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Multi-Asset Growth


Multi Asset Growth Outlook

By Philip Saunders

At a glance

  • The market appears overly pessimistic, while we are more positive on the outlook for global economic growth, and the US is likely to lead the way
  • Despite the continued concerns around China, we expect growth to stabilise for longer than expected
  • Emerging market fundamentals have improved; however, it is essential to monitor the effects of external factors on these domestic drivers
  • Investors are looking towards fiscal policy, given the recent debate regarding the ineffectiveness of monetary stimulus
  • We discuss in detail our views and the key risks for 2017: rising government bond yields, European political impacts, and a China slowdown
  • The Investec Multi-Asset Growth team seeks to manage risk through effective structural diversification and building portfolios from the bottom up

Finding growth in 2017

A low-growth environment, elevated headline valuations across some markets and fears of an imminent recession have led many investors to question prospective returns over the year ahead and beyond. As described in “Where’s the Growth?” the post-crisis environment has been weaker than policymakers expected, with the high debt burden, demographics and low productivity all keeping interest rates low and central banks wedded to additional stimulus measures.

Figure 1: Actual and trend US GDP

Source: Bloomberg and Investec Asset Management, US GDP and Trend.

Timeframes are a vital part of investing and the ability to separate the structural from the cyclical backdrop is critical, as it is the latter which often drives returns, with the former setting the broader framework. From a macroeconomic perspective, we expect 2017 to be a memorable year, with global growth likely exceeding rather than disappointing consensus expectations for a change. We believe expectations are overly pessimistic – in particular, the discussion of recession, which is principally hinged on overemphasising the weakness of manufacturing indicators and underestimating the resilience of the consumer sector.

“We expect 2017 to be a memorable year, with global growth exceeding rather than disappointing consensus expectations for a change ”

Over the past year, supportive measures via aggressive monetary and fiscal loosening in China started to bear fruit, halting the deceleration of growth in that key economy. Recent evidence in the US points to a moderately improving and broadening growth profile which is less dependent on consumer spending. How the growth picture in the US actually develops over 2017 will be influenced by the implementation of policies by the new administration and the stance of the US Federal Reserve with respect to monetary conditions.

For emerging markets, we expect the key external issues to be the implementation of more protectionist policies and the persistence of higher US bond yields and the strength of the dollar. While the issue of excessive leverage remains front and centre of concerns in China, we expect the impact of the previous expansionary measures to stabilise growth for longer than the consensus currently expects. Broadly, emerging market fundamentals have improved. Current account deficits have reduced, inflation has moderated and domestic demand has stabilised. The interplay between domestic and external forces will, however, be a critical factor to watch, particularly for local bond markets that rallied through the course of 2016.

“Broadly, emerging market fundamentals have improved ”

Against the backdrop of weak global growth and declining inflation, central banks have been biased towards loosening policy further or talking down the prospects of future tightening. These stimulus measures, however, have recently come into question as evidence suggests that unconventional monetary policy may have reached its limits. As a consequence, many investors are beginning to look towards fiscal policy to take a greater role in stimulating growth and are starting to call for a turn in the direction of interest rates and bond yields. This is likely to be most evident in the US, but other nations may heed the warning of the political upheaval and subsequently expand fiscal expenditure, despite high levels of indebtedness.

Key risks for 2017

Rising government bond yields

A more inflationary and expansionary approach in the US implies higher long-term interest rates internationally. Bond yields have defined the performance of multiple asset classes over the past few years and impacted valuations within equity markets. The response of markets to how bond yields react to shifting growth, inflation and policy dynamics is a key risk.

“A more inflationary and expansionary approach in the US implies higher long- term interest rates internationally”

European political impacts

The vote for the UK to leave the EU in June 2016 was a blow to a European structure that was already on shaky foundations. With key elections coming up over the course of the year there is the potential for political change to bring euro-sceptic parties to greater prominence.

China slowdown

Chinese stimulus was a key element in the equity market’s performance this year and measures have come into effect to control the excessively inflated property sector (similar to those in 2013). The risk is that this catalyses a slowdown in the pace of credit growth and puts pressure on already indebted property developers and banks that rely on continued liquidity injections. In this scenario we would expect industrial production to weaken sharply and capital outflows to increase.

How do we mitigate these risks?

We place significantly more emphasis on an investment’s relationship with the economic cycle in determining its place in a portfolio, than we do on its asset class label. An asset’s classification usually provides little insight, or worse still can be misleading with regards to its risk-reward characteristics. To achieve true, or structural diversification, we prefer to divide assets into ‘Growth’, ‘Defensive’, and ‘Uncorrelated’ buckets.

“An asset’s classification usually provides little insight, or worse still can be misleading”

The portfolio is constructed from bottom-up driven investment ideas researched by teams with specialist experience in each asset class. This is combined with a top-down approach to determine the mix of our three asset categories. We recognise that valuations are less attractive in many areas and there are cyclical challenges. A broad opportunity set and a bottom-up approach helps us to navigate markets and deliver our combined risk-and-return objectives.

Multi-Asset Income

Multi-Asset Income Outlook

By John Stopford

At a glance

  • We believe the era of ever-easier monetary policy may be drawing to a close. However, a still-supportive environment will continue to benefit growth assets
  • The global economic expansion is likely to continue into 2017 and may even accelerate
  • We identify the three most significant risks in 2017: a ‘hard landing’ in China, an oil price spike, or a 2017 taper tantrum
  • We believe the best way to manage risk is to build portfolios from the bottom-up

Monetary policy — is a change coming?

Against the backdrop of weak global growth and soft inflation, central banks have been biased towards loosening policy further or talking down the prospect of future tightening. Stimulus measures, however, have recently come into question as evidence suggests that unconventional monetary policy may have reached its limits. For example, the Bank of Japan has recently moved away from a commitment to buy a fixed quantity of government bonds and adopted a yield target instead. This may be more sustainable in the long-run, but reflects an inability to expand its government bond holdings indefinitely. Similarly, market participants have speculated that the European Central Bank may move to taper its bond purchases before long and have lost appetite for pushing interest rates to ever more negative levels.

“Stimulus measures have recently come into question as evidence suggests that unconventional monetary policy may have reached its limits”

As a consequence, many investors are beginning to look for fiscal policy to take a greater role in stimulating growth and are starting to call for a turn in the direction of interest rates and bond yields. Our view is that although we may have moved to an environment of less aggressive monetary easing, it is too soon to look for a decisive inflection point. Central banks will be cautious about changing direction given the risk of derailing the economic recovery, and fiscal policy is hard to expand quickly. Fiscal expansion may also be limited in some countries by debt levels, and requires a level of coordination which will challenge most governments.

Government bond yields, as a result, are adjusting to a less supportive policy environment, but are expected to remain largely range bound, with fair value only modestly above current yield levels. A structural increase in yields will require either a rise in trend growth, a rise in trend inflation or a clearer change in the direction and mix of policy. None of these are likely to happen quickly, but we may now be at the end of a 35-year bull market for government bonds.

Figure 1: Government bond yields reflect structural drivers

Source: Investec Asset Management, September 2016. Time period shown covers the period from when 30 year US government bonds were first issued.

Where are we in the business cycle?

For now, the global economy continues to grow, and we believe there is little chance of a recession over the next 6 to 12 months. Indeed, a range of indicators suggest scope for growth to accelerate as we enter 2017. Manufacturing has been notably weak and we are looking for a recovery over the next few quarters. Corporate earnings appear to have bottomed out and are now improving. Better earnings should support a recovery in capital expenditure, an important driver of growth.

“For now, the global economy continues to grow, and we see little chance of a recession over the next 6 to 12 months”

Against this backdrop, we retain a moderate bias towards growth assets, although we do recognise that many of these assets are no longer cheap. In aggregate, we believe most growth assets are trading broadly around fair value, with some areas such as emerging market equities still appearing to offer relatively good value.

Defensive assets appear challenged with a less positive environment for bonds. Government bonds’ negative correlation with other asset classes has also diminished, reducing their value to the overall portfolio in terms of diversification. While government bonds look relatively expensive, we still find pockets of value, such as New Zealand and Canada, where interest rates may be cut further.

In currency markets, we see some potential for additional US dollar strength, helped by a gradual increase in interest rates and higher bond yields. Political noise in Europe could provide further support for the US dollar (traditionally considered a ‘safe haven’ asset) as elections take place in Germany, France and the Netherlands in 2017. Italian politics is also likely to remain challenged. We also look to add protection to the portfolio by exploiting potential currency weakness. We have offset China-specific risk to some extent by holding a short position (benefiting from a fall in value) in the Chinese renminbi and North Asian currencies.

