CC-BY-SA-2.0, FlickrPhoto: Begoña. Weakening Renminbi Puts More Oil on the EM Fire
2015 ended with falling commodity prices, weakening EM growth momentum and increasing concerns about EM capital outflows. Deepening political crises in Brazil, South Africa and Turkey caused additional market nervousness in the last weeks of the year. The combination of expectations of tighter US monetary policy on the one hand and concerns about EM deleveraging, financial risks and deepening political crises in the problem countries should keep the pressure on the emerging world high in 2016 as well. The most important issue remains the Chinese situation of declining growth, increasing leverage growth, less effective economic policies and accelerating capital outflows.
The most recent source of EM risk aversion has been the depreciation of the Chinese renminbi. Since the mini-devaluation of last August, the authorities in Beijing have been managing the renminbi exchange rate relative to a basket of currencies of main trading partners. After the nominal effective exchange rate had appreciated by some 30% since 2011 (when most EM currencies started to depreciate), it stabilized in the second half of 2015. From the recent sharp daily moves relative to the US dollar – something which the Chinese had always avoided – we can now deduct that Beijing is strongly committed to avoid appreciation against the basket of main trading partners.
This decision makes a lot of sense given the weakness in the Chinese export sector and the importance of this sector for Chinese employment. Even more so because of the capital outflows that to a large extent are driven by the perception that the renminbi remains overvalued.
The problem for financial markets, however, is that a rapidly weakening renminbi means that an important anchor for EM currencies has disappeared. With the renminbi allowed to weaken relative to the US dollar, it is likely to keep pace with the other EM currencies and the euro. The latter is particularly relevant given the efforts by the ECB to push the euro weaker. Europe is China’s largest trading partner.
Another reason why the recent large CNY moves have created new unrest in financial markets is that they suggest that the economic problems in China might have become too big for the old gradual policy approach.
M.J. Bakkum is Senior Emerging Market Strategist at NN Investment Partners.
CC-BY-SA-2.0, FlickrPhoto: Vicent_AF. Asia's Long-Term Growth Prospects Still Look Good
I think it is fair to say that sentiment toward China, and by extension, Asia, within the U.S. investment community, is quite polarized. Whereas some investors I have met recently see opportunity in the weakness of the second half of the year, doubts over the reality of recent growth rates and anxiety over a slower headline rate of growth has caused many others to be quite fearful of China as a deflationary force in the world economy. I think this caution is mirrored by investors around the world, albeit that the degree of discomfort with China and Asia is perhaps less acute in Europe. Whilst those in Asia appear to be much more optimistic about the region’s own long-term growth prospects (and less suspicious about the quality of China’s historic growth), most investors are still in a “wait-and-see” mode.
It is not hard to see why. Indeed, let us just list the headwinds that Asia faces in the near term: the prospect of further tightening by U.S. monetary policy—this time in the form of rising rates; slowing nominal growth; low margins and disappointing earnings growth; a strong dollar and weak local currencies; increasing credit spreads; and poor momentum in the equity markets. And all of this is happening at a time when valuations, whilst not expensive, cannot be regarded as cheap in absolute terms. It is understandable that people may be waiting for some event or some improvement in valuations before they turn more positive. And it is rational, and almost always your best first guess, to assume that current trends will persist when you are trying to forecast the near-term future.
Now, let me just suggest that we have some data that should allow us to be more confident over Asia’s ability to weather the world’s deflationary forces. First, current accounts in Asia are generally positive. That means Asia’s countries are saving more domestically than they invest domestically. And so, they are relatively less reliant on foreign capital. There are some exceptions—India and Indonesia. But even here, reliance on U.S.-dollar capital markets has reduced dramatically over recent years. Second, inflation rates are low across much of the region (again Indonesia and India are exceptions, even though they have been successful at moderate price rises). These low inflation rates mean that Asia’s policymakers have a lot of room to offset deflationary impulses by either monetary policy or even government spending or tax cuts. A return to a more inflationary environment would relieve some pressure on margins, earnings and valuations.
