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European Equities: Politics Versus Progress

Renta variable europea: política frente a progreso — CC-BY-SA-2.0, FlickrPhoto: Woodley Wonder Works. European Equities: Politics Versus Progress

European equity markets have had a torrid 12 months. It was all meant to be so different. Quantitative Easing (QE), launched in March 2015, would accelerate the recovery – I used the expression “QE on steroids” a few times last year – given the strong starting point for growth at that point. Growth would be better across the world, and earnings would start to pick up.

The reality has been rather different. The US dollar has been weakening when it should have been strengthening, given the assumption that the US Federal Reserve (Fed) would be tightening rates, while the euro was meant to have remained at low and highly competitive levels for exporters. Politics was also not expected to feature until 2017, but not even the prospect of Trump leading the Republican charge in the US has diverted attention away from Europe’s political uncertainties. Of more immediate political concern, the referendum in the UK over membership of the EU is likely to be much closer than many had ever thought.

Given these uncertainties, it is little wonder that the equity market has found it difficult to trade at what some felt was a high rating. After five years of little or no earnings growth at an aggregate level, 2016 estimates have steadily been revised down (yet again) from a starting point of around 8% to a more recent level of nearer 1%.

Progress behind the bluster

All that may be a reason to look at the glass as half empty. So here are a few reasons to consider that it is still actually half full: gross domestic product (GDP) growth in Europe this year is expected to be somewhere in the region of 1.5%. Inflation is expected to start to pick up albeit slowly, which is perhaps why German 10 year government bond yields have risen from 0.09% at their recent low on 7 April to 0.15% on 13 May – admittedly the tiny numbers helping to exaggerate the scale of the move. Unemployment is declining, consumer demand is improving and government finances are no longer deteriorating. This may not sound all that exciting, but equally it is not actually the disaster area that anyone listening to the claptrap from (now) ex-London mayor Boris Johnson might like to believe.

In the “real” world of company results, the first quarter has been generally in line with expectations. One or two firms have pointed out that the tailwind of a weaker euro has ended, but this is simply a translational impact in most cases. Many companies have reminded anyone who might have been sound asleep for the last six months that growth globally is quite subdued and pricing pressure remains intense. Those quality companies which we expected to grow in the portfolio, such as ARM, Fresenius Medical Care, Essilor, Infineon Technologies and Valeo, have indeed done so. But, so far in 2016, so-called “fast money” has been playing a rotational game – buy the laggards, sell the winners. As the chart here shows, the weakest sectors from 2015 – energy and materials – have rebounded strongly, at the cost of previously strong areas, such as IT and healthcare:

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I can understand much of this – the fears about China were certainly exaggerated – but so is the hope that China is now recovering rapidly and returning to high growth. The probable reality is that we are in a slow growth world, where achieving anywhere between 5% and 10% earnings growth sustainably is a good achievement. That is not a bad environment for equities – but it might be a bit dull for some.

“Brexit” – unlikely but unsettling

At the time of writing, the UK referendum is only a few weeks away. Current betting patterns imply that the UK will stay part of Europe, but the general polls remain very close. It may sound extraordinary to some, from the US President to the Head of the IMF, but there is a large body of UK residents – particularly older voters – that believe the UK would be better off out of Europe. While I do not doubt that the UK will survive given either outcome, if the vote was to leave the EU, it would force us to reassess our reasonably optimistic view for European equities. Among the potential shorter-term risks, I would anticipate a sharp fall in sterling, a decline in GDP (leading to a potential recession), losses on the FTSE and a major increase in uncertainty across Europe. While we still believe that a vote for ‘Brexit’ remains unlikely, politics may overshadow Europe’s otherwise solid fundamentals for a few more weeks.

Tim Stevenson is Director of European Equities as Henderson.

Are Investors Overly Wary in the Currently Ragged Environment for Risk Assets?

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In looking at the current market climate, something that I find particularly striking is the dichotomy between investor sentiment and the changing global risk environment.

Across the board, measures of investor sentiment—whether fund flows or investor surveys—have recently reflected real skepticism about market prospects. According to the American Association of Individual Investors, for example, neutral or bearish sentiment stands at about 70%; that’s a bit better than it was but is higher than the historical average of roughly 60%. Lipper has reported continued flows out of U.S. equity mutual funds. And a few weeks ago, a BofA Merrill Lynch survey found that global fund managers were positioning themselves for an array of potential shocks in the coming months.

Litany of Fears
It’s easy to understand all the skittishness.
Negative headlines have been everywhere. The U.S. presidential election is one of the most inflammatory in recent memory, revealing a disturbing reservoir of economic resentment and creating an aura of unpredictability that is never good for markets in the near term. Politicians driven by nativist and socialist ideas have been gaining traction globally, with an extreme right party nearly gaining power in Austria. More immediately concerning, investors continue to assess the diminished, but still real, risk of a Brexit vote on June 23, and mull the political and economic crisis in Brazil. Meanwhile, fears over China’s growth have persisted, while recent statements by Janet Yellen have raised the specter of a Fed that could raise rates too fast in a climate where corporate earnings remains challenged.

A Shortened Tail
Still, for the most part, many of the drivers of tail risk that we’ve identified in this space have actually improved in the last few months. For example, the expensive dollar that has pressured earnings among large-cap U.S. companies has eased by about 5% (U.S. Dollar Index) since the end of January; oil is up, and at close to $50 (Brent) appears to be approaching a sweet spot that reduces strains on the oil patch but keeps fuel relatively affordable for consumers. More broadly, commodity prices generally have steadied, to a large degree based on a perception of stabilization in China, which itself has been a key driver of uncertainty.

Over the past few months, we’ve highlighted positives that have been peeking through the prevailing cloudy views on the markets. In Europe, for example, the perception of perpetual crisis obscures economic improvements and the strong positioning of some companies, offering up a long-term value opportunity. Emerging markets, although not yet in recovery, are benefiting from a shift to more market-friendly leadership, as well as the general stabilization of oil and the U.S. dollar. The latter trend, combined with a still accommodative Fed, could support wage and profit growth in the U.S.