The key risks for 2017

China ‘hard landing’

Concerns related to China have diminished over the year as the economy appears to have stabilised. However, the stimulus implemented through the People’s Bank of China (PBOC) has created asset bubbles in which prices are excessively inflated. This is largely a result of the lack of investment options available for these additional funds being introduced to the market. Property has been one of the areas that has felt this effect, and the PBOC is now attempting to cool the property market. Twenty-one cities have introduced purchase restrictions and tightened mortgage lending since late September. There is a risk that this tightening goes too far, creating a negative feedback loop, putting the wider Chinese economy at risk, and creating pressure for a more aggressive devaluation of the renminbi. 2017 will also see the traditional five-year rotation in the political leadership which will create further uncertainty.

Oil price spike

Supply and demand in the oil market has become more balanced during 2016. Supply has diminished as oil companies continue to cut capital expenditure in an attempt to survive the lower oil price environment. Historically, oil rarely moves in a tempered manner. As supply falls, there is potential that increasing demand could cause the oil price to spike. Not only a negative for importers and a boon to exporters, inflation would be pushed higher, forcing central banks to consider a faster interest rate hike cycle than markets expect, leading to a sell-off in international bond markets. High oil prices would squeeze consumer incomes and could, in turn, push the global economy into a period of recession. Over the last 45 years a jump in the oil price has always predated a recession.

Government bond sell-off

As we have discussed, the potential for further monetary easing appears limited. As a result of strong performance, many investors hold large allocations to government bonds and there is potential for investors to begin to unwind these positions, creating something of a repeat of the 2013 ‘taper tantrum’. Such a change would likely reverberate into other markets impacting both defensive assets and interest-rate sensitive growth assets.

How do we mitigate these risks?

Ultimately, we believe the best way to generate consistent returns, as well as minimising exposure to downside risks, is through building a portfolio from the bottom up. Despite the diminishing opportunities in the wider market, we continue to find many select securities that offer the key attributes we look for – sustainable yields, low volatility and potential for capital growth.

Global Equity


Global Equity Outlook

By Mark Breedon

At a glance

  • After several quarters of underperformance, the value factor has returned to prominence, a trend we believe will continue into 2017
  • Markets are moving less in a ‘risk on/risk off’ lock-step, showing greater differentiation and falling correlations, which we believe bodes well for fundamental stock selection strategies
  • The key risks continue to be geopolitical in nature, but as event-driven shocks subside, it is strong company fundamentals which should allow stock prices to find their fair value in the long run

Value takes the reins

This time last year we believed market behaviour suggested a rotation from Quality to Value may be imminent. That prediction came to fruition over the last half of 2016 and, in our view, it may have some staying power. Over the final half of 2016, more cyclical and economically sensitive sectors such as IT, materials and consumer discretionary sectors came to the fore. High volatility stocks, in particular, have been very strong relative to the broad market indices. The Value factor thus rebounded strongly after a long period of underperformance and the market focus has moved away from highly priced quality stocks.

“The Value factor has rebounded strongly after a long period of underperformance”

Figure 1: Individual factors vs comparison index (3 years), Investec global 4Factor™ strategies

Source: Investec Asset Management. The Factors combined show the relative performance of a portfolio of stocks comprising of the top quartile of ranked stocks from our four factors against the index over time. This strategy is rebalanced quarterly and has no risk constraints or transaction costs. Comparison index: MSCIAC World NDR (MSCIWorld NDRpre 01.01.2011).

For much of 2016, factor performance proved to be a headwind, though this turned around from the third quarter. In particular, the Value factor started to do well after a long period of underperformance and the market focus moved away from highly priced quality stocks.

Figure 2: Combined factors vs comparison index (10 years), Investec global 4Factor™ strategies

Source: Investec Asset Management. The Factors combined show the relative performance of a portfolio of stocks comprising of the top quartile of ranked stocks from our four factors against the index over time. This strategy is rebalanced quarterly and has no risk constraints or transaction costs. Comparison index: MSCIAC World NDR (MSCIWorld NDRpre 01.01.11).

Given ongoing and unpredictable political risks globally, it perhaps seems strange that investors are prepared to buy more risky assets. We suspect that much of this new trend has been driven by the broad rise in bond yields, which in turn reflects some better-than-expected economic data and a growing belief that the US Federal Reserve is committed to further tightening both this year and next. Although the evidence of economic growth is sparse and risks abound, this change in market leadership perhaps also reflects the extremity of valuation between stable growth stocks and economically sensitive stocks. It only took a marginal increment in positivity to cause a shift from a crowded to an uncluttered market segment.

The next question is whether or not this trend is sustainable. We think it might be. The Value and Quality factors are both reverting to mean, portending a period of potential outperformance for Value and underperformance for Quality. From a bottom-up perspective we’re seeing plenty of opportunities for companies which offer good potential upside on Value, which are beginning to see better Earnings and Technical momentum and are not at the extreme edge of the poor quality/low valuation and high volatility spectrum. Should economic growth continue to surprise to the upside, interest rates may (finally) rise and risk appetite should increase as we expect investors to become willing to hold more volatile value stocks.

If the broadening rally across the wider market sustains itself as we think it might, we believe this bodes well for stock-picking strategies that have suffered during a long stretch of ‘risk on-risk off’ markets.

Moving beyond ‘risk on, risk off’

Until the third quarter of 2016, markets had been in an extended period of ‘risk on, risk off’, wherein correlations within and across sectors, factors and markets were extremely high. In other words, stock prices tended to move together regardless of stock-specific fundamentals or drivers. In such a market, the fundamental drivers of a company’s growth or profitability are often ignored, which makes it a difficult and challenging market for stock selection. In addition to the resurgence of the Value factor, we are now seeing differentiation across and within markets, with pairwise correlations beginning to fall off. Falling correlation and resurgent differentiation within markets potentially provides yet another signal of a return to a stock-picker’s market where analysis of fundamental drivers of business performance matter once again.

Key 2017 risks still geopolitical

Markets shook off the Brexit shock relatively quickly allow the themes identified above to dominate markets. But ultimately the key risks to global equities are geopolitical and diverse. Should one of the key risks emerge, such as further EU instability or referenda, or more serious sabre rattling from Russia or China, we could potentially see a return to ‘risk on, risk off’, along with a rise in overall correlations. While markets have been presented with frequent challenges of late, our confidence as bottom-up managers lies in our disciplined process and the ability to select individual investments according to key long-term growth drivers. As the shocks of event-driven markets subside, we believe it is strong company fundamentals which allow stock prices to find their fair value in the long run.

Global Franchise

Global Franchise Outlook

By Clyde Rossouw

At a glance

  • Will further monetary and fiscal policy provide effective stimulus for economic growth, or have we reached an inflection point?
  • We continue to find attractive opportunities in the consumer staples sector, in spite of perceived valuation concerns and lower exposure to any short-term cyclical recovery
  • On a relative basis, the biggest risk for the portfolio is a sustained market rally driven by polices aimed at stimulating economic growth
  • Quality stocks have proven their ability to compound shareholder wealth over the long term at higher rates of return and should command a higher valuation

Interest rate normalisation

Last year we predicted that near-term interest rate normalisation in the US was unlikely, given continued challenging economic conditions and a strong US dollar. We also predicted that, in spite of weak corporate earnings, investors may nonetheless remain greedy in the face of steeper valuations, as long as accommodative central bank policy and the provision of cheap money continued. Ultimately, we did not believe this situation was sustainable and predicted a market correction at some point, but this has yet to materialise. Instead, risk appetite has strengthened.

“How sustainable is this risk-on trade and the value rally that we have witnessed in 2016?”

The question for investors as we move into 2017 is: ‘How sustainable is this risk-on trade and the value rally that we have witnessed in 2016?’ Will monetary and fiscal policy provide effective stimulus for economic growth? Or will growth falter under the weight of ever-higher public and private debt, increasingly protectionist US government policy, and more hawkish US Federal Reserve policy in the face of rising inflationary pressures?

Global economic recovery

We believe the global economic recovery remains uncertain. There will be political uncertainty as Brexit negotiations unfold, key national elections take place in France and Germany, and Trump takes over the US presidency. The outlook for monetary policy is equally uncertain, with potential changes to both personnel and policy at the Federal Reserve. Fiscal stimulus through tax cuts and increased infrastructure spending may provide a short-term boost to economic growth. However, there will likely be uncertainty in the face of anti-globalisation and anti-free-trade sentiment, which will be expected to have an impact on consumer spending and business investment.

