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Low Visibility, High Opportunity

Commentators speak about a “Something Must Be Done” approach to politics, where any action is deemed better than no action. Behavioral economists warn of a similar bias among investors, the need to tinker in ways that often end up eroding returns. In difficult environments like today’s, such biases can become irresistible.

From the standpoint of our Asset Allocation Committee, however, a dispassionate look at the global economy and markets leads to low levels of conviction. Large directional bets amongst broad asset classes, on a 6-18 month horizon, are mostly off the table for now. Global growth is uninspiring; central banks seem to have lost their ability to influence markets; political risks loom; and high levels of financial market volatility seem at odds with mostly benign fundamental economic data.

Positive results from policy moves now appear to have built-in limitations. Should the dollar rise too much, it will likely curtail U.S. corporate earnings and suppress the wider economy. Should corporate earnings and wages take off, Fed Chair Janet Yellen will likely raise rates and undermine confidence in market liquidity. There is somewhat of a guardrail around a neutral position that could limit the payoff for risk taking, and the time the market takes to second-guess these limitations gets shorter and shorter. The Bank of Japan’s move to negative rates was good news for 24 hours, but then sparked a big bout of market volatility. Last Thursday’s changes to ECB monetary policy pushed the euro down and risk markets up, before a few words in the press conference unleashed a quick reversal.

Against that background, on a 12-month horizon our Asset Allocation Committee is, not surprisingly, neutral on U.S. equity, neutral on emerging market equity, neutral on emerging market debt, neutral on inflation-protected Treasuries and neutral on commodities. Our only biases at the moment are slight overweights in non-U.S. developed market equities and high yield bonds and underweights in government and investment-grade bonds.

That’s good. The Committee is resisting the bias to action. But then again, there is a view that something should be done. And here’s the interesting thing: Underneath the disciplined neutrality at the asset class level there is a lot going on.

The S&P 500 Index ended 2015 almost exactly where it started. Today it is not far from that same level. Similarly, commodity prices and credit markets are back where they were at the start of 2016. It doesn’t feel that way, though. Recent months have witnessed some of the most vicious market rotations of the past five years.

In other words, while taking medium-term, high-conviction directional positions in asset classes has become very difficult for asset allocators, there are widespread opportunities for individual underlying investment category managers, adding value through shorter-term trading or relative-value positions (which also tend to be more tactical). In our view, positioning within asset classes may be more beneficial than positioning between them. There is also value in thinking about your portfolio as a collection of individual positions with different time horizons, as well as a collection of different asset classes.

Within fixed income, some opportunities are easier to identify: You can buy higher-yielding bonds and companies with decent credit positions and sell lower (or indeed negative) yielding sovereign debt. In currencies, everything is a relative value position by default, so this can be a robust source of added value in these environments. In equities, there are some extreme valuations out there if you look in the right places: The cumulative outperformance of momentum stocks over value stocks is higher than at any time since the dot-com bubble, for example, and we believe that relationship will eventually begin reverting to the mean.

Having said that, short-term volatility does still create opportunity at the asset class level. In this environment, you could well boost positions in risky assets more broadly when markets sell off, but perhaps on a hedged basis through long/short strategies, paying away some of the asset-class exposure in exchange for limited downside. Visibility may be low, but opportunity needn’t be.

From all of this, three principles stand out. Active management becomes crucial. Incorporating alternative sources of compensated risk—value versus momentum, liquidity and volatility plays, spread trades—becomes an important tool in the toolbox. And risk management is paramount when you include these more tactical sources of excess return potential in portfolios.

What would make us comfortable favoring more directional risk? A breakdown in the correlation between oil and stock markets; a bottom for commodity prices; stabilization for some of the fundamental data points coming out of China; improved U.S. corporate earnings; and less reliance on negative interest rate policy from central banks.

Given the current mixed signals from the global economy, markets and policymakers, the full toolbox in multi-asset investing is likely to be useful for a good while yet.

Neuberger Berman’s CIO insight

AXA IM Real Assets Launches a New Pan European Open Ended Real Estate Fund

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The open ended fund, AXA CoRE Europe has an initial investment capacity close to EUR 700 million and aims to build a highly diversified portfolio of Core European real estate assets, it has already raised over EUR 500 million from a range of European institutions.

AXA CoRE Europe will seek to provide institutional investors with long-term stable income through the acquisition of Core real estate assets across Europe, capitalizing on individual market dynamics and timing. Over the long term AXA IM – Real Assets aims to grow AXA CoRE Europe steadily into a flagship European fund with a target size of EUR 3 billion to EUR 5 billion.

