At the end of 2015, investors were confronted by a world that appeared to be full of potential pitfalls. To preserve and grow the value of their assets, they needed robust portfolios that could outperform the market in challenging environments and deliver resilient returns in the face of unforeseen events.
The investment environment in 2016 has been no easier. A slowing Chinese economy, the Bank of Japan's surprise move to introduce negative interest rates, political and economic uncertainty in the US and the UK’s momentous decision to leave the European Union have all played their part in increasing global financial instability and volatility.
Our approach to building portfolios that are resilient in the face of such tumultuous events requires a strong understanding of investment risks, beyond estimates of volatility. Portfolio construction should balance the trade-offs between potential returns and individual assets’ contribution to overall risk exposure. But we also believe that portfolios need to be diversified and to avoid those parts of the market that could be vulnerable to sudden liquidity squeezes. Investors should also have strategies to cope with periods of market stress.
Six months ago, we believed the US dollar would reach new cyclical highs, as US monetary policy slowly normalised. Then, Europe had only just started to run down private-sector debt and seemed at least three years behind the US. Asia, and China in particular, were further behind Europe. These markets’ debt to gross domestic product ratio were still high, suggesting that monetary easing would need to continue for several years.
Since then, global economic headwinds and a weaker domestic backdrop has prompted a more dovish tone from the US Federal Reserve in the first quarter of 2016, which has slowed the pace of monetary policy normalisation. This means that the phenomenon of diverging monetary policy is less pronounced than it was at the beginning of the year.
Our belief that the emerging market universe is disparate, and offers a wide range of investment opportunities still holds true. We continue to favour economies that are natural extensions of developed markets, such as Hungary or Romania are for the European Union. Nevertheless, we believe we need to continue to be selective in emerging markets, partly due to different sensitivities to demand for Chinese commodities and the US dollar.
We continue to believe that a bottom-up approach to choosing investments can help penetrate the short-term macroeconomic noise. Emerging market equities and resource stocks led global stock markets higher from mid-January, at a time when Chinese data remained negative and many analysts were forecasting a US recession. However, we still acknowledge that the environment has, even if temporarily, become marginally less supportive for stock picking.
As we predicted, 2016 is the year that many investors focused on taking account of environmental, social and governance (ESG) issues. Integrating ESG assessment into investment processes is increasingly being seen as a way of driving long-term value creation. German auto manufacturer Volkswagen could be seen as a game changer triggering increased attention on corporate behaviour and practices. The Paris Agreement on Climate Change in December 2015 has also focused investors’ minds on the environmental challenges surrounding global warming.
We believe there is a clear need for robust portfolios that can prove sufficiently resilient to meet the needs of investors. The key points we outlined at the end of 2015 are still very much in play today. The investment environment remains challenging, uncertainty clouds the outlook for economic growth and central banks have eased monetary policy further. Meanwhile disruptive changes continue to impact corporate business models and demographics are influencing spending and savings patterns. At the same time reduced market depth and liquidity pose challenges for investors. Against such a backdrop, we think that portfolio construction needs to be aware of the durability of cashflows and robust capital structures.
Figure 1 shows the rising number of dividend cuts by companies in the S&P 500 Index and Figure 2 shows the default rates of US high yield bonds. It is important to remember that risk is more than just volatility, and incorporates both durability and liquidity considerations. We believe that the building blocks for portfolio diversification should be structural in nature, reflecting asset behaviours and not simply cosmetic diversification based on asset class labels. Ultimately, the role of every holding in a portfolio needs to be understood in terms of its ability to generate absolute returns for the portfolio and its contribution to risk.
Figure 1: Number of S&P 500 companies cutting dividends
Source: S&P 500, Dec 2015
Figure 2: US high-yield trailing 12-month bond default rates
Source: Moody's Investors Service, 30 April 2016.
Trailing 12-Month Issuer-Weighted Speculation-Grade US Bond vs Loan Default Rates
Now, more than ever, investors are confronted by a world that appears full of potential pitfalls. Consequently, investors are increasingly demanding robust portfolios that can outperform the market in challenging environments and are resilient in the face of unforeseen events. But building this type of portfolio is not easy.
It requires a strong understanding of investment risks, beyond just estimates of volatility. Portfolio construction needs to balance the trade-offs between potential returns and individual assets’ contribution to overall risk exposure, and ensure a level of diversification that is robust and appropriately adaptable to an unpredictable backdrop. A vital consideration is the durability of the underlying cash flow generation of company business models, and avoiding areas at risk of disruptive change is key.