The question is: are we seeing any signs of such a response? I think we are. First, there are the natural responses of markets—prices adjust. Most obviously, in the face of deflationary U.S. pressures, Asia’s currencies have taken the strain. Acute declines have been limited to commodity-related currencies, such as the Malaysian ringgit and Indonesian rupiah. Elsewhere across the region, moderate currency declines (nowhere near as severe as what Latin America has suffered) have acted as a sort of pressure valve to protect domestic employment and maintain domestic demand. Although this is a drag on U.S. dollar returns and (to a lesser extent) Euro-based investors, the fact that currencies have been able to act as stabilizers of demand shows how far we have progressed in Asia since the late 1990s.
Then, we have the active response of policymakers. In India, we have seen the central bank successfully squeeze down core inflation rates without too severe an impact on industrial profits (perhaps helped by lower commodity prices). Now, India’s central bank seems ready to ease. In China, we are seeing authorities raise the growth rate of narrow money, continue to press with financial system reforms, and support the property market. Japan is continuing its policy of reflation and structural reform initiatives. So, in the face of a deflationary U.S. policy, the three Asia giants seem to be leaning in the other direction. The degree of offset is perhaps still small. But talking to clients and investors around the region leaves me to believe that there is no great liquidity crisis. Indeed, if the acutely bearish reaction to the Chinese currency re-pegging in the middle of 2015 taught us anything it is that, in the wake of a fall in equity prices, value was quick to emerge and buyers were quick to enter the markets.
Global Middle Class Spending
In this context, Asia’s long-term growth prospects still look good. High savings rates, large manufacturing bases, reformist governments pursuing financial, legal, and corporate reforms mean that Asia should continue to invest and potentially grow at higher rates than the rest of the world. Over time, this investment will continue to raise real wages across the region. This trend should not only support currencies and growth but also may lead to big changes in Asia’s households. We have noted before that on current trends, Asia stands to account for two-thirds of global middle class spending by 2050. We believe this is just the beginning of a sustained growth in the kinds of businesses that will help generate profits from facilitating this revolutionary change in lifestyles: consumer brands, restaurants, leisure, media, insurance, property, consumer banking and wealth management. In industry, automation equipment and IT software will help companies offset higher wages. Increased government and private spending on health care, the environment, and general welfare will open up new opportunities for companies to create competitive advantages and raise profits and shareholder returns.
In light of these trends, we should remember the monetary environment that dominates our discourse and the media headlines: By how much the Fed will raise rates? This environment, whilst important in the short-term, is to an extent just a veil that distracts our attention from the real economic changes that are evolving almost undetected before our eyes. With that said, nevertheless, we have to admit that 2016 is likely to be a landmark year in U.S. monetary policy—the first rise in rates in a decade.
Within Asia, our focus remains on the companies that will support the real economic growth trends, across all countries. However, it is true that some countries currently appear to be more fertile grounds for corporate research than others. On valuation grounds, India looks moderately expensive, with disappointing earnings growth and a lot of expectations over the still-unfulfilled reforms by the prime minister. In China, valuations are much more reasonable—parts of the Hong Kong market look cheap. And after a difficult time in 2015, the Association of Southeast Asian Nations once again looks to offer new opportunities, even as stock prices in some parts of the North Asian markets, particularly in Korea, seem to be quite advanced. Japan, at least, offers some value and some hope of better corporate returns, though one should be wary of hyping Abe’s third arrow too much.
Overall, I look forward to 2016. Although the headwinds are currently considerable, Asia’s businesses seem to be weathering the storm, and so long as we keep our eye on the long term, the investment environment should offer up some good opportunities.
Robert J. Horrocks is CIO and portfolio manager at Matthews Asia.
Following the closure of the Third Avenue fund earlier this month, liquidity issues are once again at the forefront of investor’s minds when it comes to the high yield market. Ultimately, conditions will only improve with structural changes to the market but in the meantime we think there are several steps that can be taken to help improve the underlying liquidity profile of a high yield portfolio.
Buy and Hold – by keeping portfolio churn low and buying securities with a view to a long term holding period and accepting that there will be some price volatility, the liquidity needs of a portfolio are automatically curtailed. This also means corporate fundamentals and the underlying credit worthiness of an issuer over the long term are bought more sharply into focus at the point any purchase is made. The question “Would I be happy to hold this bond through periods of market distress” is a good one to ask. If the answer is “yes”, then the chances of finding a buyer during such periods are greatly enhanced.
Stick to larger bond issues – The bigger the bond issue, the greater the investor base and the greater chance of being able to match a buyer and a seller (we illustrate this below by comparing the recorded activity trade activity for a $4.28bn bond, and a $200m bond issued by the same company). However, this can be a double-edged sword. The larger a bond issue, the more likely it is to be a constituent of an ETF portfolio which can be disadvantageous during periods of large redemptions.