AXA CoRE Europe was one of the club of investors which AXA IM – Real Assets put together and have agreed to acquire the France’s tallest tower, Tour First in Paris La Défense. This project is in-line with the Fund’s strategy to focus investments on Europe’s largest and most established and transparent markets – UK, Germany and France – while maintaining the ability to invest across the entire continent from Spain to Benelux and the Nordics or Switzerland. AXA CoRE Europe will target mainstream asset classes, primarily offices and retail, and primarily seek investments into well-located assets which have high building technical and sustainability specifications and are let to strong tenants on medium or long term leases. The Fund will also consider selective investments where it can enhance returns by improving occupancy rates and/ or through repositioning works and will also retain a flexibility of allocation which provides for the ability to manage real estate cycles over the long term.

The fund will leverage on the established capabilities of AXA IM – Real Assets to source and actively manage European Core assets in all sectors and geographies by utilizing its unrivalled network of over 300 asset management, deal sourcing and transaction professionals, as well as fund management professionals who are locally based in 10 offices and operating in 13 countries across Europe.

Regulatory Clarity Could Pave Way for Significant Increase in Active ETFs

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The number of actively managed exchange-traded funds (ETFs) is likely to increase significantly once the U.S. Securities & Exchange Commission rules on proposals designed to discourage high-frequency traders from stepping ahead of active managers, according to BNY Mellon‘s ETF Services group.

While traditional ETFs are highly transparent, this characteristic has been a detriment to some active managers who do not want every move studied by high-frequency traders seeking to front-run their transactions. The various proposals being considered by regulators would limit the transparency required for managers of active ETFs. However, many in the industry believe that investors are willing to give up a measure of transparency to access active management in a cost-effective vehicle.

Steve Cook, business executive, structured product services at BNY Mellon, said, “Uncertainty around which proposal will be adopted has slowed the launch of actively managed ETFs this year. However, once we have regulatory clarity, we expect a rebound in launches of actively managed ETFs. It will result in more options for investors, which is what everyone wants.”

Negative Rates, the Japanese Way

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The negative interest rate regime in Japan is likely to circumvent banks and target currency and market financing. According to Maxime Alimi, from Axa Investment Management, there are three main implications to this:

The Bank of Japan has room to cut further and is likely to use it;
Significant risks of financial market disruptions and
Financial repression for institutional investors.

In their view, “the BoJ played a role in the recent market correction as it sharpened the market’s pessimistic assessment of central banks’ potency to address sluggish growth and inflation.” Japanese banks have, and will continue to have, only a very small share of their reserves effectively taxed, unlike in Europe, plus “banks are very unlikely to pass on negative rates to their clients either through deposits or loans.”

What is the point, then, of cutting interest rates into negative territory? The team believes that the BoJ is counting on non-bank channels to support the economy and borrowing condition, which include:

Currency: lower policy interest rates still influence money market rates and therefore the relative carry of the yen compared to other currencies.
Sovereign yield curve: lower short-term interest rates spread to longer-term yields via the expectation channel.
Corporate bond yields: financing costs for corporates fall as a consequence of lower JGB yields as well as tighter spreads resulting from the search for yield.
Floating-rate bank loans: a large share of mortgages and corporate bank loans are floating and use interbank market rates as benchmarks.

They also believe that given “deposit interest rates have a floor at zero, largely removing the risk of cash withdrawals, the BoJ has a lot of room to cut interest rates below the current -0.1%. They have effectively made the case that ‘there is no floor.'” As well as that with negative rates, the risk of disruptions and illiquidity is high and that the burden of negative interest rates will be mostly borne by institutional investors, which have to invest in debt securities.

“The BoJ is “fighting a war” against deflation and has repeatedly proven its commitment since early 2013. But this war has to be short in order to be won. This was true with QE, it becomes even more true with negative rates. This will require not only monetary policy to be effective but the other pillars of Abe’s policies to come to fruition soon. Otherwise, not only will the benefits of this ‘shock-and-awe’ strategy fade away, but associated risks will mount. More than ever, the clock is ticking for Abenomics,” he concludes.

Concerns Over Negative Interest Rates Overshadow the RMB at the G20 Shanghai Meeting

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The Shanghai G20 meeting concluded with little to show; though little was expected. In line with other global finance leaders’ meetings, the group recognized that while the world economy continues to expand below trend growth, the situation isn’t dire enough to call for coordinated action.