Mixing Realism and Return
This is not to say that we are effusive about the current climate, but we believe assets are more apt to perform in line with the fundamental picture—both positive and negative. So, in our view, sovereign bonds have a low to negative return outlook, equities a modest return outlook, and credit falls somewhere in the middle. In other words, the balance of risk and reward across assets could lead to more normalized long-term relative return relationships.

That’s not to say that recently dominant risks couldn’t reassert themselves. Energy prices could experience another drawdown, Brexit could cause heightened angst in coming weeks, China could again disappoint. But overall we favor putting aside near-term distractions and maintaining consistent exposures across a diversified portfolio.

Neuberger Berman’s CIO insight by Erik L. Knutzen

Air Of Mystery

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La Fed ha perdido el misterio — CC-BY-SA-2.0, FlickrPhoto: Tim Evanson. Air Of Mystery

In courtship, it is often advisable to cultivate an air of mystery. Reveal everything (figuratively) to a potential suitor, and you are no longer in control of the conversation. The Federal Reserve long ago abandoned their own air of mystery, and decided to reveal everything to the market by publishing their rate projections. But the only problem is that the market does not believe the Fed’s “dot plots”. The Fed insist they are likely to hike rates several times, but the market found that as believable as a blind date claiming they are actually a secret agent.

In an effort to rekindle the romantic mystique, the Fed has been trying to generate a bit more uncertainty. First the minutes to the last meeting stressed that June was a ‘live’ meeting. So, despite the market’s scepticism, the Fed would likely vote on whether to hike rates next month. Then Bill Dudley, the influential President of the Federal Reserve Bank of New York, commented that the market was now more appropriately pricing in the probability of a June rate hike. Before the minutes the market had only priced in a 4% chance of a rate hike in June; that has jumped to almost 30% (Chart 1). And the probability of two rate hikes this year doubled from about 30% to 60%.

The pricing of rate hikes has been on a bit of a roller-coaster ride. When fears for the US economy were at their peak back in February, the market decided rates were on hold. Then right before the March meeting the probabilities rose once more, only to plummet again when Fed Chair Janet Yellen came across as more dovish. Despite the improvement in the probability of a June rate hike, the likelihood is still priced below where it was in March.

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And it is not just this year’s rate hikes. The market has even less faith in the Fed further out. The path of rates set out by the fifth most dovish dot in the dot plots (which is probably closest to Chair Yellen) still implies yield curves well above the actual market yield curve. The disconnect can be divided into beliefs about the speed of rate hikes, and also the terminal rate at which yields peak (see Economist Insights, On the Dot, for more details). This divergence widened significantly compared to last year, despite the most recent rise in bond yields (chart 2).

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Last year, the divergence between the Fed and the 3y US Treasury (UST) was all about the timing of hikes. But this year yields moved so low that the difference between the two is increasingly driven by divergences in the long-run rate (the rate at which interest rates get close to their natural rate). The divergence in the 10y UST demonstrates that the market is as doubtful as ever about the Fed’s timing of rate hikes, but even more doubtful about where rates will peak.

Trendy

The market is telling the Fed that growth is going to be lower and that inflation is not going to warrant rate increases. Some commentators argue that rates should stay low for longer because trend growth is lower. Unfortunately, this does not make any sense from the Fed’s view of how monetary policy works

If you believe that trend growth is now lower, then economic theory will tell you that you will need to hike sooner but the rate hiking cycle will stop at a lower rate than in the past. This is because a lower growth in trend, or potential, output means that the gap with actual output is smaller. The smaller this output gap is, the more likely that you will get inflation. But in any case the Fed’s objective is not actually high growth. The Fed’s dual mandate is maximum employment and stable price. So the metric for the the Fed is how tight the labour market is. The logic is similar to the output gap: what is the difference between the current unemployment rate and the neutral rate.

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The Fed is kind enough to tell us what their estimate of the neutral rate is, so we can get an idea of their forecast for the unemployment gap. Every year the Fed has been forecasting that the unemployment gap was gradually closing, and it is one indicator where they have routinely been too pessimistic rather than optimistic (chart 3). They forecast the gap to have closed in 2015 and moved into being outright tight from 2016.

When the unemployment gap closes, the Fed expects wages to start rising and inflation pressures to rise. Economic theory also tells us that when the gap is closed interest rates should not be loose – they should be neutral. The Fed’s median estimate of the neutral rate is 3.25%. The current rate is just 0.375%.

Not every Fed member would agree with this logic. Chair Yellen herself has in the past talk about ‘optimal control’, the idea that you might want to keep monetary policy looser than you normally would but hike faster later on to compensate (and possibly hike beyond neutral). But nonetheless the

Fed was rightly concerned that the market had completely disregarded the possibility of rate hikes. If markets were not even entertaining the possibility of hikes, there could be a lot of disruption if the Fed surprises them.

Then again, if the Fed really wants to change market behaviour, maybe they should have just surprised them. After all, an air of mystery loses a lot of its impact if you go around telling people that you have an air of mystery.

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

A Dollar That Stays Within the Lines

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As I look back at some of the comments made in CIO Weekly Perspectives about our constructive views on non-U.S. equity markets, a key aspect of the story has been improvement in sentiment and growth fundamentals in various countries and regions around the world. Another crucial element in my view has been a shift in currency market dynamics.

Unlike in 2014 and the first half of 2015, the recent market price action has not featured a sustained rally in the U.S. dollar. Instead, we’ve seen a healthy correction in the dollar relative to other currencies including the euro and in particular the yen, with the Fed’s U.S. Trade Weighted Major Currency Dollar Index declining almost 7% during the first four months of the year.

Our general view is that this is a positive development. Especially in the U.S., earnings growth has been a cloud over the markets since the third quarter of last year. The absence of further dollar strength, coupled with firmer energy prices, may be setting the stage for a better earnings picture in the second half of the year.
Fundamental Reasons for Dollar Decline

A key question, however, is whether recent dollar weakness is justified. We believe the answer is yes, based on both the fundamentals and technical factors.

