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Welcome to our 2018
Investment Views

Video: 2018 outlook roundtable

As we look into 2018, we debate the opportunities and risks for investors and ask how far can the bull run?


To what extent are geopolitical issues driving asset classes?

 


What are the risks in 2018?

 


Where are the opportunities over the next 12 months?

 


Is the bull market's charge about to stumble?

Selectivity is key: our 2018 outlook

By Philip Saunders

For now, global growth would appear to be sufficiently self-reinforcing to extend what has been one of the longest, if weakest, growth cycles since the 1920s.

The long cycle continues

The global reflation theme which unfolded over 2017 had little to do with President Trump. An end to the energy sector drag on growth in the US, coupled with solid consumer income and spending, led to a recovery there. The European economy finally responded to Draghi’s ‘whatever it takes’ stance. In China, the delayed impact of a dramatic loosening of monetary policy and increased spending on infrastructure caused a reacceleration in growth. Despite the return to globally synchronised growth, inflation and interest rates have remained low and liquidity plentiful.

The global economy appears to have achieved ‘escape velocity’ from the post Global Financial Crisis stagnation (a period of little or no economic growth). Whether this proves enduring or is merely a temporary cyclical respite remains to be seen. For now, global growth appears to be sufficiently self-reinforcing to extend what has been one of the longest, if weakest, growth cycles since the 1920s. Notably recession indicators remain benign, lending more support to this scenario (Figure 1).

Figure 1: Recession probability signal

Source: Investec Asset Management, Bloomberg, May 2017.

Despite a sustained period of unusually low interest rates and unconventional monetary policy in the form of quantitative easing (QE), inflation in the developed world has remained persistently low. Central bank estimates of higher inflation have been repeatedly disappointed, suggesting that powerful changes in labour markets, globalisation and technology are at work. We assume some uptick in inflation rates in key economies will occur, but such changes are still likely to be muted in 2018.

Suggested investment implication

Positive global economic momentum should enable solid revenues and profit growth.


China, moderation not collapse

Chinese growth and liquidity have become critical to the global economy. While we expect the growth rate in China itself to moderate in 2018 in response to the tighter monetary and macro prudential policies already in place, this is likely to be moderate and orderly, with rebalancing in favour of the domestic and service sector continuing.

Although China certainly has challenges, particularly in using its capital productively, it has both the will and the means to address them. Demand management has become noticeably more adept and the consolidation of power in the hands of Party Chairman Xi Jinping is likely to see an intensification of the efforts to reform the supply side of the economy via changes to state owned enterprises. In addition, financial sector reform is likely to continue at its current pace. Local authority finance has been addressed, measures to improve the efficiency of pricing in capital markets are now in place and the focus has shifted to financial regulation more generally and the shadow banking sector in particular.

Suggested investment implication

A positive growth outcome in China, as well as being supportive of Chinese corporate earnings growth, would be a boost for emerging markets more generally.

Commodities continue to enjoy cyclical support

Industrial metals prices were the first to signal an improving cyclical environment in early 2016 and have subsequently enjoyed a further recovery. With the cyclical backdrop set to remain positive industrial metals should remain well supported in 2018. In particular, growth in the use of electric vehicles should continue to boost copper prices.

Demand for oil should continue to enjoy cyclical support and remain firm, but supply will again depend in part on OPEC continuing to manage its own output. Higher prices are likely to be capped by the potential for shale producers in the United States to increase production flexibly.

Gold may benefit from a further bout of US dollar weakness, but we believe that there are other more attractive Defensive assets.

Suggested investment implication

Firm commodity prices should continue to underpin the recovery of natural resource stocks.

Interest rates and monetary conditions set to become less accommodative

The rise in long-term interest rates, particularly in the United States, discounts a meaningful move higher in short-term interest rates. Despite the current cyclical upswing, considerable structural headwinds to growth remain in the form of ageing populations, high levels of debt and poor economic productivity. As such, the normal level of real interest rates (adjusted for inflation) is set to remain more modest than it has in the past. It would appear that US interest rates might only reach 2-2.5% at the cyclical peak of the economy, which is already priced in by the market. Countries like the UK, Canada and Australia in particular will quickly struggle in the face of higher interest rates because of overextended consumer and property markets.

