9 November 2016
9 November 2016
Towards the end of the third quarter we reduced the portfolio’s duration (interest rate sensitivity) on both valuation grounds, as we hit target yield levels for key positions in Canada, but also a changing environment for quantitative easing policies. At the same time we raised cash by selling equities in Europe and US through futures to reduce overall portfolio risk. Coming into this quarter we reduced duration further removing a position in South Korean 10-year government bonds and reducing Australian government bond exposure.
More recently, with the increasing risk of Trump winning we added to our equity hedges, and adding back into duration exposure. We considered buying equity options, however, implied volatility of equities has increased by significantly more than can be explained by movements in underlying equity prices (realised volatility) in the run up to the US election, demonstrated by a sharp increase in the VIX index despite a comparatively small decline in the S&P500 index.
The portfolio’s position in gold is viewed as a further hedge as well as hedges in place through the North Asian currencies such as the Korean won, Taiwan dollar and New Zealand dollar which have been added to since quarter end. We also hedged back our exposure to the Russian rouble and South African rand which are associated with our Emerging Market (EM) ex Asia basket, while not changing the underlying equities and retaining India and Indonesia as outright long EM currency positions.
It is still unclear what president Trump might actually implement and how much support Congress will have for his plans. The system is designed for compromise and agreement, and even with Trump in the White House it is possible that his own party may not cooperate, particularly with some of his more radical ideas. However, he would likely get support for his policies on lowering personal and corporate income tax and this is supportive in the medium term for equity markets. Our underlying market views, supported from both the top down and the bottom up, are quite positive towards growth-orientated assets, and cautious towards duration. This reflects evidence that the global economy appears to be moving into a period of better real (excluding inflation) and nominal growth, with reasonable value in many Growth assets, but a risk of some further repricing lower in government bond prices. As such our plan is to use current market weakness to re-risk the portfolio through our preferred areas and those most impacted beyond what the underlying fundamentals would suggest.
The Diversified Income / Global Multi-Asset Income strategy aims to deliver a defensive return profile. As a consequence, the strategy tends to be risk averse, with a strong focus on downside risk management. Strategically, our portfolios have a modest growth asset bias with a lower than normal interest rate risk, within the constraints of a conservative overall targeted level of risk. Clearly, this bias was seen as more likely to do well following a Clinton win.
In response to narrowing polls, we added a small number of tactical hedges on top of our strategic positioning to reduce risk modestly ahead of the election and provide downside risk protection in the event of a Trump presidency. These hedges included a sale of equity futures, reducing our net equity exposure; and short positions (benefiting from a fall in value) in a basket of vulnerable Asian currencies. As we moved closer to election day, the risk of Trump winning rose. Subsequently, we increased these hedges, this included selling additional equity futures (reducing our net equity exposure further), adding interest rate risk through US Treasury futures, and buying a small amount of Japanese yen and Swiss francs in addition to closing our modest Canadian dollar exposure. Overall, these hedges had the effect of taking down our expected risk, estimated by our risk systems, by about a quarter. We chose to do no more, as we had done ahead of Brexit, because a victory for Trump still remained an outside risk, rather than closer to 50/50, as the Brexit polls had been.
Our view is that there are parallels between Trump and Brexit, with a likely initial shock being followed by a more mixed reaction, as it is still unclear what president Trump might actually implement and how much support Congress will have for his plans. As such, our plan is to use the current market weakness to reduce our hedges ideally at good levels and move back to our underlying strategic exposure.
Our Target Return strategy has an absolute return mandate that aims to be uncorrelated to the business cycle. The portfolio is built from the bottom up: every active position has both an upside target, that when reached we close the position, and a downside review level that forces us to question our investment logic. If necessary, we adjust the overall sensitivity of the portfolio to the market via a top-down approach. The core building blocks of the portfolio are slow moving, with a multi-month time horizon and the majority of our positions are the result of our assessment of a country’s interest rate regime. If there is an event risk that we have no insight into, such as Brexit or the US presidential election, but there is the possibility of an adverse market reaction, we will stress test the portfolio to understand the impact but take action beforehand to neutralise the effects where possible. However, in this case, we do not expect the election to have a significant impact on implied interest rate expectations and given our strategy is uncorrelated anyway, the win by Trump has made little difference to our stance.
We took advantage of equity strength in the summer to moderate equity exposure in the portfolio from a positive stance. We also reduced duration (interest rate sensitivity) via long dated US Treasury exposure and moved from a pro-duration stance to a tactically negative one given the extended nature of bond valuations and complacent investor positioning. Dollar exposure was also increased materially in anticipation of a rebound from the ‘soft patch’ environment that had characterised the US economy over the last 18 months. More recently, as the electoral odds shifted in Trump’s favour, we further reduced equity exposure, especially an elevated thematic allocation to Japanese equities. We also moderated a long position in the US dollar in favour of Japanese yen.
Given generally more defensive investor positioning, improving corporate earning dynamics coupled with a Congress and the Senate controlled by the Republican establishment which should moderate some of Trumps extreme policies, it is likely that we would be buyers in the event of material equity market weakness in the shorter term. Indeed, the areas that Trump may be able to get support for are corporate tax cuts, an amnesty on the repatriation of US company profits held overseas and increased spending on infrastructure. Such steps are arguably supportive of equities over bonds and positive for the dollar. Clearly markets abhor uncertainty and we have to assume Trump’s true policy agenda is set to remain unclear. Notwithstanding the election result, bonds are also challenged by improving cyclical conditions and higher inflation rates, which supports a bias towards being short duration in the context of the Fund’s bond sub portfolio and ultimately pro US dollar in a currency context.