First, the fundamentals. Prior to the dollar correction that started in early February, pessimistic views prevailed regarding the trajectory of the global economy, but we’ve since seen improved sentiment on China as well as encouraging signs in Europe.

Then there’s central bank policy. Back in Q3 and Q4 of last year, the Federal Reserve seemed determined to execute multiple rate hikes in 2016. But in the midst of a soft patch in U.S. growth, they turned more dovish in Q1, to the point where markets anticipated just one—or at most two—rate increases this year.

Unlike in previous episodes, other central banks have not aggressively “played down” their currencies so far in 2016, effectively giving a green light for the dollar to correct lower. Earlier this year, the Bank of Japan and, to a lesser degree, the ECB seemed poised to move aggressively into negative rates territory. However, following the market’s hostile reaction to the BoJ’s January rate cut, central banks appear to be pursuing alternative, more tempered, policy options.

Finally, from a technical standpoint, we think the U.S. dollar bull market simply exhausted itself. So many strategists, from asset allocation gurus to FX experts, were still in the dollar-strength camp last year. Recently, they’ve changed their minds, piling into the short dollar trade versus the euro and yen.

Where We Stand
Although we acknowledge the reasons for the dollar decline, we’re not in the bearish camp at this point. Rather, we think the dollar is settling into a trading range that could last for the rest of the year and into 2017, driven by the factors I’ve mentioned—a healthier mix of growth dynamics and cautious central bank policy. Indeed, we’ve recently seen headlines about central banks disappointing markets in their “failure” to take action, and I think we’ll see a lot more of that, and fewer surprises from monetary policymakers.

Overall, we believe there are currently few drivers to justify a sustained breakout from current trading ranges. In terms of our views and given the more attractive levels, this translates into a tactical net-overweight dollar exposure and a modest short in the yen.

A connected issue relates to commodity-driven currencies. Since mid-January, the Canadian and Australian dollars have seen a strong recovery. Although we think there is fundamental justification (i.e., better Chinese data), the move is also largely technical in nature. A recent decision by the Australian central bank to ease rates is symptomatic of the underlying reality that Australia is not immune from global disinflationary pressures. Despite opinions to the contrary, in the near term we see limited potential for a new bull market in commodities or, by extension, commodity-driven currencies.

Smoother Ride? More Potential for Shocks
In this environment of subdued market drivers, there are risks. An obvious one is the potential for a vote for Britain to leave the EU late next month. While polling numbers are still implying a reasonable chance of Brexit, bookmakers now price only a 30% chance of separation. Sterling has been factoring in a high Brexit premium for some time but it recently rebounded to reflect lower Brexit probabilities.

A more subtle issue is posed by the subdued, range-bound environment. Without big differences in growth or drama from central banks, currency markets can become more technical in nature, and more vulnerable to shocks from exogenous events.

Circling back to where I started, how does all this affect risky financial assets? For much of 2016, we’ve been talking about the potential for better earnings in the absence of headwinds from the strong dollar or commodity weakness. Now that they are actually out of the way, and central banks are becoming quieter, we believe that the focus is likely to shift to individual company and sector fundamentals. Rather than dwelling on the macro, the challenge and potential could be far more extensive at the micro level.

Neuberger Berman’s CIO insight by Brad Tank

The Market Plays a (Fed) Waiting Game

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A dovish Fed and weaker dollar could create space for both wages and profits to rise.

I was invited onto Bloomberg Television recently to talk about my outlook on equity markets, the path for Fed rate hikes, and the U.S. consumer and retail sector. It’s interesting to think about how those three subjects relate to one another. The missing link? It might be productivity.

Wages, Prices and Profits
Last week the latest Global Economic Outlook from The Conference Board projected a fall in U.S. GDP per hour worked of 0.2% this year. That would mark the first year-over-year decline since 1982.

With low productivity growth as the background, it’s extremely difficult to sustain a mix of wage growth, modest inflation and accelerating corporate earnings. Two of the three would seem possible, but not all of them, and since mid-2014 the choice the market has made has been obvious: We’ve had an earnings recession with rising wages, alongside steady, low inflation.

I warned against chasing this market over a month ago, and since then it has crept up to a multiple of around 17 times 2016 projected earnings. On the face of things, it’s not obvious those earnings will materialize. When productivity was growing, rising wages led to more demand, which enabled price increases, wider margins and modest inflation. Today, global competition and a strong dollar have eroded corporate pricing power, leaving us with rising wages, subdued inflation and meager earnings.

Industry Is Struggling Despite High Consumer Confidence
This dynamic helps explain how we got such a disappointing reading from the Richmond Fed manufacturing index last week, at the same time as we got the biggest monthly rise in new home sales in 24 years. These are just the latest in a series of data points drawing a stark contrast between the moods of U.S. industry (which worries about the strong dollar, cheap oil and falling profits) and U.S. consumers (who wield a strong currency to buy cheaper gasoline and stuff to furnish their new homes). Significant shifts in consumption patterns—more online rather than high-street shopping, more purchases of experiences over goods—amplify this dynamic.

If earnings are to recover, either wage growth must slow or inflation, in the form of companies’ pricing power, must take hold. Regular readers may guess where our bias lies. Last week, Brad Tank outlined his expectations for a range-trading dollar and for a while we’ve said that a flat-to-weaker dollar and a firmer oil price were a foundation for earnings recovery. Both would stoke inflation, too.

And that is where the Fed comes in. A dovish second half of 2016 would cement this subdued-dollar, higher-inflation theme.

Recent “Fed speak” does little to support the thesis, apparently softening us up for more than one hike this year. Markets put the probability of a June hike at around 30%, but that’s up from 4% just a couple of weeks ago. The fact that risk assets have taken this in their stride, bank stocks have rallied and gold has sold off might embolden the FOMC.