“Those individual companies that can grow in uncertain times will be most likely to prevail”

Over the last year, we have seen huge dispersions in the performance of stocks within sectors, as well as between sectors. Against a backdrop of market volatility and heightened valuations, we believe the biggest ‘theme’ for 2017 will be stock selection. It will be those individual companies that can grow in uncertain times that will be most likely to prevail.

Where are the investment opportunities?

Our portfolio is built from the bottom up with a long-term focus, targeting cash-generative companies able to sustain high returns on invested capital, with typically low sensitivity to the economic and market cycle. While macro and thematic opportunities and threats are carefully considered, this is done at the individual company level in our assessment of the long-term strength of a company’s business model and the sustainability of its competitive advantage. We continue to find attractive opportunities in the consumer staples sector, in spite of perceived valuation concerns and lower exposure to any short term cyclical recovery.

“We continue to find attractive opportunities in the consumer staples sector”

For example, after an extensive review, we recently added to our long-held position in Reckitt Benckiser on short-term weakness. This company has a proven track record of consistent organic revenue growth, even during the global financial crisis. Margin expansion has been achieved through cost efficiencies and a focus on the company’s higher-margin divisions such as consumer health, leading to even better earnings growth which has converted fully into cash. The strength and the reliability of this cash generation has enabled Reckitt Benckiser to invest in innovation and advertising and promotion, supporting its brands, improving its market share and providing a significant runway for growth at high returns on capital. This virtuous cycle is reflected in the performance it has delivered for shareholders. As shown in Figure 1, this performance has been driven almost entirely by the compounding of cashflows, with very little coming from a re-rating of the shares. We believe these drivers remain firmly in place and the company is well positioned to continue to deliver strong performance from here.

Figure 1: Reckitt Benckiser: a classic compounder of cashflows

Source: Annualised Total Shareholder Return breakdown (GBP), 2005-2015. Source: Bloomberg, company reports, Investec Asset Management, 31.12.15. This is not a recommendation to buy, sell or hold a particular security. No representation is being made that any investment will or is likely to achieve profits or losses similar to those achieved in the past, or that significant losses will be avoided.

Not all consumer staples are high-quality compounders, however, and not all high quality compounders are consumer staples. Over the last few years we have also found some very interesting stock ideas in other areas of the market, in particular the technology and financials (excluding banks) sectors. So much so that our consumer staples exposure has nearly halved over the last five years to less than 40% at the time of writing, with technology companies now representing over 25% of the portfolio and financials around 10%.

“Technology companies now representing over 25% of the portfolio and financials around 10%”

Growth in the internet and disruptive technological change has given rise to some fast growing, capital light, cash generative, high-margin and high-return businesses. Examples range from digital payment platforms and payment networks to internet domain name registries and online travel agents. While they do not necessarily have the same trading histories as many of the consumer staples and pharmaceutical companies we hold, they nonetheless share similar attributes. They have strong and durable competitive advantages, protected by significant barriers to entry. By including these stocks in the portfolio we have sought to enhance the strategy’s growth and return characteristics without compromising materially on valuation.

Major risks for 2017

The performance signature of the strategy has historically been one of seeking to participate meaningfully in ‘up’ markets, with smaller drawdowns in ‘down’ markets, and lower-than-average volatility. Therefore, on a relative basis, we believe the biggest risk for the portfolio is a sustained market rally driven by polices aimed at stimulating economic growth. This should benefit equities in general, but cheaper, more cyclical and economically sensitive lower-quality stocks would likely benefit more.

“Recent portfolio changes have reduced the portfolio’s sensitivity and reliance to any one trend or sector”

In this scenario we may be on the wrong side of the mean reversion trade that has been so conspicuously absent in recent years. However, recent portfolio changes as outlined above have reduced the portfolio’s sensitivity and reliance to any one market trend or sector. Enhanced diversification benefits should continue to contribute to a consistent return profile for the overall portfolio, regardless of market environment. We would still expect positive absolute returns in this case.

Another risk is the outlook for interest rates. Perceived wisdom is that quality performs poorly in an environment of rising rates and steepening yield curves. The theory goes that stable future bond-like cashflows are discounted at higher rates, reducing their present value. There are a number of reasons, however, why we think this risk is mitigated within our strategy. While it has defensive qualities, it is in no way a bond-proxy strategy. Free cashflow has been growing at high single digit annual rates, and we seek to avoid some of the most rate-sensitive bond-like parts of the market such as utilities, telecoms and property. In aggregate, the companies we hold are typically not reliant on leverage to fuel growth and have very little debt, meaning they do not face the risk of having to refinance at higher rates. Overall, our consumer staples positioning has reduced over the last few years, as highlighted above, in favour of interesting defensive growth opportunities primarily in technology and financials. As a result, the correlation of the portfolio is actually positively skewed to higher bond yields.

“Are quality stocks expensive? ”

Finally, one of the most common questions we are asked is about the valuation of quality stocks – are they expensive? It is important to remember here that any valuation of quality stocks needs to be made in the right context. Quality businesses are more expensive than they have been in the recent past, but ironically far more valuable in today’s low-return world. In the context of longer-term history, valuations of the wider equity market, bond yields, and quality attributes, we do not believe current valuations are stretched. Quality stocks have proven their ability to compound shareholder wealth over the long term at higher rates of return and with lower volatility than the wider market. We believe high barriers to entry, pricing power, high-quality profits, low financial leverage, low capital intensity, and consistently strong free cashflow generation, together mean that quality stocks are just as relevant now as they have proven to be over the long term.

Global Credit

Fixed Income

Global Credit Outlook

By Jeff Boswell and Garland Hansmann

At a glance

  • We believe the fundamental backdrop for credit remains positive, underpinned by reasonable leverage and good debt affordability
  • With markets transfixed on central bank policy, bouts of volatility are likely to remain the norm. Changes in the political landscape may amplify this
  • Oil and commodity sector stress has largely abated, with market default rates set to decline
  • Corporate bond spread levels are generally just inside long-term averages, but still some way above historical cyclical lows
  • The length of this credit cycle may be extended beyond historical norms, underpinned by supportive policy

Fundamental outlook

We believe underlying credit market fundamentals remain good, with corporate leverage remaining largely stable over the year (US investment grade the one exception), and debt affordability still comfortable. While GDP growth has remained fairly low (2016 US: 1.5% and euro-zone 1.6% on a year-on-year basis), and is forecast to continue to do so, such a sustained environment of low growth and low defaults remains positive for the credit market. The prospect of more stimulus via fiscal policy under a new US government may well bolster near term growth prospects. However, this is tempered by a variety of potential headwinds that remain in the wings, including the prospect of an interest rate rise from the US Federal Reserve (Fed), as well as various upcoming European elections and referendums. We believe, however, that central banks will continue to be the balancing factor, ready to raise rates to keep inflation under control in an expansionary environment, but also willing to be accommodative should that be necessary.

“We believe central banks will be the balancing factor, ready to raise rates to keep inflation under control in an expansionary environment, but willing to slow monetary tightening should that be necessary”

Figure 1: High yield leverage

Source: Morgan Stanley Credit Research, 30.06.16.

Figure 2: Investment grade leverage

Source: Morgan Stanley Credit Research, 30.06.16.

US investment grade is the notable exception in leveraging trends (see Figure 2), with 2016 reflecting a gradual increase, fuelled largely by a broad swathe of merger & acquisition (M&A) activity. The US$1.4 trillion in completed M&A deals in 2016 year-to date (30 November) has been driven by a variety of factors including: disruptive technology (AT&T/ Time Warner), the search for scale and synergies (Dow/ Dupont) or just the availability of cheap debt (Anheuser Busch/SAB). While this leverage trend is not favourable for credit investors, debt affordability (and availability) for investment-grade issuers remains good and we are typically seeing these borrowers issue long-dated debt to give themselves long-term financing certainty.

A rise in volatility?

2016 has seen a continuation of a 2015 trend in which volatility spikes have occurred twice as often in these years, relative to the prior 25 years (see Figure 3). We believe volatility is likely to remain more common in an increasingly uncertain environment. Macroeconomics (low growth), monetary factors (low central bank rates, low dealer liquidity) and politics (election surprises, separatist movements, terrorism and divisive campaigning) are all contributing to the increasing spikes in volatility.

“2016 has seen a continuation of a 2015 trend in which volatility spikes have occurred twice as often in these years, relative to the prior 25 years”

Figure 3: Volatility Index (VIX) spikes since 1990

Source: BofA Merrill Lynch Global Research. Based on daily data from 02.01.90 to 23.09.16. VIX spikes are represented by periods of time which the VIX exceeds 20 and has spiked by over 50%. The start of the spike period is the last possible day in which spot VIX was below its 1M moving average. The end of the spike is when VIX has given back at least 75% of the change from the start of the spike period to the maximum value over the spike period. A subsequent spike is measured only if VIX moves or is above 20 and the maximum value for which VIX spikes to is at least 50% higher than the value at the start of the spike period.