In the longer term, any material push towards protectionism under a Trump presidency would be likely to damage growth and corporate profits on a global basis and be particularly negative for emerging market assets. In the short to medium term, we believe there should be enough global cyclical recovery momentum to offset these forces.
9 November 2016
As the outcome of the US presidential election was announced we might have expected a degree of short-term volatility in reaction to what was broadly believed to be the less favourable outcome for the financial markets.
In the lead-up to the election the 4Factor team worked closely with our Investment Risk team to conduct stress tests of our portfolios, based on a variety of potential market impacts. However, the equity market reaction has so far been relatively muted after the initial shock. Bond and foreign exchange markets have seen a more notable reaction with an expectation that a fiscal stimulus could lead to inflation and, as ever in markets, the material moves are in stocks, sectors or currencies that are likely to be directly impacted. The Mexican peso remains the most notable in this category.
Some of the potential longer term US implications of the Trump administration may include:
The 4Factor Equity process focuses on the bottom-up analysis, confident in company fundamentals being the more reliable long-term drivers of stock prices. Our approach will be to follow our process: to understand if and where investment cases have been fundamentally impacted and where, therefore, it is advisable to sell, but also to search out new opportunities created in the market.
9 November 2016
Donald Trump's victory in the US Presidential election has impacted global markets as investors begin to digest what a Trump victory actually means. His protectionist instincts could well have significant implications for free trade, economic growth and company earnings. At the very least, extreme campaign rhetoric and policies lacking in both clarity and detail will no doubt continue to unnerve equity markets, leading to prolonged uncertainty and volatility.
We did not make any material portfolio changes in the lead-up to the election given our long-term, bottom-up Quality focus, and do not expect to make any material changes now that the result is known. Our Quality investment approach focuses on seeking cash generative companies able to sustain high returns on invested capital, with typically low sensitivity to the economic and market cycle. The performance signature of the global Quality portfolios has historically been one of participating meaningfully in up markets, with smaller drawdowns in down markets, with lower-than-average volatility. We believe the historic defensive growth characteristics and resilience of the companies we invest in will position them relatively well through the volatile market conditions we are likely to see.
9 November 2016
Donald Trump’s victory, while not a huge surprise given recent polling, is nevertheless a major event for markets. Trading overnight has unsurprisingly been volatile, with the Mexican peso taking the brunt of this, selling off at around 12% at the time of writing. So far, other emerging market currencies have also unsurprisingly sold-off, but within the ranges used to stress test the portfolio in the weeks up to this event. Volatility will remain the key theme through the day, and indeed in the days to come.
Given our bottom-up investment style, we do not look to make top-down investment decisions based on binary outcomes. Our conviction views on improving emerging market economic health, commodity prices have kept us moderately overweight EM risk across our strategies and so we were positioned for those fundamentals whilst trying to avoid excess relative performance on the outcome of the US election. Given the tightening in polls in the last couple of weeks, and after detailed scenario testing, we reduced our election risk exposure somewhat in recent days. For instance across our local and blended portfolios we have added a short exposure to the Mexican peso and a long euro position in recent days, as well as selling Chilean peso and Turkish lira. We believe this risk reduction should help ensure any potential relative underperformance is managed over the day. Overnight we made further modest adjustments to hedges (for instance increasing our euro exposure) and we are, and will, exploit this market volatility to enter and exit trades at prior established levels.
Due to the lack of policy clarity from Trump and the sometimes alarmist campaign rhetoric, the election outcome generates significant uncertainty for US fiscal and monetary policy, global trade and international security. While the long-term implications are very uncertain, we do take some comfort from the fact that the substantial checks and balances in the US political system should constrain the President to an extent, particularly given the more traditional Republican-controlled Congress. That said, we do not underplay the significance of this result; fresh on the heels of Brexit, President Trump may negatively affect globalisation and may materially impact some of our key markets.
In the coming weeks we will provide some of the team’s more long-term thoughts on what a Trump presidency means for emerging markets and the emerging market debt asset class.
9 November 2016
We believe that investments in the natural resources sector continue to offer attractive diversification in the current environment. While we do expect short-term volatility in commodity prices driven by associated moves in the US dollar and equity markets, we don’t believe the result in the US election will be a key driver in the forecast of medium-term commodity prices. As a safe-haven asset, gold is perhaps the exception as we expect to see continued volatility post-election. Gold is typically well supported when uncertainty grows around the outcome of an event, as was seen in the unexpected outcome of the UK’s ‘Brexit’ vote. However, the ultimate driver of the gold price is the outlook for global interest rates and inflation with the US Federal Reserve’s (Fed) rate cycle a main determinant. At a company level, we continue to focus on companies with improving profitability which can grow shareholder value through the commodity cycle.
Given the lack of clarity on Donald Trump’s policy framework, uncertainty and volatility will define the immediate market reaction. Gold will continue to be the main beneficiary in this environment and this volatility could also affect the Fed’s December rate hike decision. US mining and the oil and gas sector should be more resilient than others given Trump’s protectionist stance towards the US heavy industry. Furthermore, broad commodity prices could see support from a weakening dollar. However, renewable energy companies, in the US and globally, could suffer given Trump’s position on climate change and the lack of support for renewable energy.
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