How ‘Political’ Will the Fed Be?
The consensus on our teams is indeed for two hikes, not beginning in June, but at the September and December meetings. Why not in June? Because we’ll still be waiting on the Q2 GDP print and, lest we forget, the Q1 numbers were very disappointing. Furthermore, the June meeting comes just before the U.K.’s referendum on EU membership—which both the dovish Bill Dudley and the hawkish Robert Kaplan have cited as a reason to hold fire.

It is the question of how “political” the Fed might be that makes me err on the side of fewer rate hikes than some of my colleagues. Without a press conference in July and August, the FOMC risks hiking without being able to shape the message. Then we’re past Labor Day and deep into the clamor of the general election, during which you’d forgive the central bank for sitting on the sidelines.

With these sensitivities to consider, I would not be surprised to have to wait until December for the next hike. That could take some wind out of the dollar’s sails, underpin the ongoing recovery in inflation—and, potentially, free up margins to rise along with wages and place a cushion under today’s equity market multiples.

Neuberger Berman’s CIO insight by Joseph V. Amato

Missing the Target?

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Cinco mitos de los fondos de inversión a fecha fija — CC-BY-SA-2.0, FlickrPhoto: Vinoth Chandar. Missing the Target?

With the popularity of target date funds swelling assets to more than $763 billion at the end of 2015, defined contribution plan sponsors now have a sea of choices. But many are still trying to navigate the target date fund landscape based on common myths, which could steer them off course from their participants’ best interests. It’s time to dispel the myths and get back to what we think matters most based on participant time horizons and risk profile – asset allocation and robust risk management.

Myth 1: Target date funds that are passively managed have less risk.

The move to passive management, driven in large part by fee pressure, is undeniable. And, 50% of plan sponsors surveyed in the 2015 MFS DC Investment Trends Study think that passively managed funds have less risk than their active counterparts. But here are two problems: First, passively managed funds take the same risk as the market and often concentrate on stocks that become overvalued. Second, there is actually no such thing as a passively managed target date fund.

While some target date funds invest exclusively in passive funds, the fund managers still make active decisions with respect to asset class allocation, underlying fund selection, glide path design, portfolio rebalancing and risk management. On the latter, recent volatility reminds us just how important those active management decisions can be, particularly with respect to strong risk management.

Myth 2: Target date funds managed tactically can avoid market downturns.

The truth is, not many target date funds take this approach because adding value consistently through tactical asset allocation is not easy. In fact, target date fund managers have few opportunities to make market or asset class calls, because they are constrained to making decisions based on the underlying funds.

Here’s the concern: tactical investing done in a material way can change a fund’s risk profile. That happens inadvertently to funds that fail to rebalance after relative market performance causes deviations in the funds’ asset classes or underlying fund weights. Allowing the markets to dictate a fund’s tactical asset allocation this way can be dangerous – with potentially negative surprises for investors expecting a very different risk profile.

Myth 3: Target date fund glidepaths can be built based on the “average” participant.

Constructing a glide path that is optimal for a representative participant, is by definition sub-optimal for everyone but that participant. It’s like being a shoe manufacturer who makes only size nine shoes because that’s the average. The trouble is, the shoes don’t fit most of the population.

Glidepaths by design are meant to accommodate a wide range of investors. So, the discussion shouldn’t really be about “to” or “through” glidepaths or a one-size-fits-all participant profile, given how dramatically demographics vary from plan to plan. Instead, we need to make the right asset allocation decisions for the end investor. That means building a portfolio that properly balances capital appreciation against principle preservation in relation to the time to the target date. We believe glidepaths should reflect a high level of risk tolerance early on and a high level of risk aversion as the target date approaches. Studies show that 80% of participants take their money out of the plan within three years of retirement. So, a glide path that reaches its final resting spot 15 years past that target date creates a very aggressive “to” portfolio for investors who leave the fund right at or shortly after retirement.

Myth 4: You can judge a target date fund manager’s skill based on shorter track records.

Target date funds are by their very nature long term investments and investors seem to get that. A recent report from Morningstar called “Encouraging signs for target-date funds” suggested that target date fund investors might be more patient than other fund investors. As evidence, they pointed to target date fund investor results that were 74 basis points higher than their funds’ total returns, compared to the negative return gaps experienced by other fund investors who trade in and out. So, if investors are more willing to stay the course long-term in a target date fund, why are more than 50% plan sponsors looking at three-year track records, as we found in a recent study(iv)? To get a more complete picture, see how a target date fund has performed peak to peak or trough to trough – through a full market cycle.

Myth 5: Risk management is an afterthought.

When it comes to long-term outperformance, minimizing losses on the downside is just as important as capturing the upside. Many target date fund investors found that out the hard way after the global financial crisis. The fact is, there is greater persistence in risk than in return. So if you get the risk side of the equation right, you can manage a target date fund’s risk profile more effectively through time. That takes a sound investment process where risk management is baked in at every level.

As target date funds continue to evolve and grow in popularity, it’s easy to lose sight of the features that align best with participant needs. We believe putting a priority on active risk management and asset allocation will help plan sponsors make choices managed for their participants’ long-term horizons.

Ryan Mullen is MFS Senior Managing Director, Head of Defined Contribution Investments.

Pension Funds Around the World Look into Alternative Assets

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Los fondos de pensiones alrededor del mundo han aumentado su participación en activos alternativos — CC-BY-SA-2.0, FlickrPhoto: Images Money. Pension Funds Around the World Look into Alternative Assets

The 19 countries with largest pension funds in the world ended 2015 with assets under management equivalent to 35.32 trillion dollars according to the Global Pension Assets Study 2016 prepared by Willis Tower Watson. The study considers pension funds with both benefit and defined contribution schemes.

The countries analyzed are: Australia, Brazil, Canada, Chile, France, Germany, Hong Kong, India, Ireland, Japan, Malaysia, Mexico, Netherlands, South Africa, South Korea, Spain, Switzerland, UK and US. The largest markets are US, UK and Japan, while the smaller ones are Hong Kong, India and Spain.