December 17th 2015 Trade History for Sprint 7.875% 2023, $4.28bn outstanding:
December 17th 2015 Trade History for Sprint 9.25% 2022, $200m outstanding:
Diversify by market – Trading environments can and often do differ in different markets. A portfolio that can invest across the range of ABS, financials, corporate, sovereigns, emerging markets, fixed rate or floating rate, Europe or the US can often exploit better liquidity conditions in one market when another is facing difficulty.
Use liquid proxies – The daily volume that trades in the synthetic CDS index market is an order of magnitude greater than the physical cash market. Keeping part of a portfolio in such instruments provides access to a deeper pool of liquidity and can provide a useful buffer in periods when the physical market conditions worsen. However, there is an opportunity cost in terms of stock selection that needs to be considered.
Keep cash balances higher – The most effective way to boost liquidity in a portfolio is the simplest: hold more cash. 5% is the new 2%. Again, there are opportunity costs in terms of market exposure and stock selection, but the benefits in terms of liquidity are immediate and tangible.
It’s important to stress that none of these measures are a silver bullet, but they are mitigants. They can buy time and help investors tap liquidity. In today’s high yield markets, the question of how a portfolio’s liquidity is managed has become just as important (if not more so) than its investment position
Opinion column by James Tomlins from M&G Investments
CC-BY-SA-2.0, FlickrPhoto: BCE Offcial. Markets’ Addiction to Central Bank Support Leaves Investors Stunned
Markets have become increasingly volatile this year and seem to be much more driven by investor sentiment rather than economic fundamentals. In the past years, markets have developed an addiction to central bank support and their reaction to changes in monetary policy stances has become unpredictable and often dramatic.
This year we saw a couple of good examples. On August 24, or “Black Monday”, Chinese equity markets dropped nearly 9% in one day followed by the news that China’s central bank was not quickly planning to bail out markets again after already pledging hundreds of billions of dollars for this purpose earlier. Naturally this sent ripples throughout global markets, including Europe and the US. On Black Monday, the Dow Jones dropped 1,000 points at opening, the largest drop ever.
The latest example is from December 3, the day that ECB President Mario Draghi announced additional stimulus measures in order to boost the Eurozone economy and inflation. However, markets had created the image of “Super Mario”, the central banker who has proven to be able to overachieve the market’s already high expectations. In September and October, Draghi had hinted at “QE2”, an extension of the ECB’s bond buying program, partly as an answer to China’s woes potentially threatening the Eurozone economy. Markets had therefore been anticipating a substantial additional stimulus package at the central bank’s December meeting, Draghi’s status in mind. Super Mario however managed to underachieve this time and delivered less than the market consensus had expected. The market reaction therefore was one of declining stock markets, a spike in the euro exchange rate and, most notably, a sharp rise in government bond yields. The yield on the German 10-year Bund rose by as much as 20 basis points in a matter of hours, a rise of almost 50%!
It may be obvious that such a highly volatile environment presents major challenges for investors. We have seen quite some examples now of central banks having difficulties communicating their intentions to the markets. And it is clearly not unlikely that more examples will follow. From a portfolio risk management perspective, these kind of occasions emphasize the importance of a well-informed, unbiased and active asset allocation. Given the substantial volatility spikes as mentioned above, more and more investors choose to delegate their allocation decisions to specialised multi-asset teams.
As we saw ECB easing expectations being priced into the government bond market, we decided to underweight German Bunds in our multi-asset portfolios already in the first part of November. In the weeks that followed, we also took some risk off the table by neutralising our equity and fixed income spread positions. Divergence between ECB and Fed policy is – although well telegraphed to the markets – coming to the surface more clearly now. The announcements from both central banks hitting the markets in December, combined with lower-than-usual market liquidity, was for us reason enough to opt for a relatively light asset allocation stance as we move towards year-end.
Valentijn van Nieuwenhuijzen is Head of Multi-Asset at NN Investment Partners.
CC-BY-SA-2.0, FlickrPhoto: jo.sau
. All-Consuming Asia: A Retail Revolution Story
Did you know that Chinese online shoppers spent some $5.7 billion on a single day in November last year; that more and more well-heeled Indian consumers prefer to buy their tea from a pharmacy; or that urban Thais visit a hypermarket at least once a week and spend around half their monthly bills on groceries?