Going into the meeting, People’s Bank of China (PBOC) Governor Zhou Xiaochuan garnered the most attention given that China was hosting the summit. Questions surfaced about how the central bank would balance foreign exchange rates and much needed reform programs. Unsurprisingly, Governor Zhou reiterated the fact that there was no basis for continued weakening of the yuan and that he would not support exports using competitive devaluation.

Instead, growing acceptance over the use of negative interest rates as a form of monetary policy to spur growth seemed to overshadow China and the RMB. This was best summarized by German Finance Minister Wolfgang Schäuble, who said “the debt-financed growth model has reached its limits,” and central banks accepting negative interest rate policies will become a recurring and important theme. The implications are important. First, from an economic standpoint, negative interest rates are viewed as irrational policies as they counter the idea that the future value of money should be greater than the net preserve value. Second, the functioning of banks wanes as they pass up deposit costs in order to prevent withdrawals.

Like other economies, China will need to navigate around this situation. After markets closed on the Monday following the G20 summit, the PBOC cut the reserve requirement ratio (RRR) by 50bps, a move that was seen as a surprise due to the timing of the decision. Releasing an estimate RMB700bn in the banking system, the PBOC move is viewed as extended loose monetary policies, though the liquidity injection likely offsets some open market operations that are expected to mature later on. This would suggest that the PBOC is focused on its domestic policies, which investors should welcome.

China’s next major meeting will be the annual National People’s Congress (NPC) scheduled for the beginning of March. Central authorities are expected to revise their growth estimates from “around 7%” to a stabilized 6.5% to 7.0% estimate. No large scale stimulus is expected. However, following Zhou’s comments at the G20 meeting, it shouldn’t be a surprise to see the PBOC offset counter cyclical measures as it addresses supply side reform. The NPC meeting will likely provide the market with greater clarity on the thinking of the PBOC, especially since this meeting will not be attended by the other 19 G’s.

Have Central Banks Lost Their Superpowers?

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Ahead of the European Central Bank’s (ECB) meeting on March 10th, Keith Wade, Chief Economist & Strategist at Schroders looks at whether central banks’ powers are waning in their fight against falling inflation.

According to him, ahead of the March ECB meeting, three factors have set the scene for potential further policy easing:

Lower oil prices
Fears over global growth
Lower market based measures of inflation expectations

He mentions that “one may expect similar policy responses of rate cuts or quantitative easing (QE) expansion to not produce vastly different medium term results to what we have seen already, with growth and inflation so far limited in the backdrop of subdued global growth. It is perhaps this thought process that leaves the market questioning what effective policies central banks can enact further.”

Wade says that there is a cchance that we could see, for the first time, a lowering of inflation targets across the globe.

For at least the last decade the general belief within markets is that regardless of the situation, central banks will help limit losses in risk assets by lowering interest rates or introducing QE (also known as the central bank ‘put’ option). This school of thought has been questioned in recent weeks, with further possible policy action available to central banks seemingly limited, at least compared to what was available in the past. “Monetary policy has been kept very loose, yet signs of strong growth and inflation are difficult to see… with lower spot inflation used in setting future wages and prices, thus affecting core inflation. The problem with inflation is the longer it stays low, the more embedded lower long-term inflation expectations become.”

With market-based measures of average inflation in the 6-10 year range falling across many major markets, consumer-based expectations of inflation have also been falling in recent years.

The market had previously nicknamed the ECB President ‘Super’ Mario Draghi after the “shock and awe” asset purchasing programme announced in January 2015. “On March 10th we will find out whether that nickname has been reclaimed after the disappointment of the December meeting,” he concludes.

BNP Paribas Investment Partners Appoints Head of Emerging Market Fixed Income

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BNP Paribas Investment Partners announces the appointment of L. Bryan Carter as Head of Emerging Market Fixed Income. He will be based in London and will report to Dominick DeAlto, Chief Investment Officer of Institutional Fixed Income.

Bryan has 12 years’ experience of emerging market fixed income investment and joins from Acadian Asset Management in Boston, where he was lead portfolio manager for benchmark relative and absolute return fixed income strategies and was a member of the Macro Strategy and Investment Policy committees. He joined Acadian in 2007 to launch the company’s emerging market fixed income strategy. Prior to Acadian, he spent four years as an international economist, first at the United States Treasury Department and then at T Rowe Price Associates. Bryan has a BA in Economics & Spanish from Georgetown University and an MPAdm in International Development from Harvard University.