While caution and flexibility are required to negotiate such an environment, we believe such bouts of volatility will create opportunity for credit investors in the year to come, provided they are flexible and fast enough to react to them. The Brexit volatility, for example, only lasted a matter of days, with the volatility surrounding the shock election of Donald Trump as US president seemingly following a similar pattern, although still in play at the time of writing.

Oil and commodity stress contained

2016 has been something of a rollercoaster ride for borrowers within the energy and commodity sectors. The US High Yield Energy Index widened out to a spread of almost 20% in February, before roaring back in to currently stand at 6%. With a growing market consensus that both oil and a variety of other commodity prices have found a floor and are likely to remain range bound, we have seen the stress levels within these markets abate, as borrowers have regained access to capital markets. Default rates in the US energy sector have risen to 24.5% over the last 12 months; however, we believe the worst is behind us as the most susceptible issuers have fallen by the wayside, and the survivors are benefiting from more stable prices. Default rates within US High Yield currently stand at 5.1% (1.3% ex Energy), with Europe at a comparably modest 0.9%. Most market commentators are forecasting a continuation of this moderation, with Moody’s expecting default rates to ease off to 3.6% by September 2017.

Figure 4: Default rates

Source: Credit Suisse Credit Strategy, November 2016.

Valuations: How do we stack up?

After an eventful year including Brexit and the US presidential election, credit spreads for high-yield bonds in both Europe and the US have, at the time of writing, moved slightly below their long-run averages. While not quite as appealing as 12 months ago, valuations are by no means extreme and remain comfortably above cyclical lows (long term and post crisis), as can be seen in Figure 5. To the extent default rates remain subdued, which we believe to be the case in the near term, then these levels of compensation look interesting in our view.

Figure 5: Historic spread of global investment grade

Source: Bank of America Merrill Lynch High Yield Indices, October 2016.

Figure 6: Historic spread of global high yield 

Source: Bank of America Merrill Lynch High Yield Indices, October 2016.

Where are we in the credit cycle?

While the length of this credit cycle alone should point to being in its advanced stages, we believe there is a strong case to expect the cycle to extend beyond what would be considered ‘normal’. We believe the support of central banks, in a somewhat ransomed fashion, will likely sustain what has been an anaemic recovery – if fiscal expansion does not take over the baton. As a result, the path to global interest rate normalisation is likely to be slow, even if the US may be the first to trend in that direction. A structural rise in yields will require a rise in trend growth, trend inflation or a change in the direction and mix of policy. Such a potential change in policy has recently come to the fore following the election of Donald Trump, who campaigned for significant infrastructure spending and fiscal easing in order to spark US economic growth. A near-term fiscal boost would likely have a similar impact in extending the credit cycle.

“We believe there is a strong case to expect the cycle to extend beyond what would be considered ‘normal’”

Undoubtedly, one of the significant risks to this scenario is a less supportive Fed as it attempts to normalise interest rates. A quicker-than-expected rate hiking cycle could lead to a tightening of financial conditions in the US. A slowing US economy has historically preceded the end of the credit cycle and a move into a recessionary environment. We remain on alert for any indication the credit cycle is coming to an end sooner than expected and will position our portfolios appropriately.

In summary

We think that the investment case for credit still holds true as we go into 2017. The story surrounding company fundamentals, while not the main attraction of the asset class, remains decent. Valuations are still compensating investors well and we think the low default rate environment will continue into 2017. The phenomenon of more frequent bouts of volatility, which we expect to persist, should provide trading opportunities for tactical adjustment of the portfolio and outperformance of the market. As such we believe that 2017 should be a ‘spread plus a bit’ year in which credit can be expected to achieve a return in excess of government bonds, driven principally by incremental income, with some marginal spread tightening. At the same time we remain vigilant to signs that a more defensive position is required.

Emerging Market Fixed Income

Emerging Market Fixed Income Outlook

By Mike Hugman

At a glance

  • There will be clear winners and losers of the change in the US’s political administration, creating the potential for an opportune environment for active management
  • Emerging market (EM) economies are now in much better shape than historic market routs
  • Implications of rising US Treasury yields for our markets
  • Protectionist drift is evident, but risks are very manageable across the board

The health of emerging markets

Economically, EMs are in far better shape than previous periods of market stress – including the recent ‘taper tantrum’ in 2013 and Asian financial crisis in the late 90s. It is helpful to look at just how far emerging economies have readjusted, with growth surprises picking up materially, current accounts correcting and credible fiscal policy returning to some of our key markets (Brazil, South Africa, Indonesia and Argentina). Also, unlike the ‘taper tantrum’, valuations don’t appear stretched by conventional measures, which should provide an additional buffer when markets begin to normalise.

“Economically, EMs are in far better shape than previous periods of market stress”

Firstly, while the trend in EM growth is widely recognised to be lower today than historically, it has been on a cyclically upward trend in 2016 with EM financial conditions easing since the start of 2016 (see Figure 1), notwithstanding the impact of Trump. In contrast, financial conditions in the US have now reversed their easing of mid-2016 and are back to the tighter levels seen in late 2015.

Figure 1: EM financial conditions have eased since the start of 2016

Source: Investec Asset Management, the referenced model is produced by our Emerging Markets Fixed team as at 15.11.16. The model comprises of the following factors: 1) trade weighted nominal exchange rates; 2) domestic cash/policy rates; 3) 10 year local bond yields; 4) government credit default swaps; 5) corporate credit spreads; 6) domestic equity price-to-book ratio.

Secondly, as EM domestic demand has weakened from its peak in 2012, imports have moderated, allowing aggregate EM current account balances (excluding China) to move into a surplus this year (as can be seen in Figure 2). In other words, EMs have essentially gone from being net borrowers of global capital from the world, to net lenders. EM (ex-China) current accounts were in a deficit of 1% of GDP in mid-2013 as Fed tapering discussions began, in May they were in a surplus of 1.0% of GDP. Terms of trade (export relative to import prices) have also improved rapidly in favour of many EMs this year, a trend that has continued since the election (see Figure 3).

“... aggregate EM current account balances (excluding China) to move into a surplus this year”

Figure 2: EM current accounts have recovered materially from their lows

Source: Bloomberg, Haver, Investec Asset Management November 16. Countries covered: Chile, Colombia, Hungary, India, Indonesia, Israel, Korea, Malaysia, Philippines, Poland, Romania, Singapore, Thailand, Brazil, Czech Republic, Mexico, Russia, Turkey, South Africa

Figure 3: EM terms of trade have improved significantly

Source: Investec Asset Management, Bloomberg as at 15.11.16.

Thirdly, EM bonds and currencies do not appear overvalued given the extent of the sell-off in recent years, and investor positioning is generally light. GBI-EM real interest rates are at 2.9%, a differential of 3.7% vs developed markets after post-election yield increases (Figure 4). This differential was less than 2% in late 2012. On the currency side, the gap between GBI-EM currencies and their terms-of-trade is the largest since the 2008 global financial crisis.

“Emerging market bonds and currencies do not appear overvalued”

Figure 4: Historically wide real yield differential is providing a solid valuation buffer in support of EM

Source: Haver analytics as at 31.10.16. EM Weighted by GBI-EM Global Diversified Weights excluding Romania, DM includes US, Japan, UK, Germany, France, Italy, Canada, Australia, weighted by the Barclays Global Treasuries Index weights. Real yields calculated as 5-year nominal rate less 1-2 year forward expected inflation.

A final point in favour of EM resilience is political. The Trump election victory has followed close on the heels of Brexit, which was also arguably linked to protectionist and less market-friendly politics. However, in EM we have noticed a sharply different trend. While there have been some negative developments in Turkey and the Philippines, political developments in South Africa and Latin America have been strongly positive. In some cases, such as Brazil and Argentina, we now see some of the most competent, technocratic administrations globally.

“Political developments in South Africa and Latin America have been strongly positive”

So what about the risks we are seeing?

US Treasury yields and rising US interest rates

Since the election outcome and – more importantly – Trump’s acceptance speech, we have seen an aggressive repricing of US Treasuries as investors factored in higher inflation due partly to the likelihood of an increase in infrastructure spending and tax cuts.

While it is likely both will become core policy objectives, we believe the market has been far too aggressive not only in the realistic scale of this fiscal policy, but also the ease with which policies will be passed through both houses of Congress. At best, we will only see the impact of a fiscal deal in the 2018 budget. It is also very difficult to get a feel for how big any deal will be. Given traditional Republicans’ hostility to increased government spending, any infrastructure expenditure will likely have to be met with increased revenue (perhaps through extra revenue on the back of a deal to encourage income repatriation from abroad).