While the US Federal Reserve Board is now in the process of actually shrinking its balance sheet (by putting its QE programme into reverse), the ‘tapering’ of QE has only just begun in the euro zone and Japan. With strong growth in both Europe and Japan, the pace of tapering will likely pick up in 2018 and Chinese monetary policy is unlikely to loosen. Central banks are also reducing support beyond monetary policy – for example, restricting the supply of credit to certain sectors. Hence overall liquidity conditions could become, if not quite restrictive, progressively less supportive.

However, given the nature of these structural issues, the lack of consensus about the impact of tapering unconventional monetary policy and continued low core inflation rates, a gradual withdrawal of support is likely to prevail.

Suggested investment implication

Interest rate normalisation should proceed in an orderly and gradual fashion which should be supportive of Growth assets.

Government bonds – a selective source of defensive exposure

We don’t subscribe to the bond market ‘bubble’ view, believing that the drivers which have caused developed government bond yields to decline over the last 35 years are still largely in place. However, despite disinflationary forces, less central bank bond buying, a modest pick-up in core inflation rates and possible fiscal easing are likely to cause bond yields to rise in some markets. Hence our preference for government bond markets and maturities where we believe interest rate expectations are too high, such as Canada and Australia. In our view, long-dated US Treasuries also continue to offer attractive value as a Defensive asset.

Suggested investment implication

Investors are already pessimistic about prospects for fixed income returns, hence selective allocations to preferred markets and maturities represent an attractive source of defensive returns.

A maturing bull market for Growth assets

Many investors have remained sceptical of the current bull market cycle, missing out on returns for their clients. Beyond the various macro risks outlined above, valuation remains one of the principal concerns. By historical comparison, valuations of most Growth asset classes, and some Defensive assets as well, are now clearly expensive. Although this warrants increasing strategic caution, because high valuations point to lower returns over the longer term, valuation alone has tended to be a relatively poor medium-term indicator. Bull markets typically end just before an economic downturn and after prolonged periods of tighter monetary conditions, neither of which appear to be in place yet. In addition, market price behaviour is still risk seeking (see Figure 2). So given the high passive flows (which are not sensitive to valuation), this could yet cause a final ‘melt up’ in stock prices, as investor scepticism potentially gives way to euphoria late in the business cycle.

Figure 2: Elevated investor sentiment

Source: Ned Davis Research, March 2017. Shows percentage polling by NDR, with highs representing optimism and lows representing pessimism.

Suggested investment implication

Use market strength as an opportunity to add progressively to Defensive exposure and moderate outright exposure to Growth assets.

Equity markets – recovery in cyclical sectors as yet incomplete

From the summer of 2016 there was a distinct change of leadership in equity markets. Until that point leadership was provided by defensive and interest rate sensitive sectors, reflecting enduring investor caution. Since then, growth and cyclical sensitive areas have been more highly priced, supported by strong or improving corporate earnings (see Figure 3). ‘Digital leaders’ such as Facebook and Amazon in the United States and Alibaba and Tencent in China have been in the vanguard of such a change in dynamics. We have also witnessed better performance from financials and, more recently, mining stocks. Cyclical stocks supported by strong earnings growth are likely to gain further investor attention in the year ahead.

Figure 3: Robust corporate earnings

Source: Investec Asset Management, JP Morgan, June 2017.

Better operating performance and growing investor appetite for cyclical risk has also shown up in improving performance of markets outside the United States. From a ‘bottom-up’ perspective, we believe US equities, despite appearing to be relatively expensive, have consistently offered the most attractive fundamentals. With the revival in global growth this has now changed and, in our view, equity markets outside of the United States look increasingly attractive. Asian markets, including Japan, seem to be well placed to benefit from a broader rotation out of the United States.

Finally, after a sustained period of unusually low dispersion between stocks, the current trend towards a more ‘micro’ and less ‘macro’ environment means that the current revival in active returns from fundamental stock picking looks set to continue in 2018. The broadening of an equity bull market previously dominated by the United States also provides scope to benefit from higher alpha potential from structurally less efficient markets.