Finally, portfolios have to limit exposure to the least liquid parts of the market and have strategies to deal with bouts of market stress.
Potential growth rates across the developing world have been trending downwards for many years, but the after effects of the global financial crisis have added to the headwinds facing the global economy and raised the prospect of a long period of insufficient demand and low consumer spending. Many hoped that growing emerging markets, particularly in Asia, would provide enough demand to drive the global economy, but this has been dashed by the imperative for China to rebalance its economy to a slower growth model and a rapid build-up of debt in the developing world. It is now unclear what the new drivers of company profit growth and investment returns will be.
In an effort to revive investors' animal spirits central banks have depressed the yields - and thus prospective returns - offered by defensive fixed-income assets down to very unattractive levels. Low yields have caused something of an investor stampede into higher-return assets and inflated valuations, further reducing their future performance potential. Additionally, with little prospect of a material rise in real global interest rates for the foreseeable future, asset markets are susceptible to periodic asset bubbles, as investors chase returns.
If these concerns were not enough, investors also need to contend with the possibility that the current global economic expansion and equity bull market, after almost seven years, are already mature.
Low yields have caused something of an investor stampede into higher-return assets and inflated valuations, further reducing their future performance potential
The globe's ageing populations exacerbate these forces: as the proportion of working-age people shrinks, both productivity and economic growth are depressed. Moreover, older populations mean a larger number of risk-averse retirees who are looking for higher yields on their savings to provide for ever-longer retirements.
As a result, markets are likely to continue to place a premium on defensive investments, higher-income-paying securities, and assets capable of generating sustainable real growth. In some cases, however, these characteristics do not naturally go together. For example, the search for income in a low-yielding world necessarily requires a willingness to take more risk.
Search for income in a low-yielding world necessarily requires a willingness to take more risk
It also seems to be becoming harder for markets to revert to their historical mean measures of fair value. This trend is partly retirees' preference for certain asset characteristics, but also the effect of disruptive technologies, such as genomics, energy storage and robotics,) on some sectors and businesses, which can turn apparently cheap investments into obsolete value traps. Consequently, companies with more durable franchises and established drivers of growth will garner higher credit ratings.
Our models suggest that a meaningful recession is unlikely to occur in major economies in the next year, but we believe portfolios need to be able to cope with unforeseen events and be flexible enough to adapt to changing probabilities of growth and recession..
Portfolio resilience is further challenged by five structural changes which have increased financial market turnover but have reduced depth and liquidity. These trends have reinforced one another and led to an increase in so-called flash crashes in both bond and equity markets.
Building portfolios that can prove sufficiently resilient to meet the needs of investors, despite these many impediments, requires a strong understanding of investment risks, beyond just estimates of volatility. Portfolio construction will need to balance the trade-offs between potential? returns and individual assets’ contribution to risk, and ensure a level of diversification that is robust to events. Portfolios will have to be flexible and able to adapt exposure to suit the changing investment backdrop.
Investors need to consider the durability of the underlying cash flow generation of their investments’ business models and avoid areas at risk of disruptive change. Portfolios will also have to limit exposure to the least liquid parts of the market and have strategies to deal with bouts of market stress. On top of all of this, however, they will need a disciplined framework for identifying attractive investment opportunities and those to avoid.
Ensure a level of diversification that is robust to events
Despite being an increasingly consensus trade, we believe the US dollar will continue to be well supported and reach new cyclical highs as US monetary policy normalises slowly but surely. Having delivered an economic recovery, the US is in a position to raise the cost of money. Europe, however, remains at least three years behind this stage, having only just started to run down private-sector debt. Asia, and China in particular, are nowhere near this stage and their debt to gross domestic product ratio is still high, suggesting monetary policy will need to be easy for several years to come.
We first turned positive on the US dollar in 2012 when it became clear that the economy had already made progress on deleveraging, American banks had improved their capital ratios and the shale revolution in energy extraction was starting. The currency was then extremely cheap and under-owned. Fast forward three years and we have experienced a substantial re-evaluation of the US dollar against a wide range of both advanced economy and emerging- market currencies. Much of this rally has been driven by divergent monetary policy, with the Federal Reserve (Fed) indicating for several months that 2015 would be the year that their target for Fed Funds is finally raised. In contrast, the European Central Bank (ECB) managed to clear enough hurdles to enable them to launch their own version of quantitative easing and the Bank of Japan took forceful steps to boost the money supply significantly.