For most of us this is the sort of random information usually reserved for a pub quiz, but for fund managers these are valuable insights into consumer behaviour that reflect some of the changes that have occurred in Asia over recent years.
China’s meteoric rise has changed the world from the price we pay for consumer goods, to the global demand for natural resources, and even the flow of international capital. Much has been written about how policymakers there are promoting domestic consumption as a future driver of growth, but in fact the nation’s consumers have been flexing their muscles for some time.
E-commerce crazy China also happens to be the world’s biggest smartphone market with some 98.8 million shipped in the first three months of this year alone. The country is the world’s biggest car market and, with India, vies for the title of the world’s biggest market for gold.
However, it’s easy to get overly fixated on China. India is another country where reform is on the agenda and where a growing urban middle class is changing the way people spend their money. This is important because people who live in cities tend to earn and spend more.
While only three-in-10 Indians are classified as ‘urban’ in census statistics, urban consumers account for more than 70 per cent of the market for so-called fast moving consumer goods (FMCGs). These consumers are developing new patterns of retail behaviour.
For example, pharmacies have emerged as the fastest growing ‘old economy’ sales channel for FMCGs. Chemists attract a more upmarket customer who seems to prefer buying packaged teas, fruit juices and healthy foods from a man in a white lab coat.
Elsewhere, the 10-nation Association of Southeast Asian Nations, better known as Asean, has developed into something resembling a single market of some 625 million consumers. This has helped the region to emerge quietly from China’s giant shadow.
There has been a shift away from raw materials extraction towards economic activities further up the value chain. Where China talks of rebalancing, Asean has mainly found a happy medium of exporting and recycling wealth at home in the form of growing consumer demand.
Populations are young
Incomes have grown from a low base and there is a huge pent-up demand for housing, consumer durables, transport and banking services. Populations, as is common throughout the emerging markets, are young.
Domestic consumption accounts for around 70 per cent of economic growth in the Philippines, and has done so for some time, according to Jaime de Ayala, chief executive and chairman of Ayala Corp, the country’s oldest conglomerate. Remittances from overseas Filipinos have been a strong driver of middle income consumer markets such as telecoms, real estate and other services.
Meanwhile, the investment case for Indonesia, Asean’s biggest member, is closely tied to its population of some 254 million people. Over half of all Indonesians live in cities and this number increases by some 300,000 every year.
What makes all this even more attractive to us is that consumer businesses aren’t subject to stifling government controls, as tends to be the case with more ‘strategic’ sectors such as defence, utilities or aviation. This means competition exists and innovation can follow.
Clearly not everything is perfect. For one, Chinese growth is decelerating. This may be a good thing in the long run because double-digit growth rates were, in hindsight, unsustainable. But in the short term the whole world suffers.
Asia is struggling to regain momentum in part because of its reliance on Chinese demand. While growth rates are still higher than in other parts of the world, corporate earnings are falling, which may affect jobs and wages.
In particular, Asian economies that are more reliant on foreign investment are being penalized by indiscriminate capital outflows from the region. However, there are lots of people in Asia who are getting richer. Many have a disposal income for the first time in their lives and want to spend this money. The most successful companies have already figured out a way to tap into these fundamental changes.
While Asia must overcome many immediate challenges, an investor would do well to remember the longer term trends that are changing the lives of billions of people across the region every day. That’s because these changes will end up making someone some decent money.
The Fed appeared to meet expectations with its long awaited rate hike last week, coupled with a forecast that was widely viewed as gradual and fairly predictable, if not outright dovish. While all asset classes had waited for the Fed to move, emerging markets had arguably been one of the most affected, given that the average currency in the asset class has fallen roughly 40% since May 2013, the beginning of the infamous “taper tantrum” that marked the beginning of rate hike speculation.
It is difficult to argue that the Fed has been the sole factor in emerging market debt weakness. China hard landing fears, plummeting commodity prices, Brazilian political disarray, Russian policy concerns and general weakening of growth across all regions created a near perfect-storm for emerging market debt investors. However, a more predictable and less fraught path going forward for the Fed should help steady investor nerves and risk appetite. If developed market bond yields remain very low – as seems likely with a very slow hiking path, set out with some confidence – emerging market dollar yields may remain one of the few places to look for meaningful income generation for years to come.