7 of these 19 countries represent 93% of the assets under management analyzed as well as relatively high proportions to their countries’ GDP. US is the country whose Pension funds manage the largest assets at $21.78 trillion, representing 121.2% of their GDP; followed by the UK with $3.20 trillion dollars and 111.9% of GDP; and Japan with 2.75 trillion dollars and 66.7% of GDP.

In fourth place is Australia with $1.49 trillion and 119.6% of GDP followed by Canada with 1.53 trillion dollars and 97% of GDP; and the Netherlands with $1.34 trillion and 183.6% of GDP. Finally, in the seventh position is Switzerland with $804 billion and 118.7% of GDP.

In LATAM Chile manages 159 billion which represents 66.4% of their GDP; Mexico’s 177 billion are equivalent to 15.2% of their GDP and Brazil with $180 billion and 10% GDP, though Brazilian assets only include those from closed entities, highlights the study.

In terms of growth, Willis Tower Watson mentions that the assets of major pension funds had an average contraction of 0.9% in dollar terms in 2015. In many cases this contraction is explained by the movement of currencies against the dollar. In 2015 the Brazilian real depreciated 31.1%, the South African currency -24.7%; the Malaysian Ringgit -18.5%; Canadian dollar -16.1%; the Mexican peso -14.6% and the Chilean peso -14.5%.

The 7 largest pension funds at the end of 2015 had a distribution of 44% in equities; 29% bonds; 24% in other assets including real estate and alternatives and 3% in cash. If the figures are compared in a 20 year horizon it can be seen that the participation of Pension funds in alternative assets has increased from 7% in 1996 to 24% in 2015. While equities have lowered from 52 to 44% and debt from 36 to 29%.

The above percentages are an interesting comparative parameter for the composition of the portfolios of the Afores in Mexico, which have 20% of their assets invested in equities (13% international and 7% national); 74% in debt ((53% government, 20% national private debt and 1% international debt), and only a 6% (4% Structured, 2% Mexican REITS) in alternative assets. While the percentages have increased for Mexico there is still a wide margin to reach international standards, and to do so, both a healthy supply of alternatives, and the opening of the investment regime are key.

The Compound Annual Growth Rate (CAGR) in dollars, for Pension funds in the last 10 years (2005-2015) grew on average 5.1%. With rates above 8% are Mexico with 9.2%; Australia with 9.1% and Hong Kong with 8.8%.

According to Willis Tower Watson, the countries that increased the most their proportion against GDP over the past 10 years were the Netherlands, which went from 109% in 2005 to 184% in 2015; Australia going from 84% to 120%; and the UK from 79% to 112%. In LATAM Chile steped from 61 to 66% and Mexico increased from 8 to 15% while Brazil dropped from 15% in 2005 to 10% in 2015.

Column by Arturo Hanono

Credit Market DéJà Vu: Volatile And Full Of Value

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The bond market’s volatility in the first quarter of 2016 had a familiar feel to it, as persistently sluggish global growth prompted renewed efforts by central banks to combat it. The good news is that after the quarter’s gyrations, value in specific credit sectors discussed in our fourth-quarter 2015 report remains intact, despite strong rallies in these sectors after mid-February.

The year started ominously for risk assets, with a large sell-off in equity markets as well as the high-yield bond and floating-rate loan credit sectors. Investors reacted to fears of another global downturn akin to the financial crisis, possibly sparked by a Chinese hard landing and currency devaluation, and a U.S. recession. The S&P 500 gave up 9% between January 4 and February 11, with smaller losses for high-yield bonds and loans.

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Central banks responded with a multipronged stimulus package by European Central Bank President Mario Draghi, and moves by Federal Reserve Chair Janet Yellen to scale back the number of rate increases expected this year, citing risks posed by “global economic and financial developments.” China, for its part, denied that it was planning a major currency devaluation and pledged to do more to boost its economy.

Markets bounced back sharply – the S&P 500 regained 12.6%, and high-yield spreads tightened from 887 basis points (bps) to 705 bps – just 10 bps wider than year-end, based on the BofA/Merrill Lynch U.S. High-Yield Master II Index. Exhibit A shows the V-shaped recovery of equities in the second half of the quarter.

Taking measure of interest-rate and credit risks

Despite the rebound, today’s environment poses a unique set of interest-rate and credit risks for fixed-income investors. Profits for S&P 500 companies are expected to fall 9% for the fourth quarter, which would be the fourth consecutive quarterly earnings decline and the first such streak since the financial crisis. Tepid economic growth remains a burden on companies. At the same time, we believe the Fed is still likely to raise its target fed funds rate this year, as it is very close to achieving (and perhaps exceeding) both its unemployment and inflation targets. Though not as urgent as previously thought, fixed-income investors remain vulnerable to rising short-term interest rates.

In this vein, we believe the case for the three sectors we highlighted in our fourth-quarter report – high-yield bonds, floating-rate loans and municipal bonds – remains intact, should short-term rates rise.

In Exhibit B, the dotted square box shows the last period (2004-2007) in which the Fed hiked its target fed funds rate. All three sectors had positive total returns during that period, so it would appear that a likely scenario of modest hikes would pose relatively little threat to returns in these three sectors.

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Credit concerns also remain legitimate, given continuing slow economic growth combined with a reasonable likelihood that the U.S. economy is in the latter innings of the current credit cycle. Despite this, however, in our view current valuations and income offered by below-investment- grade debt more than compensate for the credit risks assumed. We also believe active management is particularly important and relevant currently, given deep credit stress in particular sectors, including energy and commodities issuers.

Spreads on both high-yield bonds and floating-rate loans are at levels comparable to 2011, in the aftermath of the financial crisis, and are 143 basis points and 68 basis points higher than the median over the past 10 years, respectively. Of course, spreads could always widen further, but today’s levels represent a “value cushion” that is very rare – slow growth and high expected default rates are already reflected in today’s prices, with discounts below fair value, in our view.