One interesting aspect of recent price action has been the changing behaviour of currency dynamics. Traditionally, the US dollar has been defensive, rallying when markets are nervous and falling when markets are upbeat. However, the euro has also begun to exhibit defensive behaviour . We believe there are two factors behind this change. First, with negative interest rates, the euro is a funding currency for higher-risk currencies and second, the euro zone has accumulated a substantial current account surplus and the excess savings from this flow out to investments beyond its borders.
When markets are calm this situation presents few problems, but as soon as volatility rises or participants become nervous, these flows reverse rapidly as higher beta currency trades are unwound and capital flows back into the euro zone, boosting the single currency. This, of course, is exactly the market price behaviour traditionally displayed by the yen.
This situation raises a possible risk to a further US dollar rally, but there are others. In particular, the future trajectory of the US economy is crucial to our narrative, and whilst the labour market has largely healed, inflation remains well below the Federal Open Market Committee’s (FOMC) desired level and so the FOMC needs to be confident that its forecasts are robust enough to ensure that inflation rises back towards the target level.
Given the likelihood of a further rate rise in 2016, we expect that the US dollar will remain well supported by investors. The greenback’s continued strength will, therefore, keep pressure on those emerging market borrowers who have hard-currency debts. The countries most affected will be those whose income depends on natural resource revenues, which will likely remain subdued.
What are the investment implications of this theme? Foremost is an increasing awareness of the need to dynamically manage our currency exposure to manage down-side volatility and capture opportunities when presented.
Greenback strength will put pressure on emerging-market borrowers with hard currency debts
The landscape for investing in emerging markets over the past six months has benefited from a more dovish US Federal Reserve and signs of stabilisation in China’s economy and capital markets. A weaker US dollar and the related broad-based rebound in global commodity prices has seen a strong recovery in many of those emerging markets which had previously suffered the heaviest outflows. Despite these broad trends, we believe that we must continue to be selective. Different economies have different sensitivities and will react differently to global shifts. We will also be watching how Brexit will echo across the globe and what effect it will have in emerging markets, particularly those close to the EU.
We previously discussed our preference for economies that are natural extensions of developed markets, such as Mexico and Hungary, which benefit from growth and activity in the US and the euro zone, respectively. The local currency bonds of these countries scored well according to our Compelling Forces framework of valuations, fundamentals and market price behaviour. In Hungary, for example, lower inflation and a slower expected growth path had encouraged further central bank policy easing which boosted the attractiveness of these bonds at the beginning of the year. Valuations at the front end of the yield curve, particularly within the two-to-four year part of the curve, where positioning had been structurally short, appeared attractive in relative terms. Despite the adjustment to a slower growth path, Hungary’s economy has been underpinned by strong domestic consumption and exports, particularly to the rest of Europe and Germany. A positive credit rating outlook was also supported by its current account surplus – which is the largest in Eastern Europe as Figure 1 below shows – and Hungary has since managed to regain investment-grade status from credit ratings agency Fitch Ratings, with the other major ratings agencies expected to follow suit.
Figure 1: National current account as a percentage of gross domestic product
Source: Bloomberg, June 2016
The emerging-market universe is a disparate one offering a wide range of investment opportunities. While there are some unifying factors, the year ahead is likely to continue to be characterised by continuing divergence between markets. This will present us with some fundamental challenges, but also some pockets of value that is better than we have seen for some time.
At a high level, emerging markets are caught between the twin economic powerhouses of the US and China. While it has been this way for many years, the exact nature of those influences has changed through time. Many emerging markets, particularly commodity exporters, have been hit by the sharp fall in demand for basic materials and commodities from China. As the People’s Republic rebalances its economy to favour services over heavy industry and infrastructure, fixed-asset investment and property have slowed from 25% year-on-year growth to 15% today. We consider that these rates are likely to slow gradually over the medium term, rather than declining precipitously, as China works through capacity overhangs in many industries. Nonetheless, for countries that relied on extracting natural resources and selling them to China for their economic growth, this slowdown has come as a distinct economic shock and continues to hold back growth.
For many emerging markets, the US has shifted from being a strong demand and export driver through its consumption of their products, to a monetary driver as they import its ultra-low, quantitative-easing driven interest-rate policy. In some cases, notably in Asia, this cheap money-fuelled excess credit growth has allowed companies much freer access to global capital markets. If, as we expect, interest rates begin to rise in the US, those economies with high debt loads will be vulnerable over the coming year. To combat the impact of the US rate rise and maintain competitiveness, these countries are likely to let their currency weaken against the US dollar and cut interest rates.
