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Brazil – The Comeback Kid?

An economy set to rebound. A president committed to implementing reform. A government of competent technocrats. A crackdown on corruption. A set of new CEOs to oversee inefficient state-owned companies. A central bank embarking on a rate cutting cycle. A country with deep, liquid capital markets.

Would anyone believe us if we said this is Brazil?

According to Yacov Arnopolin and Lupin Rahman, emerging market portfolio managers at PIMCO, “before tagging on the requisite caveats, we tip our hat to the country’s impressive turnaround in policymaking. As always, much will ride on the ability to push through fiscal reforms and improve the supply side of the economy. But with confidence in the government returning, Brazil could be set for a comeback ‒ one that could restore nominal interest rates to single digits and put credit rating upgrades back on the table.”

Not politics as usual

On their recent trip to Brazil they witnessed a stark change in what the International Monetary Fund (IMF) called the “counterproductive” politics and policymaking of the previous administration. “Impeachment has paved the way for a centrist, business-friendly government under President Michel Temer, who has a team that can get things done. This coincides with Brazil starting to exit the worst recession in its history and a turn in inflation from double-digit figures earlier in the year.”

They believe the change in sentiment has sparked a strong rally in Brazilian assets, but as the new administration’s honeymoon draws to a close, the country’s prospects ride on reform. Will the government’s proposals be enough to bring about the necessary changes?

Brazil’s challenges ahead

The positive sentiment for Brazil notwithstanding, they see three main risks to President Temer’s plans.

Brazil’s debt-to-GDP is set to reach 90% of GDP by the end of this decade. While the vast majority of the debt is in local currency, that level still ranks among the highest in the emerging markets. Reforms cannot change the near-term fiscal and debt path; they can merely seek to avoid an even more dire scenario. And they will take more than one political cycle to be effective.
Disinflation could be lower than expected. Years of indexation and supply-side bottlenecks could limit the disinflationary pressures from high unemployment and a large output gap and keep inflation “stuck” at high levels. Moreover, the multiple levels of subsidized lending that de-fanged monetary policy may take years to unwind or simplify.
Public opinion may prove to be more sensitive to increasing unemployment and the realities of lower social security and pension benefits. In fact, Brazilian voters still generally favor large governments and a strong social safety net. In addition, Lava Jato (“Operation Car Wash”) corruption investigations could spill over to the government. The risk is that Temer’s popularity fades and political noise around the 2018 election race increases.

The positive scenario

If Temer’s reforms are successful, PIMCO believes they could trigger a virtuous circle of deeper reforms after the 2018 elections. A sustained return of confidence would likely increase foreign direct investment and portfolio flows; and a return of “animal spirits” would lift consumption and prompt faster lift-off for the economy. All of this bodes well for the currency. And while the real is unlikely to have the same uninterrupted climb as in recent months, its high carry of nearly 13% offers a decent cushion against potential weakness.

“The Brazilian Central Bank has recently initiated what we anticipate will be an extended cutting cycle, lowering the overnight rate by 25 bps to 14%. Although the local yield curve is pricing in cuts of just over 320 basis points (bps) to January 2018, we believe the total cycle – subject to meeting the requisite fiscal milestones – could total about 500 bps or more, bringing nominal rates back to single digits. Thus, while local rates are less attractive than they were at the height of the political crisis, they offer potential to rally further, particularly given their starting point which is by far the highest in the G-20! An even bigger prize would be to reduce the high real rate burden the country is facing – nearly 6%. Just as poor fiscal management took Brazilian securities into a downward spiral, reform could improve valuations on Brazilian sovereign and corporate credit versus those of higher-rated EM peers. As a result, we believe the country’s fixed income assets continue to present compelling opportunities.” They conclude.

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

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

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

An Eventful and Uncertain Fall Ahead

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

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

Recession Risks Are Rising

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

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

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

We Are Late Into an Elongated Cycle

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

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

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

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

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

Neuberger Berman’s CIO insight by Joseph V. Amato

Cash Allocations are Close to 15-Year Highs

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The BofA Merrill Lynch October Fund Manager Survey shows global investor risk-aversion is growing as cash allocations increase to near-15-year highs. “This month’s cash levels indicate that investors are bearish, with fears of an EU breakup, a bond crash and Republicans winning the White House jangling nerves,” said Michael Hartnett, chief investment strategist at BofA.

Manish Kabra, European equity quantitative strategist, added that, “Although investors see an EU-disintegration as a big tail risk, European fund managers surveyed are more optimistic about the economic growth outlook for the Eurozone and expect stronger inflation.”