“Trump’s pro-growth policy pipeline faces a number of political hurdles”

Growth and economic conditions in the US have been on a gradual upward trend for some time, and the potential for tax cuts and a rollback in regulation only reinforces this. Admittedly, if we see a meaningful pickup in nominal US growth, sustained rise in wages and tighter employment market the Fed will most likely increase interest rates faster than was initially anticipated. Although, since the global bond rout we have seen a sharp rise in the US dollar (as measured by a basket of currencies) – a symptom of speculation of aggressive US Federal Reserve rate hiking. This in itself, will place tightening pressure on US financial conditions and threaten the very modest US economic recovery. Needless to say, we believe the increase in US Treasury yields to date is not consistent with any rapid pickup in US economic activity. Trump’s pro-growth policy pipeline faces a number of political hurdles, not to mention he won’t even step into the Oval office until early next year. Even the most aggressive economist’s views factor in above-trend growth only returning during 2019, so the scale of rising US Treasuries seems overly optimistic for growth.

Protectionist drift is real but far from a disaster

In contrast to a fiscal demand shock, the risks from Trump’s supposed trade policies would represent a negative supply shock for some countries’ exports. But similar to fiscal policy, we have little insight into how far Mr Trump is prepared to go.

Trump’s talk on the campaign trail of 35% and 40% tariffs on Mexico and China respectively are highly unlikely to be enacted. Such a move could only conceivably happen under a full scale trade war that would hurt the very people that elected him in the first place. Nonetheless, it would be naïve to think that Mr Trump’s campaign rhetoric was just empty bluster – he will almost certainly take some measures to show his voter base that he is taking action to make global trade ‘fairer’ for the US. And unlike fiscal policy, Trump faces little direct constraint from Congress on trade and can in theory take action from day one. A US President has considerable power through executive order to cancel or renegotiate trade agreements without necessarily the consent of Congress.

Our base case is that he will follow through with promises to order a renegotiation of the North American Free Trade Agreement (NAFTA). However, we do not expect Trump to pull-out of NAFTA; the economic risks of doing so would waste considerable political capital. Rather we expect Trump – a man who prides himself on business negotiations – to strike a modestly ‘better’ deal for the US and reduce further manufacturing foreign direct investment flows into Mexico from US companies. On China, we also expect some action. While the criteria for labelling a country a currency manipulator have tightened somewhat, it should be fairly straightforward for Trump to ensure China is labelled a currency manipulator – this will allow some action over time (e.g. further world trade organisation tariff cases) but the immediate impact would be modest. Beyond that, China also has a reasonably strong hand in discussions; in addition to retaliatory trade measures the Chinese have two credible deterrents: the threat of letting its currency devalue through free float and/or selling some of its US$1.2 trillion US Treasury holdings. The most interesting approach the administration might take with Asia is to insist on much greater efforts to open those economies to US imports, an area in which the US has considerable grounds to demand action.

“It should be fairly straightforward for Trump to ensure China is labelled a currency manipulator”

Aside from these two specifically targeted countries, we see an increased likelihood of the US pursuing more stringent anti-dumping measures and possible countervailing duties (i.e. tariffs). This would be a headwind for global trade, but it wouldn’t be a disaster. Indeed it would be in keeping with the trend of global trade growth matching global GDP growth – we expect that the era of rapid increases in globalised trade is in any case behind us.

What does this all mean for emerging markets?

Firstly, while a fiscally-induced increase in demand and a trade supply shock will have an opposite impact on US domestic growth, both may put upward pressure on longer-term inflation. Nonetheless, we stress that it remains to be seen with what ease and to what scale these will be enacted. While ongoing speculation may place upward pressure on US Treasuries in the short term, we expect yields to normalise over the coming weeks and assist in returning liquidity to EMs. Also, above-trend US growth over the longer term is by no means a market wide negative for EM. The prospect of increased infrastructure spending could easily translate into higher commodity prices and promote already strong EM terms of trade.

If we see a sustained devaluation in EM currencies (which we feel is unlikely) then we will likely see some moderation in the reasonably strong disinflationary momentum across EMs. Nevertheless, some of our biggest markets, such as Brazil and Russia, should have sufficient disinflation to continue cutting rates through to 2017. The notable exception is Mexico, where the central bank will likely have to hike rates to provide some support for the peso.

While there is little upside to the Trump’s trade agenda for EMs, we have seen some toning down of anti-trade rhetoric since being elected. Moreover, any drastic change to trade agreements would be generally more harmful for the US economy (at least initially) as the practicalities of a lack of skilled labour and infrastructure will complicate any resurgence of US manufacturing. As a result and because of Trump’s ‘deal-making’ image, we think any trade negotiations will be watered down and take much longer to put in place than is currently being anticipated.


We believe the scale of the EM debt sell-off since the election was exacerbated by short-term market illiquidity and some excess positioning. There will be inevitable winners and losers of a Trump presidency, but this does not undermine the thesis for investing in the asset class as a whole. EM debt enjoys a strong valuation buffer relative to developed markets (with real yields becoming even more compelling), and currency valuations have not fully recovered from a three year bear market. The recent weakness only strengthens this argument. We believe the short-term market dislocations have created interesting investment opportunities. More broadly the case for active management within this asset class is likely stronger now than at any time over the last five years.

“The case for active management within this asset class is stronger now than at any time over the last five years”

Emerging Market Corporate Debt

Emerging Market Corporate Debt Outlook

By Victoria Harling

At a glance

  • We believe the recent volatility in the asset class has provided medium-to-long-term investors an attractive entry point into the market
  • Emerging market (EM) credit fundamentals have improved significantly from recent periods of market stress
  • The changing political administration in the US has implications for EMs, although in our eyes the risks are very manageable
  • Market dislocation has created an excellent environment for active management in this asset class

The importance of timing…

It takes a great deal of intuition, research, skill and quite simply luck to perfectly time your entry into any new investment. As we have consistently communicated to our existing and prospective clients, we believe a yield between 5.5-6.0% is an attractive entry point into EM corporate debt. The current yield on the portfolio is 6.1% (as at 23/11/16).

The asset class enjoys comparatively low duration risk (compared to the EMBI1 and US IG indices2 ), a diversified investment universe, and improving debt metrics. We continue to build our portfolio from the bottom up, and position ourselves in the market where we see value irrespective of the concentration of the index. Below we aim to inform you of the risks, opportunities and our current view of the world under President-Elect Donald Trump.

Characteristics of our investment universe and companies progress through the credit cycle

In our view, the resilience, diversity and overall financial health of our asset class is often underappreciated. Our investment universe consists of 536 companies3, across 12 sectors and 51 countries, meaning we have a wide playing field when selecting attractive investment opportunities. Also, a number of our investable companies are attractively priced multinational corporations, which generate revenue from multiple jurisdictions.

A key part of our analysis is looking at where different regions are in the credit cycle. As shown by Figure 1, a credit cycle references the full rotation companies go through when accessing credit. A downward trend reflects a tightening in credit conditions, usually associated with rising interest rates, stricter lending standards and lack of credit availability. While in a rising trend, interest rates are generally falling and credit is usually easier to obtain.

After a prolonged period of deterioration, we are finally starting to see Latin American companies (in general) approach the bottom of their credit cycle. We believe they will actually start to improve towards the latter half of next year. Meanwhile, the Asian region is currently at its peak and could stay there for some time given its strong economic growth, although inevitably we believe it will begin deteriorating as it grapples with high indebtedness and tightening credit standards. With valuations much more attractive in Latin America, we believe we are being well compensated for the risks relative to Asia.

Figure 1: Emerging market regional credit cycle trend

Source: Investec Asset Management, December 2016

Default rate trends are a real and important consideration for any credit investor. In EM, we have witnessed a modest increase in the high yield default rates since July 2014 (as shown by Figure 2), which partly reflects the average point of EM companies in the credit cycle and their gradual increase in indebtedness. While admittedly leverage has increased, it still remains very manageable in a historical context and relative to developed markets (DM). Also, importantly EM companies generally have just as good, if not more, access to bank loans and other sources of private funding compared with corporations in DM. We therefore believe refinancing risks should be fairly well contained over the coming 12 months.

Figure 2: Developed and emerging market high yield default rates

Source: BofA-ML, Bloomberg, 31 October 2016

What are the key risks of a Trump presidency?