However, not all countries face the same pressures. Countries that have substantial current account deficits such as, Brazil and Colombia, and which were the primary beneficiaries of quantitative easing between 2009 and 2013 are the most exposed to the impact of rising interest rates. Banking systems with high loan-to-deposit ratios and open capital accounts will also likely come under strain. The key risk for 2016 is, therefore, related to the financial cycle, particularly in Asia, where debt build-up is leading to the instability of the financial system and its attendant risks, even though the risk of global recession remains very low.
Our favoured markets are those of countries including India and Hungary, that continue to adopt market-friendly growth strategies, remove obstacles to do business effectively, tame inflation and gain credibility.
Our favoured markets are those of countries that continue to adopt market- friendly growth strategies
We also favour economies that are natural extensions of developed markets, such as Mexico of the US and Hungary of the EU. Both of these countries benefit from their neighbours’ recovery in growth and activity. The relatively robust US economy, propelled by an increasingly confident consumer, provides a potential broader benefit to Mexico. The previous stage of US growth, powered by manufacturing and the shale oil boom, by its very nature did not pass through demand to emerging markets. However, a more typical recovery with consumers assisted by easier lending standards and a buoyant housing market could see a stronger source of demand.
Fundamentally, however, those countries that were reliant on natural resource revenues, which couldn't mine it fast enough, and then couldn't stop mining it fast enough, are distinctly out of favour with investors. Some of these commodity producers may now be fair to good value. However, even then we have to differentiate between those economies that have exhibited the deep political problems associated with a struggling economy, Brazil for example, and those that are simply adjusting to a slower growth path.
We also favour economies that are natural extensions of developed markets
It is easy to be pessimistic about this challenging macro scenario – indeed our central case remains another year of growth disappointments – but value has come back as relative and absolute valuations now more accurately reflect growth prospects. With 150 countries, US$7 trillion in market capitalisation for the MSCI Emerging Market Index and $3.25 trillion of investible debt, according to JP Morgan in March 2015, the emerging market universe is significant and its divergence, in terms of what is on offer, is huge.
Assets invested in emerging markets have proved sticky as institutional investors continue to make strategic allocations and to rebalance fixed-income mandates. The breadth of opportunities offered by the divergent bottom-up trends offers great scope to look for attractive returns and for value among the still fundamental challenges. The investor’s challenge is to discriminate between the value and the value traps.
The adoption of environmental, social and governance (ESG) issues into investment decision-making has gone mainstream in 2016. In a low-growth, low-yield and uncertain environment, investors are looking for new tools to drive long-term value creation. For institutions, increased attention has been placed on corporate behaviours and practices which are neither delivering shareholder value nor building sustainable businesses that will enable them to fulfil their fiduciary duty to their stakeholders.
So what has happened in 2016 that has galvanised ESG action?
The Paris Agreement on Climate Change in December 2015 has focused investors’ minds on the environment. This is the first global pledge to limit carbon emissions and is the fastest-ratified UN accord to date.
The speed with which the governments of over 175 countries signed the agreement – a little over four months – has added momentum to efforts to integrate environmental factors into investment processes. It has also spurred investors to look for new opportunities in industries to meet the objective of limiting the global temperature rise to less than 2 degrees Celsius (2°C) above pre-industrial levels.
While the focus has been on environmental issues, the UN Sustainable Development Goals also encouraged momentum behind the social aspects of ESG. Several new organisations, such as the Business and Sustainable Development Commission, have formed to plan practical steps to achieving these goals. Increasingly, major asset owners and investment managers are getting involved.
Poor share price performance and mediocre company results have rallied shareholders into action. Investors have showed a renewed willingness to administer stinging rebukes over top management pay. In the UK, oil giant BP, miner Anglo American, engineering company Weir Group and Irish building materials group CRH all suffered major votes against pay policies. Even major US corporates have not been immune. In April, over a third of voting Citigroup shareholders cast their ballots against the bank’s pay package for top executives.
Shareholder activism has not just been about executive pay. Investors are also looking more closely at the composition of company boards. There was some disquiet over Warren Buffett’s Berkshire Hathaway and Coca-Cola, as both of these US companies have three board directors that have served for over 15 years, which has contributed to a lack of board diversity and independent thinking. In Europe, auto manufacturer Volkswagen (VW) has been subject to intense scrutiny over its unusual governance structure in the wake of the emissions scandal. VW’s shareholders are beginning to ask whether, after three scandals in 20 years, the company's supervisory board has the authority and independence to hold management to account. The company's three largest shareholders, the Porsche-Piëch family, the German state of Lower Saxony and Qatar’s sovereign wealth fund, currently dominate the board. In June this year, Norway’s giant sovereign wealth fund (the fourth-largest shareholder in VW) joined the California State Teachers’ Retirement System (CalSTRS) and around 800 other institutional investors in suing the company over the failure of oversight that led to the emissions scandal.