Other highlights include:

Cash levels jumped from 5.5% in September to 5.8% this month. Investors’ average cash balance was last this high in July 2016 (post-Brexit vote) and in Fall 2001.
Investors identify fears of an EU breakup, a bond crash and a Republican winning the White House as the most commonly-cited tail risks.
With inflation expectations at a 16-month high and perceptions of developed market equity and bond valuations at record highs, investors are no longer underweight in commodities for the first time since December 2012.
Rotation out of healthcare/pharma, REITs and bonds, into banks, insurance, equities, commodities and EM.
Investors cite Long high-quality stocks, Long US/EU IG corporate bonds and minimum volatility strategies as the most crowded trades.
Allocation to EM equities rises to the highest overweight in 3.5 years, from 24% last month to 31% in October.
Allocation to U.S. and Eurozone equities is unchanged from last month, while allocation to UK equities falls to net 27% underweight from net 24%.
Allocation to Japanese equities improves modestly to net 3% underweight from net 8% underweight last month.

You can download the report attached.

New Quantitative Strategies Launching Under GAM Systematic Name

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GAM has completed the acquisition of Cantab Capital Partners, which was first announced on 29 June 2016. Cantab, a multi-strategy systematic manager based in Cambridge, UK, manages USD 4.1 billion in assets for institutional clients worldwide (as at 1 October 2016). It’s technology and its team of over 30 scientists, led by Dr Ewan Kirk, form the cornerstone of GAM Systematic. This new investment platform is co-headed by Adam Glinsman, CEO of Cantab, and Anthony Lawler, Head of Portfolio Management at GAM’s Alternative Investments Solutions (AIS) group.

Two new UCITS funds are to be launched, subject to regulatory approval, that will offer daily liquidity and will be available under the GAM Systematic name. Both funds will be designed to deliver attractive risk-adjusted returns as well as offering diversification to equity and bond investments over the cycle. The new funds will also be structured to be cost-effective.

The systematic global equity market neutral strategy will contain Cantab’s established equity-focused models, which have delivered a successful return track record as part of Cantab’s flagship Quantitative Fund launched in 2007. It will invest in liquid equities globally using proprietary research and trading systems, without taking equity market beta. Over a three-year cycle, the strategy will aim to deliver attractive returns with annual volatility of 6-8%.

The systematic diversified macro strategy will be a multi-strategy, multi-asset product based on Cantab’s established Core Macro fund, which launched in 2013. It will seek to generate returns uncorrelated to traditional asset classes by identifying persistent and recurring sources of return across over 100 markets in currencies, fixed income, equity indices and commodities. Over the cycle, it is expected to deliver attractive returns with negligible correlation to traditional markets and annualised volatility of 10-12%.

Despite Positive Asset Flows, Negative Market Impacts Lowered AUM in the European ETF Industry in September

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The latest European ETF Market Review from Thomson Reuters Lipper shows that negative market impacts led—in spite of net inflows—to lower assets under management in the European ETF industry in September (€480.1 bn for September, down from €480.4 bn at the end of August).

According to Detlef Glow, Head of EMEA research at Thomson Reuters Lipper and author of the report, the decrease of €0.3 bn for September was mainly driven by negative market impacts (-€2.4 bn), while net sales contributed a positive €2.1 bn to the assets under management in the ETF segment.

Other highlights include:

Bond ETFs (+€1.3 bn) posted the highest net inflows for September.
The best selling Lipper global classification for September was Bond Emerging Markets Global in Local Currencies (+€0.8 bn), followed by Equity Emerging Markets Global (+€0.5 bn) and Equity Global (+€0.5 bn).
iShares, with net sales of €1.0 bn, maintained its position as the best selling ETF promoter in Europe, followed by Vanguard (+€0.8 bn) and UBS ETF (+€0.4 bn).
The ten best selling funds gathered total net inflows of €3.1 bn for September.
Vanguard S&P 500 UCITS ETF USD (+ €0.7 bn), was the best selling individual ETF for September.

You can read the report in the following link.

Lennar Announces Final Close of $2.2 Billion Lennar Multifamily Venture

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Lennar Corporation has announced that LMC, its wholly owned subsidiary, received an additional $250 million commitment to its Lennar Multifamily Venture (“LMV“), which completes the fund raising for this long term multifamily development investment vehicle. With commitments totaling $2.2 billion, the Miami based company LMV is well capitalized to develop and own Class A multifamily communities in 25 target markets throughout the United States.

