accelerates, and what lasting impacts, if any, these political forces will have on companies around the world. Geopolitical conditions are ever shifting, but great businesses always seem to find a way to adapt and prosper over time. We suspect they will be able to weather this storm.

Pilar Gomez-Bravo, Fixed Income Portfolio Manager, and Ben Kottler, Institutional Equity Portfolio Manager – UK.

Market Turmoil After Brexit Could Create Opportunity

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Market Turmoil After Brexit Could Create Opportunity

This time the opinion polls got it right. The “Remain” and “Leave” camps were running neck-and-neck coming into Thursday’s U.K. referendum on membership of the European Union and in the event some 52% of U.K. voters opted to reject the status quo and pull out.

Markets have responded dramatically. U.K. equity index futures have slumped and the pound sterling has tumbled to 1980s levels. Safe havens such as gold, German Bunds and U.S. Treasuries are seeing substantial investor demand. The euro has also come under pressure.

Fears of ‘Lehman Moment’ Overblown
No doubt Friday’s will be the first of many volatile trading sessions, and the major central banks may intervene if necessary. But we caution against reacting as though this were a second “Lehman moment,” as some commentators have suggested.

The likelihood of at least medium-term damage to the U.K. economy from a “Leave” vote, as well as pronounced market volatility on the back of political uncertainty for the U.K. and the EU as a whole, did lead our Multi-Asset Class (MAC) team to adopt a relatively neutral stance coming into the vote. But this stance was not only designed to try to buffer against volatility, but also to position the MAC team to take advantage, potentially by increasing allocations to riskier assets based on a longer-term view of fundamentals.

Still, the U.K. has chosen the rockier of two paths. It piles up the political distractions that have dogged the administration of U.K. Prime Minister David Cameron and his chancellor, George Osborne. The “Brexit” camp is clearly in the ascendant but the vote revealed a lack of national consensus. And even consensus would not wish away the complexity of this exit, a “monumental,” multi-year task in the words of one legal expert.

Economic Damage Likely to Be Contained
That complexity is likely to prolong the period of low corporate investment we have seen leading up to the vote, both within the U.K. and in the form of foreign direct investment. This, together with the higher costs of trading, is what led mainstream economists to forecast a 3-7 percentage point negative long-term impact on U.K. GDP.

The pain may not be felt evenly. Many of the large companies in the FTSE 100 Index are global rather than U.K. businesses—80% of the index’s revenues come from overseas. This should help insulate them from any domestic downturn and potentially deliver a windfall from the weakened pound. Smaller, more domestically-focused companies are more vulnerable to a fall in consumer demand and higher import costs. That could be a source of opportunity during a sell-off in U.K. assets, particularly if the U.K. makes its new status work over the longer term.

Elsewhere, the economic impact is likely to be felt most keenly in Europe and, in the words of one Federal Reserve Bank president, to have only “moderate direct effects on the U.S. economy in the near term.” Again, we expect an excessive market reaction to be a potential source of opportunity.

Another Blow for Globalization?
A more pessimistic reading of the vote would see it as one more crack in the edifice of international political and economic co-operation built over the past 70 years. Anti-EU parties in countries like France, Germany and Italy may take heart from the result and attempt to further exploit the euro-skepticism increasingly evident in opinion polls across the Continent.

But to us this merely confirms that globalization is under siege, a trend already well-advanced and understood by financial markets. Beyond Europe, a big effect on the outcome of the forthcoming presidential election is unlikely—and besides, as former Treasury Secretary Hank Paulson told Brad in an exclusive interview at our CIO Summit this week, neither the Republican nor the Democratic candidate is promoting a positive view of global trade and investment.

Look Through the Noise to Fundamentals
Most importantly, this vote will probably exert only a marginal effect on global economic fundamentals, which remain stable but weak. We still live in a slow-growth, low-inflation, low-interest rate environment, characterized by sluggish productivity and investment. “Brexit” has been a tail risk stalking markets in the same way that the oil price, the strong dollar and concerns about China created volatility back in January and February, but we think its implications are overstated. For that reason, we again stress the importance of looking through the noise to focus on fundamentals and watching for opportunities to add risk to portfolios. The market reaction may provide opportunities to add to some positions in riskier assets once the worst of the initial volatility has passed.

Looking further out, in a lot of places in the world we still need structural reform and a more appropriate fiscal response to the current malaise if we are going to allow our economies to grow on a proper footing, and our companies to generate sustainable earnings growth. Part of that progress will involve addressing the legitimate concerns of those who have failed to benefit from globalization, but populism and political division is not the way to do it. In that respect, today’s result is hardly good news. But we believe its effect will be marginal and the market’s initial response is likely to create opportunity for patient investors with cool heads.

MSCI Delays Inclusion of China A-Shares in Index

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MSCI retrasa la inclusión de las acciones chinas de clase A en el índice
CC-BY-SA-2.0, FlickrPhoto: David Dennis. MSCI Delays Inclusion of China A-Shares in Index

Late on 14 June, MSCI, a provider of global equity indexes, announced that it would delay including China A-shares in the MSCI Emerging Markets Index. This was the third year running in which MSCI has denied China’s onshore equity markets entry into the index.

MSCI acknowledged that China had made significant progress towards addressing its previously cited concerns: issues regarding beneficial ownership, regulations on trading suspension, and the allocation and capital mobility restrictions for qualified foreign institutional investor (QFII) quotas. However, the index provider still believed that the 20% monthly repatriation limit remained a significant hurdle for investors that may be faced with redemptions. The firm also stated that its concerns about local exchanges’ pre-approval restrictions on launching  nancial products remained unaddressed.

Both international investors and local regulators have been impatient for the MSCI nod, which would be a signi cant step towards the internationalisation of China’s largely closed capital markets. Despite many being disappointed by this decision, the press release from MSCI is positive. It said that it did “not rule out a potential off-cycle announcement should further significant positive developments occur ahead of June 2017.” We believe that the Chinese authorities will continue to work with MSCI to achieve inclusion in the MSCI Emerging Markets Index, as this is a key area of focus for the government. It is less a case of if A-shares become included, but when.

Ultimately, we believe that China is too big to remain out of MSCI’s flagship emerging markets index, to which an estimated US$1.5 trillion is benchmarked. The People’s Republic has the world’s second largest economy (almost US$11 trillion) and equity market (total market capitalisation of approximately US$7 trillion) and cannot be ignored.

We believe that the A-share market is changing rapidly and has an abundance of investment opportunities, with over 4,000 companies listed. As China rebalances its economy, and services grow faster than heavy industry, the equity market increasingly represents a new consumer-facing Chinese economy. We believe there are manifold opportunities in sectors and services such as food producers, automobiles, appliance manufactures, leisure and gaming companies, pharmaceutical and healthcare. And not forgetting some of the world’s most innovative internet companies.

Although MSCI’s decision is not necessarily the one we were expecting, we continue to build and invest in the 4Factor EquityTM China team of highly capable and talented investment professionals focusing on the domestic A-share market. We have been investing in the country for almost two decades and have experience and expertise to enable us to identify a large number of good-quality companies with good growth at attractive valuations. Now, more than ever, we are sticking with our belief that early moving investors are likely to reap long-term rewards.

Greg Kuhnert is a portfolio manager and financials sector specialist in the 4Factor Global Equity team at Investec Asset Management.