Suggested investment implication

Continue to emphasise cyclical exposure both in terms of regions and sectors. More specifically via allocations to natural resources, Asian and emerging market equities. Favour ‘active’ versus ‘passive’ exposures to take advantage of an improving environment for stock selection ex-US equities.

Credit markets – caution warranted

Credit markets tend to be sensitive to material shifts in monetary policy. In the past, credit spreads have typically started to widen between 6 and 24 months before a more general equity market peak. The starting point is one of tight credit spreads, supported by improving corporate fundamentals and investor appetite for yield. We are confident in the former, but liquidity could prove to be more challenging and the risks are asymmetric.

Suggested investment implication

This warrants a defensive approach and selectivity in focusing allocations in credits supported by improving fundamentals. Within the spectrum of Growth assets we continue to favour equities, as a source of income, in an environment which should continue to see solid operating performance.

Currencies – a further phase of dollar weakness?

The US dollar weakness which occurred in the first half of 2016 surprised most investors. Previously, the dollar had experienced a six-year bull cycle against the currencies of its major trading partners. A slightly shorter period than its bull cycles in the early 1980s and mid-to-late 1990s. The subsequent recovery has been muted – despite a significant covering of short positions – which suggests to us that a new down leg could unfold in 2018, confirming a medium-term bear market for the US dollar.

Despite its recovery against the euro, the US dollar remains cheap. However, in our estimation the Japanese yen is cheaper still, making it one of the most attractive Defensive exposures. If, as we believe, the Japanese economy continues to perform strongly, the Bank of Japan is likely to continue to moderate its ultra-loose monetary policy. Should market conditions turn more negative in 2018, the Japanese yen has the potential to rally dramatically.

Suggested investment implication

Reduce US dollar exposure into rallies. Among developed market currencies, favour the Japanese yen as a cheap Defensive asset.

Emerging market debt and foreign currencies – selectivity to be rewarded with good returns

Whereas the developed world has been in a long but weak growth cycle since the catharsis of the Global Financial Crisis, with a few exceptions, the recovery of the emerging world is a much more recent affair. Generally speaking, the combination of pent up demand and continued low inflation rates should underpin the relative recovery in emerging market assets already underway. The best opportunities are likely to be found in local currencies and debt markets, provided investors avoid some of the more specific risks within the region. Selectivity will be required to extract returns from a diverse opportunity set supported by improving fundamentals.

Suggested investment implication

Selective exposure to emerging market local currencies and debt are likely to offer attractive income and returns.

ESG – A shift in attitudes can lead to opportunities

A shift in attitudes and regulations is now prompting disruptive change in consumer and corporate behaviour, such as the take up of electric and hybrid vehicles. Slow at first, this is now proceeding more rapidly than most forecasters anticipated.

Professional investor behaviour is changing too. Over the past few years investment processes have increasingly incorporated an analysis of ESG (Environmental, Social and Governance) factors into any investment decision, alongside more traditional factors such as an assessment of valuation and company fundamentals. Increasingly, the evidence is that, if done well, this can help to improve the profile of returns.

Suggested investment implication

It is likely that high ESG standards will increasingly be rewarded by investors. Opportunities are emerging for companies and materials, such as copper, which are beneficiaries of the shift towards environmentally and societally friendly technologies.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Investing in China: Investment in mainland China may involve a higher risk of financial loss when compared with countries generally regarded as being more developed. Commodity-related investment: Commodity prices can be extremely volatile and significant losses may be made. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed.