Lennar launched LMC in 2011, and since that time the company has been among the nation’s most active developers. LMC currently has approximately 13,300 apartment homes in 45 communities operating or under construction and including these communities, a total development pipeline that exceeds $7 billion and over 23,000 apartments. The company builds high-rise, mid-rise, and garden apartment communities.

LMV’s ownership includes six prominent institutional investors, comprised of foreign pensions, sovereign wealth funds, and insurance companies. Lennar also has a $504 million commitment to the venture.

Currently, the venture has approximately 9,100 apartment homes under development in 31 communities for a total development cost of $3.1 billion. With the combined equity commitments and 50% leverage, LMV has approximately $1.3 billion in dry powder to invest in future opportunities.

Macquarie Capital acted as a financial advisor and placement agent for LMC.

When Politics and Policy Collide

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Political risk has significant implications for economic growth and market sentiment. While such risk has traditionally been more associated with emerging markets, it has become increasingly apparent in developed markets in the aftermath of the global financial crisis.

Consequently, Standard Life Investments has established an in-house process for examining political risk. The aim is to identify how these risks contribute to policy uncertainty and the subsequent potential for reduced economic growth.

The system categorises risks as either institutional or cyclical, before identifying the precise factors that create a risk to investments. Developed markets most commonly exhibit cyclical risk in the form of elections, and we have isolated three factors that amplify the risk that these cyclical events carry.

Populism – the increased popularity of anti-establishment parties and policies
Fragmentation – the move of political systems from two party to multi-party regimes, as seen in Spain
Polarisation – a hardening of ideological divisions across parties and electorates, as seen in the US

These factors bring added policy uncertainty and the potential for aftershocks following political events in developed markets. By understanding how politics and policy measures are intertwined, we can test the likely effects of political events on investments.

Stephanie Kelly, Political Economist at Standard Life Investments commented “Our approach to political analysis is based on the view that one of the key mechanisms through which political risk is transferred to the investment outlook is through policy uncertainty. The theory suggests that policy uncertainty can reduce growth prospects for an economy because corporate investment slows and consumers delay spending on big ticket items.

“During our analysis of political risk, we assessed the impact of policy uncertainty on a number of major economic and market factors; the results indicate that such an uncertainty shock is usually associated with lower GDP growth, as well as downward pressure on national equity markets and the outlook for interest rates.

“Given that policy uncertainty has a tangible effect on economic and market indicators in developed markets, understanding the political dynamics and structures that drive this uncertainty is crucial.”

Asset Managers Must Increase Their Commitment to Digital and Social Media

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Clients across all demographic groups are increasingly interested in using digital media to interact with their asset manager. It is ever more important for managers to provide up-to-date and relevant information via digital channels, Cerulli Associates‘ European Marketing and Sales Organizations 2016: How to Thrive in an Evolving Landscape report finds. However, fewer than two-thirds of managers update their website daily and more than 7% believe that updating their site just once a month is satisfactory.

Four in five of the managers surveyed by Cerulli assign responsibility for digital and social media to their marketing departments and few managers currently have dedicated, stand-alone teams for managing these channels. In addition, 80% of the asset managers Cerulli surveyed employ just one dedicated person to manage their social media communications.

“Asset managers have traditionally been reluctant to devote significant manpower to digital and social media,” says Barbara Wall, managing director of Cerulli Europe. “However, their clients’ increasing use of these channels will put pressure on managers to devote greater resources to this aspect of their business. The vast majority still hand responsibility for digital and social media management to their marketing department rather than to distribution specialists. This needs to change if they are to provide the level of service today’s clients demand.”

Cerulli’s research shows that the typical asset manager’s social media budget is less than €100,000 (US$110,825). Given that clients increasingly wish to communicate with their asset managers digitally, it is surprising that the majority of managers’ outlay on social media is relatively modest.

The good news is that slightly more than half (54.5%) of asset managers expect to increase their overall digital and social media headcount over the next 12 months. This suggests that they are coming to realize the value of this form of dialogue. However, it remains to be seen whether managers’ current commitments to increase headcount will be sufficient.

Cerulli’s research also found that only 6.7% of European asset managers have a dedicated compliance specialist for digital and social media. “Given the sensitivity with which asset managers must handle their communication with clients, it is surprising that so few firms employ a dedicated compliance specialist for their digital and social media output,” says Laura D’Ippolito, an associate director in Cerulli’s European retail team. “If a controversy were to arise, it would inevitably lead to questions about why compliance appears to be low on most managers’ list of priorities.”

This and several other new findings make up Cerulli Associates’ European Marketing and Sales Organizations 2016 report.