The Fed move comes at a time when emerging market dollar debt seems particularly attractive. Yields in the primary sovereign dollar index are at highs not seen since 2010, when Treasury yields were much higher than today. Yield spreads over Treasuries for investment grade sovereign debt are just under 300 basis points, and remain at elevated levels that were last seen consistently during the European crisis of 2011. High yield sovereign debt currently has a yield to maturity of 8.5%.
The divergence between developed market monetary policies has driven the dollar nearly 20% higher on a trade-weighted basis since July 2014. Emerging market currencies have fallen in lock step. With the European Central Bank now charting a path towards a steady dose of quantitative easing as growth in Europe stabilizes, Fed predictability should help curb that dollar appreciation. Emerging market currencies should then likely steady at attractive levels, boosting sentiment towards the asset class. Even a modest virtuous cycle led by these factors could make emerging markets one of the strongest global fixed income performers next year, given today’s generous yield levels.
2050. A huge dam seals off the Inn Valley at Kufstein. Behind it, a reservoir containing millions of cubic metres of green, shimmery water. The Emperor Maximilian Dam is the crown jewel of a number of dams that line Greater Tyrol from Kufstein to the Andreas Hofer Dam at Rovereto and that are one of the pillars of prosperity in Europe in what has been the wealthiest country for years.
Tyrol was able to benefit more than others from the climate change, which had caused the temperature to rise by 4% annually. The biggest dam system in the world dwarfs the Three Gorges Dam in China and comes with one enormous upside on top: the water does not just pass through the dam, but it is recycled by a sophisticated system of pump accumulators. It is used whenever power is needed – and, in particular, paid for – in the big metropolitan areas of the hot lowlands outside the borders of Tyrol. Tyrol, with its third dimension, i.e. altitude, was practically destined to become the battery of Europe.
The numerous dams and the climate change made the second source of prosperity possible in the country: prime property. A large number of exquisite lakeside properties that allow filled purses to enjoy the pleasant temperatures in higher altitudes and to escape the heat of the lowlands. No surprise that many millionaires who used to frequent places like Monte Carlo or the palm islands of the nouveau-riches in the UAE love their life in Tyrol.
What sounds like the fifth and yet unpublished part of Felix Mitterer’s “Piefke Saga”* (i. e. an Austrian soap opera about Tyrol) is the extrapolation of two current developments: global warming and the way we deal with it. The climate change is now taken as scientific fact. Even optimists expect the earth to warm by at least two centigrade in the coming years.
This development will come with massive repercussions on us and our lifestyle. There will not only be winners, but also losers as described above. The development will not care about state or cultural borders, and it will probably also shift some of them. One day we will have climate refugees along with war and economic refugees at the borders of Europe and Austria.
From my point of view it is important to realise that we have to be prepared to compromise. Wind parks are not always pretty. Alternative forms of energy do not only have to be generated but also distributed, which requires new power lines.
This will on the one hand entail many, also economic, opportunities, which we at Erste Asset Management want to seize in our sustainable funds. On the other hand this also means that we will have to change. In Giuseppe Tomasi di Lampedusa’s famous book “The Leopard” the main protagonist comments on the political revolution that has Italy in its grip: “If we want everything to stay as it is, everything has to change.” I think that climate change will teach us a similar lesson, no matter how we handle it.
Column by Gerold Permoser, Chief investment Officer and Chief Sustainable Officer of Erste Asset Management
CC-BY-SA-2.0, FlickrPhoto: Seher Basogul. It Really Is Different This Time
Now that the US Federal Reserve has raised interest rates for the first time in nine years, investors want to know how this rate-hiking cycle might proceed and, more important, how markets will react. But searching past rate-hiking cycles for clues this time is like looking for your lost keys under a streetlight rather than in the dark, where you probably dropped them. It’s easy to see why investors would search somewhere familiar and convenient — but it’s still likely the wrong place to look. Fed tightening cycles over the past 30 or so years are simply not a good guide to what lies ahead. This time, the circumstances facing the Fed are far too different to rely on past economic cycles for any comfortable frame of reference.