Multi-Asset

An ageing bull

By John Stopford & Jason Borbora

At a glance

  • The current bull market in Growth assets is intact, but vulnerabilities are increasing
  • We have begun to reduce risk, seeking attractive opportunities from the bottom-up
  • Current positioning:
    • Cyclical and financial equities look relatively attractive
    • Corporate bonds require being cautiously selective
    • Government bonds have supportive long-term drivers but cyclical challenges remain
  • The Japanese yen offers Defensive characteristics and support for the dollar is likely to fade
  • We are closely monitoring the market reaction to the withdrawal of central bank monetary easing

Still intact…

The bull market for Growth assets such as equities and high yield corporate bonds is maturing, with increasingly stretched valuations. While valuations alone rarely cause markets to reverse, they imply lower longer-term returns. Bull markets typically only end just before an economic downturn and after a prolonged period of tighter liquidity conditions, neither of which are yet evident. The risk of recession appears low, monetary conditions are loose and growth momentum is strong.

Market price behaviour is still risk-seeking. Flows from passive investments could even cause a final ‘melt-up’ in stock prices as investor scepticism potentially gives way to late cycle euphoria.

…but vulnerabilities increasing

However, the fundamental backdrop is slowly weakening. Global economic growth has used up much of the spare capacity available for above-trend growth. At the same time, monetary policy looks likely to become steadily less supportive. The Trump tax reduction plan could spark a classic end to the current business cycle, creating a boom followed by a bust. Cutting taxes with unemployment at its current lows would boost growth, but should also push up inflation expectations and risk in the bond market.

Figure 1: G7 GDP growth vs. trend

Source: Investec Asset Management, as at 31.10.17.

Portfolio positioning – Incrementally less risk

The cost of being a little early in getting out of the market is similar historically to being a bit late. Many talented investors have already missed much of this bull market by being bearish too soon, and this could remain the case if the business cycle is extended. We believe the right approach is to run incrementally less risk within our allowed risk budget, but to keep some exposure to Growth assets given the probability of further market strength.

We build portfolios from the bottom-up, which allows us to find securities which offer an attractive combination of yield, sustainable income generation and potential for rising prices.

Equities – Opportunities in cyclicals and financials

Within equities, we are finding interesting opportunities in financial and cyclical stocks, which tend to benefit from an improved economic backdrop and are less sensitive to volatile bond yields. From a regional perspective, valuations and cyclical momentum appear better outside the US, but the US still contains many great companies and may see additional upside if the proposed tax cuts are passed.

Corporate bonds – Cautiously selective

We are cautious towards corporate bonds. However, we do see selective opportunities in emerging markets, which typically offer more value than their developed market peers and are better supported by the higher economic growth. We are still cautious, however, due to a number of idiosyncratic risks – investor flows into the asset class remain lumpy, driving bouts of volatility.

Government bonds – Long-term drivers still in place

The factors that have driven government bond yields down over the last 35 years remain largely in place, particularly inflationary forces and the causes of muted growth. This makes us buyers of long-dated US Treasuries if we see further price weakness.

Figure 2: Global equities vs. US Treasury yields

Source: Bloomberg, as at 30.09.17.

However, we still see the risk of higher yields in the near term, due to less central bank bond buying, a probable pick-up in core inflation next year and the potential for fiscal easing in the US. Any of these factors could push up real and nominal yields, even if slower trend growth and secular disinflationary forces are tending still to pull bond yields in the opposite direction.

We prefer bonds from issuers where the economies are unlikely to be able to tolerate the high interest rates that many investors expect, such as Canada and Australia. We also see value in being short long-dated Japanese government bonds, as a hedge against higher yields globally.

Currencies – Defensive yen, fading the dollar

We own the Japanese yen as a Defensive position. As a global lender, Japan is an exporter of capital. In a crisis, we believe the yen would climb as capital tends to stay at or return home. The currency also appears cheap and would probably rally on any further softening of the Bank of Japan’s expansionary monetary policy.

In our view, the US dollar bull market may be over after six years of real appreciation against major trading partners. Previous up cycles in the currency have lasted slightly longer, but have then been followed by long periods of underperformance. The dollar may, however, stabilise, or recover temporarily in the short term, before resuming a downward trend, given how far sentiment has already shifted in the last year – investors are becoming much more optimistic about Europe than the US.

Risk beyond the bust

The main market risk is always the possibility of recession. However, beyond this our concerns are focused on how well markets, fuelled in part by liquidity, will deal with a reduction of central bank bond buying. We also worry whether or not China can successfully transition to a growth model driven less by debt.