Scatterplots point to high-yield value

For some perspective on today’s pricing of credit, Exhibit C has two scatterplots – the left for high yield, the right for the S&P 500. The dots compare valuation levels for each month since 1988 with subsequent three-year annualized total returns. While the dots aren’t tidy, they make two basic points. In general, the southwest-to-northeast slant of the dots indicates that as the sector gets cheaper (measured by spreads for high yield and earnings yields, or E/P1, for stocks), subsequent three-year returns get higher.

Enlarge

The dots on or very close to the red horizontal lines – indicating the current spread level and earnings yield, respectively – make a specific point about today’s valuations. For high yield, whenever spreads have been at or near the current level of 705 bps (on the BofA/Merrill Lynch U.S. High-Yield Master II Index), subsequent three-year annualized returns have all been strongly positive, ranging from 8% to more than 20%. For the S&P 500, when stocks had earnings yields roughly equivalent to today’s level of 3.8%, the range of outcomes has been much wider – from negative 20% to positive 30%, and about a third of the time the results were negative. At current relative valuation levels, high yield has been the stronger-conviction choice for investors seeking a tighter range of expected return outcomes.

The observation above should not surprise investors. Over the past 10 years, high yield has provided almost the same return as stocks, with two thirds the volatility; over the past 20 years, stock annual returns exceeded high-yield annual returns by 121 basis points, but high yield exhibited just under two thirds the risk and a superior (higher) Sharpe ratio. The high annual income generated by high-yield bonds has been a big factor contributing to these historical risk/return relationships.

Defaults as a lagging indicator

Given that we are in the latter part of the credit cycle, we anticipate that defaults for both high-yield bonds and floating-rate loans are likely to increase from current levels; each are currently near their 10-year medians. However, if investors wait for defaults to peak, we believe they will have missed a value opportunity, because current discounted prices already reflect a significant rise in default rates.

In floating-rate loans, for example, the March 31 Index price of 91.5 means the market is expecting total credit losses of 8.5% over the lives of the loans, which on average has been three years. When you factor in an average 70% default recovery rate that lenders have historically achieved, this implies a three-year annual default rate of 9%, which exceeds the three-year annual rate during the height of the financial crisis. This scenario seems very unlikely to us.

Second, active management can be key in building portfolios of companies that may help mitigate default risk – passive allocations that mirror the Index must include all issuers, including those most at risk. Third, waiting for defaults to improve can reduce potential total return because spread tightening (bond price appreciation) historically has preceded peaks in default rates. Exhibit E shows that in 2009 and 2011, high-yield spreads anticipated the turn in default rates – the tightening started while default rates were still increasing.

Déjà vu going forward

For the bond market, the first quarter of 2016 was déjà vu all over again, which is likely to be the pattern for some time. We believe that staying focused on credit fundamentals and investing for the medium term in active credit strategies is the best approach to seek profit (or protection) from volatile markets.

Navigating the Regulatory Maze: An Overview of Key Regulations Impacting the Offshore Private Wealth Business

| For Gabriela Huerta | 0 Comentarios

For years, practitioners have been signaling the apocalypse for the offshore private wealth business due to strangling regulation. Yet, year after year, clients are well served, products are well developed and doomsday never quite arrives. Former Secretary of the Treasury Nicholas Brady is said to have once remarked: “Never bet on the end of the world; for one thing, even if you win there’d be no one around to collect from.”

And so it is with regulation. No doubt that technology and the otherwise shrinking and connected world have greatly accelerated the pace of global initiatives like tax transparency. Similarly, the pace of change in many countries has lagged and the ability to gather and share personal data globally has not moved consistently with governmental stability and the ability to keep private data private. Nonetheless, the global initiatives and their reduction to local law and regulation are a current reality.

No practitioner in the private wealth world should be without at least a conversational familiarity with those pieces of regulation shaping our world. While the regulations themselves vary from aspirational multinational initiatives by non-governmental bodies to specific national legislation or treaties, together they form a mosaic that is, in fact, beginning to resemble something recognizable.

I. United States Anti-Money Laundering Act

From 1970 the United States has had at least some measure of comprehensive anti-money laundering legislation. While the intricacies of the AML framework are vast and broad, certain areas directly impact the offshore private wealth world.

Broadly, money-laundering is the process of making illegally gained proceeds appear legal. It was officially established as a federal crime in 1986. Importantly, the ultimate offense of laundering criminal proceeds applies with specificity only to those Specified Unlawful Activities (SUA) enumerated in the legislation. Not all crimes are listed, and many are noticeably omitted, including tax non-compliance in foreign countries.

In the aftermath of the September 11, 2001 terrorist attacks, the US Congress passed the PATRIOT ACT. Title III of the Act is its primary AML component and greatly changed the landscape for brokerage and other non-banks. The Act greatly increased the diligence provisions of AML KYC (Know Your Customer) and crafted those as part of broader Customer Identification Programs (CIP) to which nearly all financial institutions must adhere. These CIP requirements, including its Customer Due Diligence and Enhanced Due Diligence prongs are most familiar to private wealth practitioners as they today form an essential piece of client onboarding and account opening. Foreign customers are treated differently than the domestic US national customers and require additional data gathering including identification documents which may range from passports to country verification cards.

The Customer Due Diligence Program (CDD) is designed to demand more from those clients and institutions that may present higher risks for money-laundering and terror financing. Customers that pose higher risks including certain foreign accounts such as correspondent accounts, senior foreign political figures and personal corporate vehicles, require even greater diligence. This “enhanced” due diligence (EDD) is the normal course for the offshore private wealth client.

Part and parcel of enhanced diligence is the concept of “looking through” corporate investment vehicles, whether simple entities or trusts, to determine and verify true ownership. The use of these vehicles is regularly regarded as an additional risk factor which requires “high-risk” documentary procedures in account opening and subsequent monitoring. Of particular interest are potential underlying crimes of political corruption. Enhanced scrutiny of accounts involving senior foreign political figures and their families and associates is required to guard against laundering the proceeds of foreign corruption.