How will these trends evolve in the years to come? We expect that shareholders will become increasingly frustrated with boards if performance continually fails to meet expectations. We believe that can only be a force for good. Investment in low-carbon and energy saving technologies will also become an important consideration in the portfolio construction process as governments strive to meet the 2°C target set out in Paris. Even in the oft-neglected social aspects of ESG, we believe there will be momentum as investors seek less-crowded, high-growth areas to drive future returns. Our appointment as manager of the Emerging Africa Infrastructure Fund (EAIF), a public-private partnership created to mobilise capital into private sector infrastructure projects across sub-Saharan Africa, is testament to our belief that social benefits are not incompatible with healthy long-term returns.
We believe that 2016 will be the year that environmental, social and governance (ESG) factors will move centre stage for many investors and be seen as a driver for long-term value creation. Of course, attention to ESG is not new and many investors, especially those in Europe, will claim to integrate ESG considerations into their investment processes.
The figure below shows the growth in signatories to the UN Principles of Responsible Investment, where the first principle to which members sign up is to “incorporate ESG issues into investment analysis and decision making processes”. However, in reality, ESG efforts are seen by many as a box-ticking exercise, or at best a moral obligation, but not as a way to improve investment returns.
For most investors, the link between governance and shareholder returns, at least, is clear. As summed up by the UK’s 2009 Walker Review of Corporate Governance, its role is “to protect and advance the interests of shareholders through setting the strategic direction of a company and appointing and monitoring capable management”.
If the state is likely to disappoint, non-state actors can and, increasingly, will play a role
Japan is an example of a country that is going through a programme of governance reforms that is helping to send encouraging signals to shareholders. Japan has traditionally had a challenging corporate governance culture characterised by closed boards, anti-takeover measures, worrying related party transactions and capital management strategies. But over the last two years, measures to promote greater transparency have included the launch of the JPX-Nikkei 400 index that included capital efficiency as a criterion for stock weightings.
Japan has also introduced a Stewardship Code and a Corporate Governance Code. In July 2014 ISS Japan, a corporate governance and socially responsible investment solutions provider, recommended that shareholders vote against proposals to elect directors where a company's ROE has remained below 5% for five years or ore. From February 2016 they will also oppose top management at companies that do not have at least two outside directors.
Japan’s focus on governance has also led to more tangible benefits, such as share buybacks at levels not seen since 2008, a gradual elimination of cross shareholdings, a rolling back of takeover defences and ROEs that are close to 10% (albeit other factors have played a role).
Providing a nexus between both governance and environmental concerns is Volkswagen. In mid-September the company admitted to using a cheat device in many brands of their cars that turned on full pollution controls only when the cars were being tested. Once news of this deception emerged, the company’s shares fell by almost 40%.
Although some see this as part of the uncertainty inherent in investing, attention has frequently been drawn to the poor governance of VW in terms of its voting structure and, more importantly, its board composition.
Attention has frequently been drawn to the poor governance of Volkswagen
In March 2013, Olaf Storbeck wrote for the news service Reuters that VW’s supervisory board was highly politicized and lacked real external control consisting as it did of local politicians, trade unionists and two related, but often warring, families. He finished by observing that “Management theory and the history of other companies show that this structure is a recipe for disaster”.
It may be too early to tell exactly how significant a role the corporate structure played in the lack of oversight and protection. However, it may hold valuable lessons on clearing up some of the more opaque structures used by VW, such as cross shareholdings and dual share classes. The effects from the VW case on the company and the industry are likely to be far-reaching with new value chains emerging within the transport industry if the move away from diesel is accelerated in city centres.
Moreover, the VW scandal occurred at a critical point for the global response to climate change: the UN Climate Change Conference in Paris (COP 21) that took place in December 2015. The gathering aims to achieve a binding and universal agreement on climate from all the nations of the world, which has never been achieved in over 20 years of negotiations.
Although global warming has been widely recognised as one of the world’s most critical challenges, the effect of feedback loops is extremely complex making it difficult to assess the timing and severity of the threat. A response to this threat requires global coordination and, given the vested interests, it is inevitable that any response will initially be inadequate and delayed.
However, if the state is likely to disappoint, non-state actors can and, increasingly, will play a role. The idea that sustainability should be a pillar of sound investing is not new but as the German economist Professor Rudi Dornbusch wrote "things take longer to happen than you think they will, and then they happen faster than you thought they could".
If the state is likely to disappoint, non-state actors can and, increasingly, will play a role