In this role Bryan will have oversight of the management of all emerging market fixed income portfolios and will be responsible for overall investment strategy, performance and the allocation of the risk budget across multiple sources of alpha within emerging markets. BNP Paribas Investment Partners’ emerging market fixed income team currently consists of eight investment professionals and manages client assets totalling $1.3 billion across a range of mutual funds and segregated client accounts.

Dominick DeAlto, Chief Investment Officer of Institutional Fixed Income at BNP Paribas Investment Partners, comments: “Bryan Carter has considerable experience of evaluating emerging market risks and opportunities, gained within both asset management and central government planning, and we are pleased to welcome him as Head of Emerging Market Fixed Income. BNP Paribas Investment Partners has an extensive network of analytical resources based across the broad emerging markets universe, providing us with access to real-time local information. Bryan will be instrumental in further harnessing these capabilities in order to ensure that we continue to deliver optimum investment performance for our clients.”

Bond Markets: a Macro-Economic Cocktail that Calls for a Selective Approach

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The global economy is struggling to grow, and is likely to do so for some time to come. Investors should adapt to this new reality, just as they are being buffeted by a number of economic crosswinds: a strengthening US dollar with its disruptive impact on emerging economies, the knock-on effect on developed nations, deteriorating US fundamentals sparked by a turn in the credit cycle, but an improving economic outlook for Europe, helped by supportive monetary policy.

Against this background, finding investment opportunities is a delicate exercise. With such uncertainty, I believe it is important to focus on quality and liquidity.

The world, in my view, is facing three major challenges: levels of global debt, demographics and deflation.

Since 2007, global debt has increased by $57tn, outpacing world GPD growth. The rise in debt is particularly noticeable in countries like China where the level of corporate debt has scaled new heights, in particular debt issued by non-financials (energy and construction).

When it comes to demographics, the falling birthrate in developed countries has led to the ageing of the population, notably a drop in the population aged between 24 and 52. This age group is the one that drives consumption and economic growth. In other words, demographics will most likely weigh on economic growth over the next few years.

While we are optimistic about the outlook for government bonds because of these two factors – debt levels and demographics – we think what is most important is the phenomenon of “good deflation”, which comes from disruptive technologies and the way firms such as Google, Uber and Amazon change how to do business.

Slowly but surely, these disruptive technologies are taking pricing power away from companies and putting it into the hands of the consumer. As a result, firms are finding it increasingly hard to increase prices, hence “good deflation”. By contrast, deflation, or disinflation, is a long term trend, and has more to do with global overcapacity. Firms are simply producing too much, helped by quantitative easing which has led to a misallocation of capital.

Another consequence of QE has been an increase in the prices of every asset, particularly when it comes to house prices. Housing is the most important component of inflation, looking at the inflation structure in the US. QE has led to higher prices of houses, and then to higher rents. Without this component, inflation in the US is close to zero and the US Federal Reserve, in our view, should focus on that point.

Additionally, the official US unemployment rate is 4.9%, but it doesn’t take into account the participation rate. Factoring this in the real unemployment rate is closer to 13%. Pressure on wages is not that significant, particularly as the jobs created are mostly low-paid jobs in the services sector, including many part-time positions, while the jobs lost were largely well-paid positions. We think therefore there is slack in the labour market.

The manufacturing PMI in the US is about 48, so below a reading of 50 that signifies the sector is expanding: in other words, this key indicator is suggesting there is more than a 50% probability that the country is heading into recession. Services PMI is still above the 50, but it usually takes the same route as the manufacturing PMI (historically, the manufacturing PMI leads the way.)

We think the US Federal Reserve was mistaken in raising the rate in December, because it increased volatility in emerging markets. Despite recent acknowledgment by Janet Yellen of increased macro weakness both within the US and globally, the path of interest rates in the US remains far from clear.

For all these reasons, we prefer to stay away from US corporate debt.

In addition, we are avoiding emerging credit markets. Emerging debt, particularly emerging corporate debt, has been growing significantly in the last few years. The debt burden has getting heavier as loans were often taken out in US dollars. At the time, servicing the debt was relatively cheap but the strengthening of the US dollar has raised the cost of repayment by quite some margin.

Emerging market dollar reserves are falling, suggesting investors are unwinding one of the biggest carry trade we’ve ever witnessed. Since 2009, between seven and nine trillion have been borrowed in US dollars and invested in emerging assets (Chinese financial markets, Chinese housing market, Brazilian debt). Given the fall of local currencies and recession in emerging countries, the situation seems perilous and we prefer to avoid it, even more so as we think it is only a question of time before Saudi Arabia break its peg with the US dollar and China proceeds with a devaluation of its currency.