Perhaps the biggest difference between this economic cycle and those past is that the Fed has just initiated a rate-hiking cycle while both real growth and inflation are very low. Historically, year-over-year nominal GDP growth rates have been above 5% at the beginning of a tightening cycle. Today, nominal growth stands at 3%. During past hiking cycles, CPI headline inflation has typically been around 3%, with core personal consumption expenditures (PCE) inflation usually above 2% — well above the current levels. Rate hikes generally come amid periods of rising corporate profits, not during an earnings recession such as the one we’re seeing now.
In another indication of how different this cycle is from any other, the Fed has now achieved liftoff amid a collapse in commodity prices, the primary catalyst for the drop in earnings. On the manufacturing side, this is the first time in 30 years that the central bank has started a tightening cycle while the Institute for Supply Management (ISM) manufacturing index has been below the breakeven level of 50, as it is now.
And while the global backdrop has generally supported the case for past rate-hiking periods, that’s clearly not the case at present. Growth and inflationary pressures remain sluggish in both the developed and developing world, so it’s no surprise that much of the globe is maintaining or enhancing monetary accommodation. Expectations of a tightening Fed have fueled robust US dollar gains, which run counter to a rate-hiking mentality, as these act to tighten US financial conditions. Indeed, if US rates had been a couple of hundred basis points higher, rather than brushing up against zero, we might have seen a rate cut rather than a hike.
Moreover, when was the last time the Fed raised rates after having been on hold —at zero— for seven years or with a $4.5 trillion balance sheet or when domestic and global debt burdens were this high and the global demographic profile was this unfavorable? The answer, of course, is never. This is the first time. So why are we so enamored with looking to the past for lessons? Perhaps because it is easier, but we would be better off looking at this episode as its own unique moment instead of applying the wisdom contained in dusty economic history books.
To be sure, large swaths of the US economy are performing well, highlighted by the robust service sector, strong vehicle sales and healthy income generation from a firm labor market. But what is markedly different here are the many areas of the domestic and global economy that are performing uncharacteristically poorly or are facing significant challenges as we progress with Fed tightening.
One direction?
What does all this mean for rate hikes that follow this one? A very different path. The terminal rate will likely be much lower than it has been in the past — nowhere near the average 600-basis-point rise in the federal funds rate we’ve seen since 1970. The likely outcome is lower for longer, with the front end of the yield curve rising with policy rates but the long end likely not moving very much. Will the Fed be able to tighten all the way into 2019, as it now projects? That seems doubtful, given that this business cycle is already seven years old.
We also see a risk in the Fed heading up one path while the rest of the world staggers down another. As a cautionary note, we recall that the European Central Bank and the central banks of Canada, Australia, New Zealand, Sweden and Norway all raised rates earlier in this cycle, only to lower them again before too long. Given the weak global outlook, the Fed may end up doing the same.
Now that the FOMC has met, we know when rate hikes will begin. But if we expect this knowledge to shed some light on the rate-hiking cycle further out, we could be in the dark for quite some time.
Column by Erik Weismann, Chief Economist & Fixed Income Portfolio Manager at MFS.
Photo: Taner Peets. Six Lessons We Learned About Bonds in 2015
In 2015, bond investors faced slower nominal global growth, less liquid markets and a looming US rate hikes. But with challenges come lessons: here are some takeaways from 2015 that should remain important in 2016.
1) The Fed tightened without raising official rates. It pulled this off mostly by winding down asset purchases. That means that when a quarter-point hike in the federal funds rate comes, it won’t be the first time the Fed will have tightened policy. The market spent the past 12–18 months adjusting to tighter conditions through a stronger US dollar and periodic sell-offs across bonds, stocks and commodities.
Things could get trickier in 2016 as the Fed’s balance sheet starts to shrink and rates creep higher. That will drain dollars from the global financial system—call it a decline in dollar liquidity—and it could pressure those who need dollars most, such as emerging-market borrowers. It could also be tough on asset prices and trading liquidity, which brings us to our second lesson.
2) Low liquidity is the new reality for bond investors. Fixed-income trading liquidity issues have been around since the global financial crisis. But most investors didn’t start paying much attention to them until this year. Expect these issues to stay front and center in 2016. And if Fed tightening keeps draining US dollar liquidity, trading liquidity may dry up further, making it even harder to trade bonds without having a big effect on their prices. Of course, investors who manage liquidity risk well may be able to profit. Having a manager who understands this will be critical.