II. FATCA

In what is the most significant legislation impacting financial transparency, the Foreign Account Tax Compliance Act (FATCA) has reshaped the world of international tax reporting and cooperation. FATCA’s original intent was to enforce the requirements for US persons to file yearly reports on their non-US financial accounts by requiring foreign financial institutions to search the records for indicia of US person accounts and to report these to the Department of the Treasury. For those who fail to adequately search and report US persons within those foreign institutions, a 30% penalty would be assessed to qualifying payments. Because the US capital markets remain the world’s foremost, access by foreign institutions to those markets quickly became FATCA dependent.

For foreign institutions, FATCA commands they search their customer base for FATCA indicia of US person status, including place of birth, US mailing address, a current US power of attorney, and other indicators. Additionally foreign institutions are to annually certify compliance and implement monitoring systems to assure the accuracy of the certification.

An important FATCA feature is its complex definitional scheme. Many of FATCA’s definitional criteria impose bank-like requirements on commonplace personal investment entities designed to suit the needs of only one individual or family. Practitioners need to be aware that under FATCA simple PIC’s may well qualify to be FATCA foreign financial institutions.

In its most familiar implementation, FATCA devises a model of international financial data exchange through bilateral Intergovernmental Agreements (IGA’s). Today, there are over 100 IGA’s calling for exchange of information between governments. Beginning with France, Germany, Italy, Spain and the UK in 2012, other countries have joined the data sharing protocols which provide for either the foreign institution to directly provide the US person account data to the IRS (Model 2) or the institution reports to its home authority, which in turn reports the data to the US IRS (Model 1).

It is important to note that while mutual, not all IGA’s are reciprocal and that the reporting obligations may vary among the signatories. By example, under Model 1A, the US shares information about the country’s taxpayer, while under Model 1B there is only exchange to the US, but not from the US. The quality of the data may also vary greatly. As an example; Mexican financial institutions must identify the ultimate owners of corporate entities with US persons. Non-reciprocally, US financial institutions need not report those corporate entities beneficially owned by Mexican residents.

III. Automatic Exchange of Information

Taking its cue from the developing US FATCA framework, the OECD and the G20 crafted its own version of a global transparency framework beginning in 2014. The Automatic Exchange of Information Act (AEI) framework imposes an automatic standard requiring financial institutions in participating jurisdictions to report individual account holders to their respective home countries, including “looking through” legal entities and trusts.

The actual data exchange implementation requires bilateral agreement between the countries. Countries are free to deny exchange with other signatories if confidentiality standards are not satisfactory, among other factors. Importantly, the US is not committed to the AEI or it’s Common Reporting Standard (CRS) which dictates what the signatories are to report and contains many of the “look through” features which reveal the identities and home countries of the ultimate beneficial owners of corporate entities and trusts. While to date the US remains committed to its FATCA/IGA framework as its mode of implementing global tax transparency , IRS Commissioner John Koskinen recently has called for the adoption of the AEI/CRS standard.

Common Reporting Standard

In order to affect meaningful data exchange, there must be a uniform standard for the quality of data to be exchanged. Those provisions exist under Common Reporting Standard. Unveiled in February 2014, over 50 countries have expressed their willingness to join the multilateral framework. The US is not yet an adopter, and the OECD has noted that the “intergovernmental approach to FATCA is a pre-existing system with close similarities to the CRS.” In deference, the OECD views FATCA as a “compatible and consistent” system with the CRS. Under the CRS, institutions must report passive investment entities and look through the entity structure to report its “Controlling Persons”. Also included in the reporting scheme are trusts both revocable and irrevocable.

IV. Conclusion

The recent wave of regulation is fast and fervent. While it builds on an existing foundation in many instances, nothing will quite ever be the same again. Transparency and data sharing are inevitable. For the offshore private wealth practitioner, the only answer is transparent and locally tax efficient and compliant solutions. Consulting a learned wealth planner is no longer a luxury; it has become a necessity.

Precisely Wrong on Dollar, Gold?

| For Gabriela Huerta | 0 Comentarios

Since the beginning of the year, the greenback has shown it’s not almighty after all; and gold – the barbarous relic as some have called it – may be en vogue again? Where are we going from here and what are the implications for investors?

Like everything else, the value of currencies and gold is generally driven by supply and demand. A key driver (but not the only driver!) is the expectation of differences in real interest rates. Note the words ‘perception’ and ‘real.’ Just like when valuing stocks, expectations of future earnings may be more important than actual earnings; and to draw a parallel to real interest rates, i.e. interest rates net of inflation, one might be able to think of them as GAAP earnings rather than non-GAAP earnings. GAAP refers to ‘Generally Accepted Accounting Principles’, i.e. those are real-deal; whereas non-GAAP earnings are those management would like you to focus on. Similarly, when it comes to currencies, you might be blind-sided by high nominal interest rates, but when you strip out inflation, the real rate might be far less appealing.

It’s often said that gold doesn’t pay any interest. That’s true, of course, but neither does cash. Cash only pays interest if you loan it to someone, even if it’s only a loan to your bank through a deposit. Similarly, an investor can earn interest on gold if they lease the gold out to someone. Many investors don’t want to lease out their gold because they don’t like to accept the counterparty risk. With cash, the government steps in to provide FDIC insurance on small deposits to mitigate such risk.

While gold doesn’t pay any interest, it’s also very difficult to inflate gold away: ramping up production in gold is difficult. Our analysis shows, the current environment has miners consolidating, as incentives to invest in increasing production have been vastly reduced. We draw these parallels to show that the competitor to gold is a real rate of return investors can earn on their cash. For U.S. dollar based investors, the real rate of return versus what is available in the U.S. may be most relevant. When it comes to valuations across currencies, relative real rates play a major role.