The key risks, in our minds, are the prospect of faster-than-expected US nominal growth driving up US Treasury yields and the incoming US administration adopting a severe protectionist bias. Both risks are clearly front of mind, although we believe the aggressive market repricing post the election outcome is currently overcompensating investors for the added risks. In addition, postelection President-elect Trump has softened his stance on some promises made on the campaign trail which suggests some of his most feared policies may not materialise or will be watered down.

Threat and impact of rising US Treasury yields

The election outcome has clearly increased the likelihood of a pickup in infrastructure expenditure and implementation of tax cuts, which will likely place upward pressure on US growth. However, the extent that both policies will be enacted and their impact on US growth is noticeably less clear. Therefore, we consider the swift rise in US Treasury yields to be overly optimistic for US growth, inflation and the ultimate reaction from the US Federal Reserve (Fed).

Republican administrations traditionally exert significant resistance to any increase in infrastructure expenditure, especially if it cannot be justified by any supplementary rise in fiscal revenue. Even if we get a deal through both houses of Congress next year, it will likely only come into effect during the 2018 budget. Furthermore, the Republican-controlled Congress will likely insist on the Government expanding its revenue net and/or reducing expenditure elsewhere in the economy, which would dilute the impact of any policy shift on growth.

Despite the complications, if we see a meaningful pickup in US nominal growth, sustained rise in wages and tighter employment market we will likely see US interest rates increase faster than initially anticipated. That said, the swift rise in US Treasury yields and adjustment of interest rate expectations post the election outcome have both prompted a significant rise in the value of the US dollar (relative to a basket of currencies). This in itself will immediately place tightening pressure on US financial conditions and threaten the short-term economic growth recovery. With the bulk of Trump’s policies only likely to be enforced during 2018, we question just how quickly the Fed will likely want to increase rates.

US protectionist shift

It would be foolish to think Trump will not seek to pursue any renegotiation in US trade policy, given it was a key priority for his voter base. Nevertheless, we don’t believe a full-scale revocation of the North American Free Trade Agreement (NAFTA) is likely, although we do think Asia will be pressed to open up its market and trade more openly with the US after a prolonged period of unbalanced trade policy.

The economic risks of the US revoking its NAFTA membership would be significant, not just for Mexico, but also the US itself. The US simply does not have the skilled labour and/or the level of infrastructure to warrant a mass return of manufacturing in the immediate future. Furthermore, if there was a significant imposition of tariffs on Mexican imports (as was suggested on the campaign trail), working-class discretionary incomes would be among the hardest hit as import costs surge. Although, we do think Trump will seek to renegotiate terms in the free trade agreement to strike a somewhat better deal for the US, and attempt to stem the flow of capital into Mexico from US companies. Our feedback from companies with businesses in Mexico is that labour costs remain competitive enough to absorb higher tariffs, and that businesses make strategic decisions on factory and distribution locations over 10-15 years, rather than a four year presidential term. Hence any changes are likely to be relatively gradual.

However, we do expect a somewhat harsher stance with Chinese trade negotiations, whose trade relationship with the US has arguably been tilted in its favour for some time. Trump could easily label China a currency manipulator – which would allow some action over time (e.g. further world trade organisation tariff cases) but the immediate impact would be much more modest. Despite China’s reasonably strong hand in negotiations, we still expect the incoming administration to rightly pursue a strategy of opening up closed Asian economies to US exports, although we don’t believe this would be a disaster for international free trade.

Market volatility is creating abundant opportunities in emerging market corporate debt

The swift rise in US Treasury yields and ultimate dry up in liquidity post the election outcome is at least partly distorting prices within this asset class, and is creating an exceptional environment for active managers. So far, we have seen longer-dated and highly rated bonds materially lag their peers in DM, and we simply don’t think this is sustainable in the long term. Also, in Latin America, and particularly Mexico, spreads have widened significantly as the market priced in a hard-line stance against Mexico and its implications for the economy.

As we have consistently communicated to clients, we feel this asset class offers investors exposure to a comparatively high yielding (relative to DM) and reasonably diversified investment proposition with lower duration risks than peers within EM. We follow a disciplined bottom up investment process, and the composition of the index will not dictate the positioning of our portfolio. The current environment is no doubt challenging, although we are excited for the period ahead and wish our clients well for the upcoming year.

1 JP Morgan EMBI Index – proxy for EM hard currency sovereign (government) bonds
2 BoAML US Investment Grade Index - proxy for US IG corporate bonds 
3 As at 31/10/16

Africa Fixed Income

Africa Fixed Income Outlook

By Antoon De Klerk and Andre Roux

At a glance

  • Africa’s current economic performance is characterised by a high degree of diversification
  • Non-commodity producers continue to register decent economic growth numbers
  • Reform – often associated with the presence of IMF programmes – is a strong theme on the continent and will have important implications for investors
  • Dealing with devaluations: risks and opportunities in the face of uncertainty
  • High yields and lack of foreign ownership partially protect African fixed income from rising US interest rates
  • Africa fixed income continues to be an attractive source of uncorrelated return within a global context

Attractive opportunities in African fixed income

The African fixed income market offers a diversifying and potentially rewarding opportunity for long-term investors. African bonds and currencies enjoy high yields, low correlations with conventional fixed income markets (both developed and emerging), very manageable duration risks and a great opportunity for active managers with resources on the ground. Within African debt and currency, strong returns are definitely on offer, although we strive to manage money in a risk-controlled manner to protect your capital. Below we look to inform you of the opportunities and themes we are currently seeing in the region over the coming year.

“African bonds and currencies offer a great opportunity for active managers with resources on the ground”

African bond and currency markets

US$440bn market cap, 12% yield, 21 countries and three years duration1

Source: Investec Asset Management, as at March 2016.

Strong economic reform pipeline

Encouragingly, a number of African countries are undertaking reform programmes and are leveraging off the resources within the International Monetary Fund (IMF). The IMF has been important in promoting sustainable economic development by encouraging countries to abolish inefficient practices that weigh on the economy and ultimately the government’s finances. This poses an interesting proposition for African investors, with asset prices tending to react positively to successful reforms.

Investors in Ghana have been handsomely rewarded for the reform package being driven by the Ghanaian authorities, with both the Ghanaian cedi and its dollar bonds among the top year-to-date performers globally. Ghana has enjoyed an improving fiscal situation, lower inflation trend and a reduction in refinance risk that have all been partly driven by the country’s successful reform programme.

Zambia is now showing tentative signs of following a similar path as it holds ongoing discussions with the IMF. So far, talks have been encouraging, with the recently elected government publicly acknowledging its willingness to accept financing in exchange for agreeing to the IMF’s terms. With yields on short maturity Zambian dollar debt above 10% (as at 31 October 2016), this is somewhat enticing, although we will continue to monitor the situation closely.

More than just a commodity story

In certain African markets, such as Nigeria, Zambia and Angola, commodities are an important investment consideration. The commodity downturn and overreliance of some countries on commodity-sourced revenues has created challenges for these countries. Importantly for us, Africa provides access to a diversified group of both oil and hard commodity importers and exporters, which allows us to diversify and limit our commodity risk within this strategy.

“Africa provides access to a diversified group of both oil and hard commodity importers and exporters”

So far this year we have seen a change in fortune for a number of hard commodities. In our view, this has not been fully reflected in some African countries’ economic growth forecasts and is now starting to turn from a growth drag to a mild tailwind. Nevertheless, the recovery in commodities thus far is still insufficient for some countries, notably Nigeria, Angola and Mozambique, where we currently have no positions.

Our commodity outlook is now more constructive than it has been over the last few years. Nevertheless, we are not in the business of allocating capital based on binary outcomes. Therefore we are looking to invest into countries that have a more diverse investment case.

Rising US interest rates: implications for Africa

The path the US Federal Reserve (Fed) follows in its interest rate tightening is obviously important for the asset class, although it typically has much less impact on African fixed income. Yields on local African fixed income markets are predominantly driven by domestic, rather than global dynamics. This is in part due to foreign ownership of African debt and currencies being much lower than any other region, which further dilutes the long-term impact of developed market monetary policy.

“High interest rates and slowing inflation creates a compelling entry point for prospective investors in some African countries”

We believe the historically high sensitivity of conventional developed market and emerging market debt strategies to US interest rates presents a great opportunity for African fixed income investors. Our strategy has typically had a very low correlation and sensitivity with developed market global fixed income strategies, as shown in Figure 1, which allows you to truly diversify the fixed income component of your portfolio.

In 2015 a number of African nations significantly increased interest rates to help insulate their economies from a stronger US dollar, lower commodity prices, regional food shortages and energy outages. In our view, high interest rates and slowing inflation creates a compelling entry point for prospective investors in some African countries, especially those which are currently in the process of implementing economic reform programmes.