Man Group Acquires Aalto and Launches Man Global Private Markets

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Man Group has announced that it has entered into an agreement to acquire the entire issued share capital of Aalto Invest Holding and launched Man Global Private Markets (“Man GPM”), forming the firm’s private markets offering, which provides clients with access to longer term investments with a complementary risk reward profile to its current product suite.

Aalto is a US and Europe-based real asset focused investment manager with $1.7 billion of funds under management as of 30 September 2016. Aalto will form the real assets platform of Man GPM. Founded in 2010 by Mikko Syrjänen and Petteri Barman, Aalto specialises in the management of real estate equity and debt strategies including direct investments in single family homes in the US and lending to commercial and residential real estate in Europe and the US. Aalto has a strong track record across its differentiated product range, and serves a client base of predominantly large institutional investors.

The Company, which is wholly-owned by its founders and current and former senior staff members, has demonstrated a compelling growth trajectory having grown fourfold over the last four years. Aalto has 33 employees and is headquartered in London, with offices in the US and Switzerland. The Acquisition is expected to complete in January 2017, subject to regulatory approvals and other customary conditions.

Man Group believes the acquisition provides it with a core component for the long term expansion into private markets strategies; provides the clients with access to a range of strongly performing, differentiated real assets strategies; And it further expands Man Group’s presence in the US.

The transaction is expected to be EPS accretive from 2017 onwards. The total regulatory capital usage associated with the acquisition is expected to be approximately $75 million.

Launch of Man GPM

Man GPM will over time develop strategies across private markets such as real estate, credit, and infrastructure. On completion of the acquisition, Aalto will form a central component of Man GPM, providing a core platform upon which the firm can develop this new offering for clients.

The Aalto management team will continue under the leadership of the company’s founders. In addition, Mr Barman and Mr Syrjänen will be appointed Co-Heads of Real Assets within Man GPM, taking on a broader role in the strategic development of Man GPM’s offering in real assets. No change will be made to Aalto’s investment process as a result of the Acquisition and investment independence will be maintained. Mr Barman and Mr Syrjänen will report to Jonathan Sorrell, President of Man Group, and will join Man Group’s Executive Committee.

Melissa Hodgman Named Associate Director in SEC Enforcement Division

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The Securities and Exchange Commission has announced that Melissa Hodgman has been named Associate Director in the SEC’s Enforcement Division. Hodgman succeeds Stephen L. Cohen, who left the SEC in June.

Hodgman began working in the Enforcement Division in 2008 as a staff attorney. She joined the Market Abuse Unit in 2010 and was promoted to Assistant Director in 2012.

Hodgman has investigated or supervised dozens of enforcement recommendations spanning a variety of misconduct, including: The SEC’s first case against a brokerage firm for failing to file SARs when appropriate; Fraud charges against a Wall Street CEO and his company, family members, and business associates accused of secretly obtaining control and manipulating the stock of Chinese companies they were purportedly guiding through the process of raising capital and becoming publicly-traded in the United States; And charges against Charles Schwab Investment Management, Charles Schwab & Co., and two executives for making misleading statements regarding the Schwab YieldPlus Fund and failing to establish, maintain and enforce policies and procedures to prevent the misuse of material, nonpublic information.

Hodgman has led the Enforcement Division’s Cross-Border Working Group, which provides expertise and assistance of matters with international actors and implications. Hodgman also co-founded and served as the enforcement representative on the Chair’s Attorney Honors Program, and is a member of the Enforcement Division’s hiring committee at its Washington D.C. headquarters.

“Melissa has supervised and investigated a broad range of noteworthy and first-of-their-kind cases across the spectrum of the securities industry and involving misconduct located around the world,” said Andrew J. Ceresney, Director of the SEC’s Enforcement Division. “She has distinguished herself with her excellent judgment and creativity, and I am pleased to have her join the senior ranks of the Enforcement Division.”

Hodgman said, “I am honored by this appointment and look forward to continuing our tradition of pursuing tough but fair enforcement actions in complex and cutting-edge cases, especially matters involving cross-border issues and efforts to hold gatekeepers accountable for breaches of their professional standards.”

Before joining the SEC staff, Hodgman worked as an associate at Milbank, Tweed, Hadley & McCloy in Washington. Hodgman earned her masters of law with distinction in securities and financial regulation in 2007 from Georgetown University Law Center, her law degree with high honors from Georgetown University Law Center in 1994, and her bachelor of science degree from Georgetown University School of Foreign Service in 1990. Hodgman received the Ellen B. Ross Award as well as an SEC Chairman’s Award in 2010.