As a major player in the commodities market, China’s slowdown has an important impact. Commodity prices are currently low and are likely to stay low for a while. Only gold is likely to hold its own, helped by its reputation as a safe haven asset especially if a currency war breaks out, which we believe is bound to happen sooner or later, and above all, when the Fed starts reversing its monetary policy.

The European economy has started to deleverage, unlike the United States. Europe has good momentum, judging by current PMI levels, and its monetary policy is supportive.

In short, we continue to see opportunities within European credit, investment grade bonds and high yield, although we are adopting a more defensive stance and security selection remains paramount.

Column by Ariel Bezalel, fund manager of the Jupiter Dynamic Bond Fund at Jupiter AM

EFG Asset Management Bolsters US Equity Franchise

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EFG Asset Management (EFGAM) – an international provider of actively-managed investment solutions – announced it has brought the management of its top-performing, award-winning New Capital US Growth Fund in-house.

The strategy underpinning the New Capital US Growth Fund was launched for EFGAM in July 2010; based on the firm’s convictions of multi-year growth across the Atlantic, and has since successfully delivered long-term outperformance for clients.

Core members of the existing investment team have officially joined EFGAM as part of the transition. Citywire A rated, Joel Rubenstein, who has been co-lead on the fund since inception will continue as lead manager, working alongside senior portfolio managers Tim Butler and Mike Clulow, as well as research analyst Chelsea Wilson and client portfolio manager Don Klotter, all of whom have been running the fund since inception. There will be no change to the investment process. The US team will continue to be based in Portland, Oregon, and will remain focused on managing the fund. In addition, they will now have the benefit of working alongside other New Capital portfolio managers and analysts with access to the broader global team of investment professionals.

The New Capital US Growth Fund has proven to be a successful component of the wider New Capital fund range, which comprises seven equity funds, three fixed income funds and one multi-asset fund. The Fund has a 5-star rating by Morningstar and a 5 crown rating from FE Trustnet. Compared to the universe of US large cap growth equity funds (approximately 330 funds), it has consistently performed in the top quartile over 1, 3, 5 year periods and since inception. – Moz Afzal, CIO, EFG Asset Management: “This move reflects the successful growth of our New Capital funds franchise. At the time of the fund’s launch we wanted to ensure we had the best managers to implement our strategic views. The strategy has been very fruitful for us, and we are now in the position to provide clients with the best service possible by incorporating all aspects of the fund’s management under the New Capital umbrella.” – Joel Rubenstein, lead portfolio manager: “We have always worked extremely closely with the EFGAM team. Given the success of the fund we are looking forward to taking the relationship to the next stage. We are confident that by joining a much bigger organization with a larger analyst platform, cross-collaboration will enhance the investment process and ultimately performance for clients.”

Bill Gross: “Keep Bond Maturities Short and Borrow” Cheap

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In his latest monthly outlook, Bill Gross compares the sun’s lifespan and that of capitalism and inmediate needs, “our finance based economic system which like the Sun has provided life and productive growth for a long, long time – is running out of fuel and that its remaining time span is something less than 5 billion years,” he writes on his letter, adding that “our global, credit based economic system appears to be in the process of devolving from a production oriented model to one which recycles finance for the benefit of financiers. Making money on money seems to be the system’s flickering objective. Our global financed-based economy is becoming increasingly dormant, not because people don’t want to work or technology isn’t producing better things, but because finance itself is burning out like our future Sun.”

He mentions that what people should know is that the global economy has been powered by credit. And that with negative interest rates dominating 40% of the Euroland bond market and now migrating to Japan, it is less likely that someone will loan money knowing they will receive less in the future. “Negative investment rates and the expansion of central bank balance sheets via quantitative easing are creating negative effects that I have warned about for several years now.” He adds that governments, pension funds and corporations are suffering because they cannot earn enough on their investment portfolios to cover the promises, and that “the damage extends to all savers; households worldwide that saved/invested money for college, retirement or for medical bills. They have been damaged, and only now are becoming aware of it. Negative interest rates do that”.

In his opinion, “the secret in a negative interest rate world that poses extraordinary duration risk for AAA sovereign bonds is to keep bond maturities short and borrow at those attractive yields in a mildly levered form that provides a yield (and expected return) of 5-6%.”

You can read the full letter here.