Figure 1: Our strategy’s historical beta with the Barclays Global Aggregate Index (a proxy for global bond markets)

Source: Bloomberg, Concerto, JPMorgan, and IAM calculations, as at 30.09.16.

The risks and opportunities of currency devaluations

So far in 2016, we have seen two high-profile African currency devaluations in Egypt and Nigeria. Both countries could no longer justify defending their currency peg with insufficient foreign currency reserves and bleak economic conditions. Currency devaluations can be painful for investors in Africa, but their recovery can also be very rewarding, depending on timing. We mostly access currencies through non-deliverable forwards, designed to mitigate convertibility risks when converting back to hard currencies.

The devaluation of the Egyptian pound and Nigerian naira is no doubt a positive step for both countries’ economies. Nevertheless, we feel the naira needs to devalue further to have a meaningful impact on foreign investment. Meanwhile, Egyptian authorities recently announced a free float of its currency, and while execution remains key, initial indications are positive.

“We have tended to stand on the side-line until prices become dislocated enough to reward investors”

In terms of managing our portfolio in the face of these type of events, we have tended to stand on the side-line until prices become dislocated enough to reward investors willing to look through the market noise. We have benefited from this strategy over last year by being tactically short the Nigerian naira and Egyptian pound at certain points. We will continue to watch closely the situation in both countries. In Nigeria, we will be looking for a level which would enable the country to finance its current fiscal deficit and also lower currency volatility, before we would consider taking a long position in the currency. Meanwhile in Egypt, we are looking to initiate a position in the pound as further devaluation risk has been minimised and black market exchange rate differences have converged. We also expect foreign direct investment will react positively to a lower exchange rate.

Investing in Africa for 2017

“If the risks outweigh our perceived benefits, we simply won’t invest”

We believe this strategy provides access to attractive long-term returns that have a relatively low correlation with traditional fixed income strategies. By their nature, African capital markets tend to be reasonably volatile from a holistic perspective, therefore we think it makes sense to adopt a completely benchmark agnostic total return investment style. We will continue to focus on investments that we think will deliver positive absolute returns. If the risks outweigh our perceived benefits, we simply won’t invest. We believe we have the necessary resources to conduct thorough and thoughtful research into this region, which we believe puts us at a distinct advantage to some competitors.

1 As at 31.10.16

Global Natural Resources


Global Natural Resources Outlook

By Tom Nelson

At a glance

  • Commodity prices will be less correlated to each other than they have been in prior cycles. Supply and demand trends in individual commodities are different, and changing fast
  • Supply will continue to be a more important driver than demand, as it has been in 2016. This also means that commodity prices are less sensitive to economic cycles, which is why they could see growth in a low growth world
  • Equity over commodity: companies are still cutting costs, selling assets and focusing on returns rather than growth
  • ESG and climate change. The focus on this sector will only intensify from here. Companies need to be transparent about carbon, co-operative with shareholders, and act as responsible asset owners
“Things take longer to happen than you think they will, and then they happen faster than you thought they could.” Professor Rudi Dornbusch, MIT economist

Less correlation equals opportunity

2016 has been a better year for commodity prices. Many of the key physical commodity prices have moved higher (crude oil, iron ore, coal, gold), which has driven outperformance from natural resource equities and improved confidence in the sector. One thing that has become clear is that commodity prices have become less correlated and we believe this will present investment opportunities in the coming year for the specialist investor.

“Commodity prices have become less correlated and we believe this will present investment opportunities in the coming year”

There are many drivers at play, which have led to sharp changes in the individual market fundamentals of commodities:

- Government enforced supply cuts, including Opec
- De-leveraging and cost reduction
- Investment vacuums due to periods of ‘lower for longer’ commodity prices
- Demand dynamics
- Consolidation through M&A
- Disruptive weather patterns

One recurring characteristic is the linkage between supply reductions and commodity price appreciation. Zinc and coal are the clearest examples of this over the course of the year, while crude oil has seen the most recent supply related price activity following the Opec meeting in late November.

Figure 1: Positions of key mined/extracted commodities in the fundamental cycle – arrow shows two-year progression

Source: Macquarie Research, September 2016

Commodity producers have done a lot to help themselves. Cost-cutting, reduced investment, asset disposals, debt reduction and a clear focus on returns rather than growth have enabled companies to capitalise on a more supportive backdrop than we saw in 2015. Looking into 2017, we expect more of the same. Commodity prices will continue to be driven more by supply than demand, which will lead to continued variability within the commodity complex. The ‘value over volume’ mantra will continue to drive improved cashflow and profitability at a company level.

Within our portfolios, we seek to identify companies which benefit from both improving commodity fundamentals and ‘self-help’. These companies are battle-hardened, right-sized for a lower growth world, and have the financial flexibility to withstand the inevitable macro uncertainty.

In terms of specific commodities where we see improving fundamentals in 2017, we highlight crude oil, gold and copper – exactly as we did at the end of 2015!

We will take a more in-depth look at the crude oil story and how the shifting supply dynamics have the potential to drive future prices. Since Opec, primarily Saudi Arabia, surprised the world in October 2014 by abandoning its role as oil market moderator, the market lost all confidence in Opec’s willingness and ability to intervene and support prices. Opec’s intention to protect market share resulted in increased production into an over-supplied market: in other words, ‘volume over value’, rather than ‘value over volume’. This now appears to have been reversed, starting with the meeting in Algiers in late September, and cemented by the Vienna meeting on 30 November. As a reminder, the meeting concluded with an agreement to reduce production by 1.2 million bl/day, the first formal cut to production since the global financial crisis. The cut is effective from January 2017, with a review meeting to be held in late May. This agreement has restored cohesion within Opec, and is an interesting signal that regional tensions in the Middle East can be overcome when objectives are aligned. The addition of potential production cuts from non-Opec countries is also important, particularly from Russia, which has delivered strong growth recently. There is a risk that the agreement with non-Opec producers is not finalised, and that compliance with agreed cuts is weak, however the quantum of the cuts is significantly greater than we calculate is needed to balance the market.

“The quantum of the cuts is significantly greater than we calculate is needed to balance the market”

Of course, the natural question to ask is why this apparent policy reversal has come about and what will it mean for the sector?

  • First, the data suggests the main producers are struggling to maintain investment at recent oil price levels and are producing at close to maximum – in some cases, at rates they are uncomfortable sustaining
  • Second, maintaining low oil prices was becoming self-defeating as it was causing excessive financial pain to Saudi Arabia and other central Opec players
  • Third, the sale of a stake in Saudi Aramco via an IPO was likely a motivating factor in Saudi Arabia doing everything it could to create an agreement; and looking longer term, as the new regime in Saudi Arabia has been endeavouring to do, there is a chance the Kingdom is pre-empting a future price spike

We believe Opec knows that if oil prices do not recover relatively quickly to US$60/bl, investment levels will be insufficient to balance the market in the future. The US shale industry was more innovative and resilient than expected.

On the demand side, 2016 looks likely to see demand growth of 1.2-1.4m bl/d – in line with the 20-year trend on a percentage basis. Of course, the demand outlook for oil is changing too. The outlook for global oil is best defined by a tension between growing population consumption and transportation on the one hand and fuel efficiency, electric vehicles and climate change on the other. Oil demand continues to grow at over 1% per year, led by gasoline demand and the developing world (India accelerating while China slows) but it seems logical that over the next 20 years there will be a transition away from the Internal Combustion Engine (ICE). The speed of the transition is difficult to predict: while it is tempting to bet on the unstoppable force of human ingenuity and scientific progress (electricity storage, battery technology), we do not underestimate the immovable object of man’s love affair with the ICE. It is telling that the debate has shifted from peak oil supply to peak demand in less than ten years but we would not be surprised to see oil demand continuing to grow until 2025-2030, with transportation demand the hardest to displace. In the near-term, we do not expect the adoption of electric vehicles to be rapid enough to displace oil demand within five years.

It is not only in the oil market that we have seen 2016 supply moderation. Below is a table of year-on-year supply reduction in certain metals. The correlation with recent price growth in metals, such as coal and zinc, is clear.

Figure 2: Expected supply growth, 2016

Source: Wood Mackenzie, Macquarie Research, September 2016.

Opportunity in equities over commodities


We believe that 2016 marked the bottom of this cycle for commodity prices and corporate profitability in the sector. Heavy de-stocking of physical commodities and panic around balance sheets at the end of 2015 saw capitulation by many equity-holders, exacerbated by a wave of short-selling. It appears this period of low prices has seen miners re-emerge with a new ‘value-over-volume’ philosophy, particularly in Chinese production. After nearly a decade of massive volume growth in response to China’s demand surge, the last few years have seen metal markets struggling to rebalance. Companies have tried to restructure operations through widespread cost-cutting, asset disposals and focusing on costs and capital spend rather than just driving volumes.