Other important risks are largely geopolitical and include further political instability in Europe, the potential for a hard Brexit, the chance of a follow through on Trump’s protectionist rhetoric, and rising tensions with North Korea and Iran.

Our focus on downside risks suggests we should be aware of and manage the potential consequences of these risks. We will look to quickly scale back exposure if the market environment starts to deteriorate.

One final rally?

With no immediate sign of an economic slowdown, the current market looks like it may have life to it yet. Investors are still seeking risk and the bull market could attract further passive flows and a late-cycle buying spree.

But it is certainly beginning to show its age with valuations looking stretched in places, a global economy with less slack for further above-trend growth and central banks looking to withdraw monetary support. A prudent response is to selectively and incrementally reduce risk in the portfolio.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Multi-asset investment: The portfolio is subject to possible financial losses in multiple markets and may underperform more focused portfolios.

Equity

Crunch time for Central bankers

By A Mundy, A Dicorrado & S Woolley

At a glance

  • Central banks are now focused on slowly normalising monetary policy
  • A defensive position in bonds and exposure to precious metals could offer some protection from central bank error
  • Bank shares could surprise to the upside
  • Many UK consumer stocks are pricing in recessionary conditions
  • We have found a number of interesting spin-off opportunities

Central banks looking to reverse QE

The language of central bankers changed in the second half of 2017. There is now clearly some reluctance to keep monetary policy on the post-financial-crisis emergency setting. Consequently, the next phase of policy should see higher short-term interest rates and the reversal of quantitative easing (QE). Can this be executed without unsettling markets? Given there is no historical precedent for QE in the size it has been implemented, we believe investors should be highly sceptical.

We believe the main risk is that central banks reduce their bond exposure too aggressively and bond yields rise. This could force them to suspend their actions while they reassess the timing and scale of the strategy. A failure to normalise monetary policy could encourage investors to conclude that central bankers are addicted to QE. In that scenario, we would expect bond yields to rise, while equities, which have been so reliant on low bond yields the past few years, could very easily fall.

The Goldilocks scenario for central banks would be a successful reversal of QE with little impact on bond or equity valuations. We attach a fairly low probability of this happening.

Preparing for central bank scenarios

Despite these apparent risks, as we move into 2018 we believe bond and equity investors remain relaxed, if not complacent. Equity valuations in certain sectors remain particularly high, while bond yields remain low (thus valuations high). In our UK funds, we consequently remain defensively positioned in equities (and in bonds in our Investec Cautious Managed Fund).

If the market starts to lose faith in the central banks in 2018, we could see precious metals come to the fore.

Figure 1: Weighing up the possibilities

UK themes

Banks – the pariah sector

Investors reluctant to embrace banks highlight issues such as business opacity, regulatory risks and intense competition. However, we believe this is priced into the stocks with little potential good news priced in.

If interest rates increase, particularly longer rates, loan growth is higher than expected, margins increase (as capital requirements limit growth) profits and dividends could generate positive surprises. We are exposed to UK and US listed banks to benefit from this theme.

Repair, maintenance and improvement

Spending on extensions and conversions has remained fairly depressed in the last decade, but we think this is storing up future demand. The average house in the UK is more than 60 years old and maintenance spend cannot be deferred for long. Major renovation is more cyclical, but remains well below its long-term trend. The repair, maintenance and improvement industry is slowly consolidating and the large players should grow their competitive advantage as a consequence of their economies of scale. We see attractive demand and supply characteristics for this industry that is not reflected in current valuations.

UK consumer stocks - looking attractive

Many UK consumer-facing stocks have performed poorly in recent years. This leaves them on similar discounts to the market as during the last (deep) recession. In other words, we think many domestic companies are now pricing in a recession. With such bad news priced in, stocks such as Next, M&S, Tesco and WM Morrison are sufficiently attractive for us to hold.