3) The US economy has turned a corner. But will markets stay on track? After the global financial crisis, US banks spent years licking their wounds and refusing to lend. That’s changed recently, and the economy has shifted into a higher gear, paving the way for Fed rate hikes. But will global financial markets run into a rough patch if the Fed keeps tightening policy throughout 2016? Hard to say, but it’s definitely worth keeping an eye on.
4) China is successfully rebalancing. Sure, the Chinese economy is slowing, but it’s also evolving from an export-oriented economy to one in which consumption and services play a bigger role. A lot of observers have overlooked this, possibly because many Western companies are exposed to China’s heavy industry sector, which has struggled. Meanwhile, the renminbi’s new status as an IMF-designated elite reserve currency will augment China’s growing presence in global bond indices and draw a lot of investment dollars into China. We think there’s a good chance that China will experience a cyclical upswing next year.
5) If you’re investing in high yield, avoid passive ETFs. Investors rushed into high-yield exchange-traded funds (ETFs) this year. They may come to regret that haste. High-yield ETFs have a terrible track record and have underperformed most actively managed funds over the long run.
High yield has offered equity-like returns, with less volatility over time, and it isn’t highly correlated with interest rates. But the market is complex, relatively illiquid and hard to navigate, which gives skilled asset managers an advantage over index-tracking ETFs. Sure, ETFs can be useful for short-term tactical trades. But if you want to invest in high yield, ETFs are the wrong way to go.
6) When building a bond portfolio, go beyond your backyard. Investors tend to prefer home-country bonds. But global bonds—provided they’re hedged to the investor’s home currency—have delivered returns comparable to domestic bonds, with lower volatility. And global bonds help diversify interest-rate and economic risk, which is important now because monetary and economic policies are diverging. The Fed is on the verge of tightening policy, while Japan is holding steady and the euro zone is in highly stimulatory mode.
Navigating the bond market won’t be easy in 2016. That doesn’t mean investors should turn their backs on bonds. Instead, make sure your bonds are global, diversified and with a manager that has the flexibility to reduce risk without sacrificing opportunity.
Opinion column by Douglas J. Peebles, Chief Investment Officer and Head—AllianceBernstein Fixed Income.
CC-BY-SA-2.0, FlickrPhoto: Simon Pielow
. Membership of the Reserve Currency Club is But Part of China’s Master Plan
Until recently, by maintaining a watertight capital account, China deliberately postponed its membership of the reserve currency club. A few years ago, China had grown to be a giant in the world of trade, yet remained a dwarf in the world of capital. More recently, the People’s Republic reached a point where – given its rapidly increasing economic size and trade footprint – this contradiction was no longer sustainable or sensible.
The next phase in China’s economic renaissance is now well underway. It is actively pursuing its twenty-first century manifest destiny to regain the mantle it lost in the 1830s: being the world’s largest economy. This means it must expand its role in global capital markets to match those it has already achieved in global trade. This will balance the two windows through which China looks at the world – and just as importantly through which the world looks at China. Being a member of the reserve currency club is but a stepping stone on the renminbi’s path to achieving that worldwide acceptance, and especially in China’s efforts to master the world of capital. Expect a new Shanghai-Hong Kong-Shenzhen triptych to become one of the world’s three main fountainheads of capital and the next pit-stop on China’s road to global economic pre-eminence.
For this to happen sustainably however, China will need to move from being an exporter of capital – born of running a current account surplus – to being an importer of capital – which follows on from running a current account deficit. This answers the Triffin Dilemma which says that to have a truly acceptable reserve currency, one needs to produce a surplus of that currency so that third parties can hold it. Only when the appetite of China’s consumers for foreign goods exceeds that of foreigners for China’s goods – when China runs a current account deficit – can this be truly achieved.
In the interim, China has to find a way of recycling its trade surpluses so that foreigners get easy access to its currency. Here Xi Jinping’s signature foreign policy doctrine – the One Belt One Road programme – achieves this aim. By forcing Chinese surplus capital abroad to revive the terrestrial Silk Road of Central Asia and its maritime equivalent through the Indian Ocean, China is repeating what Britain did in the late nineteenth century: establishing its reserve currency status first by investing its trade surplus abroad before, one suspects, the eventual rise of the import-hungry Chinese consumer spreads the renminbi worldwide ‘naturally’, after China’s current account stops being a surplus and instead becomes a deficit.
Michael Power is Strategist at Investec Asset Management.