So let’s commit the first sin in valuation: we talk about expectations, but then look at current rates, since those are more readily available. When it comes to real interest rates, such a fool’s game is exacerbated by the fact that many question the inflation metrics used. We show those metrics anyway, because not only do we need some sort of starting point for an analysis, but there’s one good thing about these inflation metrics, even if one doesn’t agree with them: they are well defined. Indeed, I have talked to some of the economists that create these numbers; they take great pride in them and try to be meticulous in creating them. To the cynic, this makes such metrics precisely wrong. To derive the real interest rate, one can use a short-term measure of nominal rates (e.g. the 3 month T-Bill, yielding 0.26% as of this writing), then deducting the rate of inflation below:

The short of it is that, based on the measures above, real interest rates are negative. If you then believe inflation might be understated, well, real interest rates may be even more negative. When real interest rates are negative, investing cash in Treasury Bills is an assured way of losing purchasing power; it’s also referred to as financial repression.

Let’s shift gears towards the less precise, but much more important world of expectations. We all know startups that love to issue a press release for every click they receive on their website. Security analysts ought to cut through the noise and focus on what’s important. You would think that more mature firms don’t need to do this, but the CEOs of even large companies at times seem to feel the urge to run to CNBC’s Jim Cramer to put a positive spin on the news affecting their company.

When it comes to currencies, central bankers are key to shaping expectations, hence the focus on the “Fed speak” or the latest utterings coming from European Central Bank (ECB) President Draghi or Bank of Japan’s (BoJ) Kuroda. One would think that such established institutions don’t need to do the equivalent of running to CNBC’s Mad Money, but – in our view – recent years have shown quite the opposite. On the one hand, there’s the obvious noise: the chatter, say, by a non-voting Federal Open Market Committee (FOMC) member. On the other hand, there are two other important dimensions: one is that such noise is a gauge of internal dissent; the other is that such noise may be used as a guidance tool. In fact, the lack of noise may also be a sign of dissent: we read Fed Vice Chair Fischer’s absence from the speaking circuit as serious disagreement with the direction Fed Chair Yellen is taking the Fed in; indeed, we are wondering aloud when Mr. Fischer will announce his early retirement.

This begs the question who to listen to, to cut through the noise. The general view of Fed insiders is that the Fed Governors dictate the tone, supported by their staff economists. These are not to be mistaken with the regional Federal Reserve Presidents that may add a lot to the discussion, but are less influential in the actual setting of policy. Zooming in on the Fed Governors, Janet Yellen as Chair is clearly important. If one takes Vice Chair Fischer out of the picture, though, there is currently only one other Ph.D. economist, namely Lael Brainard; the other Governors are lawyers. Lawyers, in our humble opinion, may have strong views on financial regulation, but when it comes to setting interest rates, will likely be charmed by the Chair and fancy presentations of her staff. I single out Lael Brainard, who hasn’t received all that much public attention, but has in recent months been an advocate of the Fed’s far more cautious (read: dovish) stance. Differently said, we believe that after telling markets last fall how the Fed has to be early in raising rates, Janet Yellen has made a U-turn, a policy shift supported by a close confidant, Brainard, but opposed by Fischer, who is too much of a gentleman to dissent in public.

It seems the reason anyone speaks on monetary policy is to shape expectations. Following our logic, those that influence expectations on interest rates, influence the value of the dollar, amongst others. Former Fed Chair Ben Bernanke decided to take this concept to a new level by introducing so-called “forward guidance” in the name of “transparency.” I put these terms in quotation marks because, in my humble opinion, great skepticism is warranted. It surely would be nice to get appropriate forward guidance and transparency, but I allege that’s not what we have received. Instead, our analysis shows that Bernanke, Yellen, Draghi and others use communication to coerce market expectations. If the person with the bazooka tells you he (or she) is willing to use it, you pay attention. And until not long ago, we have been told that the U.S. will pursue an “exit” while rates elsewhere continue lower. Below you see the result of this: the trade weighted dollar index about two standard deviation above its moving average, only recently coming back from what we believe were extremes:

f reality doesn’t catch up with the storyline, i.e. if U.S. rates don’t “normalize,” or if the rest of the world doesn’t lower rates much further, we believe odds are high that the U.S. dollar may well have seen its peak. Incidentally, Sweden recently announced it will be reducing its monthly bond purchases (QE); and Draghi indicated rates may not go any lower. While Draghi, like most central bankers, hedges his bets and has since indicated that rates might go lower under certain conditions after all, we believe he has clearly shifted from trying to debase the euro to bolstering the banking system (in our analysis, the latest round of measures in the Eurozone cut the funding cost of banks approximately in half).

On a somewhat related note, it was most curious to us how the Fed and ECB looked at what in some ways were similar data, but came to opposite conclusions as it relates to energy prices. The Fed, like most central banks, like to exclude energy prices from their decision process because any changes tend to be ‘transitory.’ With that they don’t mean that they will revert, but that any impact they have on inflation will be a one off event. Say the price of oil drops from $100 to $40 a barrel in a year, but then stays at $40 a barrel. While there’s a disinflationary impact the first year, that effect is transitory, as in the second year, inflation indices are no longer influenced by the previous drop.

The ECB, in contrast, raised alarm bells, warning about “second round effects.” They expressed concern that lower energy prices are a symptom of broader disinflationary pressures that may well lead to deflation. We are often told deflation is bad, but rarely told why. Let’s just say that to a government in debt, deflation is bad, as the real value of the debt increases and gets more difficult to manage. If, in contrast, you are a saver, your purchasing power increases with deflation. My take: the interests of a government in debt are not aligned with those of its people.

Incidentally, we believe the Fed’s and ECB’s views on the impact of energy prices is converging: we believe the Fed is more concerned, whereas the ECB less concerned about lower energy prices. This again may reduce the expectations on divergent policies.

None of this has stopped Mr. Draghi telling us that US and Eurozone policies are diverging. After all, playing the expectations game comes at little immediate cost, but some potential benefit. The long-term cost, of course, is credibility. That would take us to the Bank of Japan, but that goes beyond the scope of today’s analysis.

To expand on the discussion, you can register for Axel Merk’s upcoming Webinar entitled ‘What’s next for the dollar, currencies & gold’ on Tuesday, May 24.