“We believe equities will outperform the underlying commodities for the next phase of the cycle”

This change in strategy by many mining companies is a sign we are moving to the next stage of the cycle when profits normalise and volatility subsides. If we are correct in our view that efficiency and productivity improvements will continue to drive earnings and returns growth, then even at current commodity prices, we have potential upside to many equities. For this reason we believe equities will outperform the underlying commodities for the next phase of the cycle. For example, we see good opportunities in gold equities and believe a well-constructed portfolio of gold equities should also offer better returns than physical gold in the current environment, without foregoing the defensive qualities which gold offers.


“We are confident that we have seen the bottom of the cycle in the oil market”

We are confident that we have seen the bottom of the cycle in the oil market. Most importantly, the oil price crash has caused a re-evaluation of oil company strategies, just as we saw in the mining sector starting earlier in the decade. In the last cycle, oil companies chased production growth which led to escalating costs, poor project delivery and deteriorating returns – even with significantly higher oil prices. The industry needed to control costs, improve efficiency and allocate capital correctly. We believe that the ‘value-over-volume’ mantra should improve return on capital (ROC), dividend pay outs and total shareholder return over the next cycle. We continue to look to the tobacco sector 1999-2016 as an interesting case study for improving profitability and tremendous shareholder returns in a sector which faced similar structural challenges in terms of demand substitution, regulatory intervention and taxation. Could ‘big oil’ follow ‘big tobacco’s, lead?


We have previously noted that the agriculture sector contains companies that can perform well without rising prices for bulk grain commodities. We are positioned more towards recipients of these commodities rather than input providers, given our current lower crop price outlook. However, we stand ready to re-align the portfolio towards beneficiaries of increasing grain prices as soon as fundamentals start to improve for corn, soybeans and wheat. Another area which we believe will continue to drive returns is the salmon-farming industry. We saw evidence of strong margin growth in 2016 and the best-in-class Norwegian producers have worked hard to get their cost inflation under control. We believe further price and margin gains will be realised into 2017.

Environmental, social and governance (ESG)

“We are acutely aware of our responsibility as shareholders in the commodity and natural resources sector”

We are acutely aware of our responsibility as shareholders in the commodity and natural resources sector. The focus on climate change and other ESG issues will only intensify from here. Companies need to be transparent about carbon, co-operate with shareholders and act as responsible asset owners. There is an economic risk of value destruction through stranding of assets, and there is risk of damage to the environment through carbon emissions. The two are clearly linked. As a result, understanding and quantifying ESG risk is a key part of fundamental stock analysis. We use a combination of our own proprietary inputs, based on our in-depth knowledge of the companies and MSCI ESG scores. Most importantly, we believe that ESG analysis in this sector must be fully embedded in the equity analysis, rather than as a separate procedure.

Major risks for 2017

US policy

Given the lack of clarity around the new US administration’s policy, investors will inevitably approach 2017 with caution. Furthermore, with two populist election results in 2016 and three major European elections in 2017, investors may reasonably expect more of the same. We expect a protectionist agenda from President Trump alongside support for US ‘old industry’ sectors. This should help the energy and mining sectors. We could also see dollar weakness, which may support commodity prices. However, at a geopolitical level there is widespread risk and US relations with Russia, China and the Middle East will change in 2017.

Ill-discipline within Opec

The market will remain healthily skeptical about Opec cuts until it sees physical evidence of reduced production levels. Imports of oil into the US and OECD oil inventory levels will remain under close scrutiny. If Opec member countries do not adhere to the new production levels, this will have a compounding negative effect: the supply reduction will be delayed, the credibility of the group will be further damaged, and their ability to enact a cut in the future will also be reduced.

China slowdown

Chinese fixed asset investment (FAI) strengthened in 2016, compared to 2015, which aided the supply-led recovery in metals prices, particularly in the second half of the year. Given the importance of China for metals demand, a significant slowdown in China FAI in 2017 would put pressure on metals prices and negatively affect mining company profitability.

Global Real Estate Securities

Global Real Estate Securities Outlook

By Peter Clark and Alex Moss

At a glance

  • Listed real estate looks set to have a high profile year, as it has become a separate Global Industry Classification Standard (GICS) sector* within equities, which should attract more attention and potentially flows
  • As capital growth moderates, the 2016 trend of income becoming a more significant component of absolute returns should strengthen. Likewise, the attractive yield on offer and concerns over bond valuations draw investors to the sector
  • The transformation of certain parts of the economy towards internet shopping and cloud usage is driving rental growth in selected areas, such as logistics and data centres

Listed real estate strikes out on its own

The separation of listed real estate as a separate index sector group will reverberate through at least the first half of 2017. This could also have long-range consequences for the sector, while potentially stimulating investor interest.

Real estate became a separate sector in the GICS Index in September 2016, becoming the 11th sector and the first to be carved out of the original groupings. The new sector includes REITs, real estate management companies and development companies, but has excluded mortgage REITs, which have remained within the financial sector. It is of a similar size to the telecommunications services and utilities sectors, as shown in Figure 1.

Figure 1: GICS sector weights

Financials (ex Real Estate) 16.3% Energy 6.6%
Technology 15.3% Materials 5.0%
Consumer Discretionary 12.5% Telecom Services 3.9%
Healthcare 12.4% Real Estate 3.5%
Consumer Staples 10.6% Utilities 3.5%
Industrials 10.3%
Financials (ex Real Estate) 16.3%
Technology 15.3%
Consumer Discretionary 12.5%
Healthcare 12.4%
Consumer Staples 10.6%
Industrials 10.3%
Energy 6.6%
Materials 5.0%
Telecom Services 3.9%
Real Estate 3.5%
Utilities 3.5%

Source: MSCI, as at 30.09.16.

REITs dominate the global real estate sector which reflects their dominance in the US and the high weight of the US in the global index. REITs are companies which own and operate incomeproducing real estate assets. They first emerged as an investment vehicle in the US with the passage of the Real Estate Investment Trust Act in 1960 and now exist in various forms in more than 37 countries.

Income: attractive yields finding favour

Going into the new year, income will become a much more significant component of the total return for the global listed real estate sector. This should continue to attract investors to the sector as global macroeconomic uncertainty has led to a preference for long term stable cashflows and dividend yield. The ongoing low interest rate situation, combined with concern over bond valuations bolsters the attractiveness of allocating to the sector. Figures 2 and 3 show just how attractive the yield has become, one that may continue well into 2017 if not longer.

Figure 2: Long term global premium to bonds

Source: Investec Asset Management, Bloomberg. Global real estate securities represented by FTSE EPRA/NAREIT Developed Index, which is designed to represent general trends in eligible real estate equities worldwide. Global bond yields represented by Bloomberg Barclays Global Treasury 7-10 year yield.
As at 30.09.16.

Figure 3: Current country premia to bonds

Past performance should not be taken as a guide to the future, losses may be made. Bond yields from tab on bond market correlations. Source: Investec Asset Management, 30.09.16.

Income yield, in combination with growth are two components of returns which we believe will underpin return in the year to come. In addition these components are generally less volatile and Easier to predict. Figure 4 shows the consensus growth forecasts of global listed real estate markets using three common metrics, namely dividend growth, NAV growth (growth in asset value), and earnings growth. We can see that for developed markets as a whole, growth forecasts remain robust and provide an attractive underpin to returns. Looking at the UK market, we can see that despite the fall in capital values, due in part to Brexit, an attractive income growth profile is underpinned by contractual rental income.

Figure 4: Consensus growth forecasts of global listed real estate markets

Source: Investec Asset Management & consensus estimates, 30.09.16. *United States NAV growth only for 1 year based on data availability.

Tech disruption offers opportunities

The disruptive impact of innovation is becoming more apparent and will only strengthen going into next year, with particular impact on data centres, logistics facilities and mobile phone towers (e.g. vertical real estate). These sectors will continue to benefit from radical repositioning of the economy towards internet sales and the penetration of cloud usage. Logistics is a particularly attractive area with signs of solid rental growth. On the flip side of this are cyclical sectors, such as office space, which are suffering from oversupply and potentially becoming obsolete as the economy adapts.

*The Global Industry Classification Standard (GICS) is a standardized classification system for equities developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor's.

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Global Credit Jeff Boswell & Garland Hansmann Download PDF
Emerging Market Fixed Income Peter Eerdmans, Werner Gey van Pittius, Mike Hugman Download PDF
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Global Natural Resources Tom Nelson Download PDF
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