Global themes

We have been increasing exposure to ‘unloved’ spin-offs. These are companies which have been spun-off from larger parents. Investing in spin-offs has historically proven very profitable for investors. While there must be a number of reasons for this, probably the greatest driver is the management focus a spin-off has as an independent unit. Perhaps the management was starved of cash (for organic and inorganic growth), not permitted to sell non-core time-consuming assets, or not optimally incentivised.

Even if there are investor roadshows to highlight the spin-off, investors might be sceptical. There is often a lack of an impressive track record and if the spin-off is not looking to raise fresh money, management have no great incentive to talk the story up.

Obviously, not all spin-offs work well for investors. They can start life with too much debt, poorly incentivised management or too high a valuation. But, in general, they have performed better than the market and continue to generate some interesting opportunities. In the Investec Cautious Managed Fund we currently have spin-off holdings in:

  • Welbilt – an equipment supplier for commercial kitchens
  • Now – a distributor of products to the energy industry
  • Cars.com – a US auto sales platform aggregating car dealer inventories and other information
  • Conduent – a provider of outsourcing service

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Multi-asset investment: The portfolio is subject to possible financial losses in multiple markets and may underperform more focused portfolios.

The fine balancing act of 2018

By Simon Brazier, Blake Hutchins & Matt Evans

At a glance

  • Conflicting signals lead to an uncertain outlook
  • Strong employment and trade masks weak investment growth
  • Sterling volatility has clouded the underlying strength of corporate earnings
  • With the economic and market environment both finely balanced, we continue to believe in the merits of an active quality approach

Taking the good with the bad

As we look forward to 2018 in the UK, there are a number of conflicting signals that lead to a highly uncertain macroeconomic outlook. On the positive side, the unemployment rate has reached its lowest level since the mid-1970s. In addition, net trade is being bolstered by stronger and more synchronised global growth, as well as the fall in the value of sterling since the Brexit vote in June 2016. The Bank of England has moved recently to combat above-target inflation by raising interest rates for the first time in ten years. However, we do not see significant further tightening from here as the impact of the past falls in sterling on consumer prices starts to fade.

On the negative side, however, the savings ratio is at multi-decade lows and wages continue to fall in real terms. A number of indicators are pointing to fragile consumer sentiment, crucial for an economy where consumption comprises more than 60% of GDP. Elsewhere, investment growth remains weak as Brexit uncertainty persists. Productivity gains are also still proving elusive, as highlighted recently by both the Office for Budget Responsibility and the Bank of England, while the UK’s fiscal position continues to provide little room for manoeuvre.

The IMF recently cited the UK as a “notable exception” to an improving global economic outlook and the economy is likely to remain on its lower post-crisis-trend rate of growth. The political outlook is uncertain at best with the risk of a crisis in 2018 with the risk of a crisis in 2018, as the realities of any Brexit deal are revealed. A fragile minority government with a cabinet that is split on the preferred outcome for Brexit could prove to be problematic.

The sterling effect

The significant movements we have seen in the valuation of sterling continue to cloud the underlying strength and quality of corporate earnings. The changing state of Brexit negotiations and overall political instability is driving currency fluctuations. This in turn is driving market movements, particularly the relative fortunes of large corporates with overseas earnings and the more domestically focused smaller and mid-sized companies.

Valuations remain fair to full and, while more economically sensitive sectors with global exposure such as energy and mining have rallied more recently on an improved global growth outlook, the sustainability of this improved performance is far from certain. We expect the Brexit-driven currency boost to earnings to prove relatively short-lived. As proven by the share price reactions of companies that have warned on profits recently, we also expect the market to be unforgiving in response to any signs of earnings weakness.

The fine economic and market balance

With the economic and market environments both finely balanced, we continue to believe in the merits of an active quality approach, driven by stock selection and implemented through diversified portfolios, whether growth, income or small-cap oriented.

Even in these challenging economic and market conditions, opportunities still exist at the stock level across the market-cap range for companies able to generate cash and reinvest that cash at rates of return well in excess of their cost of capital, supporting future growth in cashflows and dividends.

The trade-off between what appears to be a tough consumer environment with generally lower domestic valuations and strong overseas earners with generally higher valuations is also creating opportunities for bottom-up stock pickers. Quality companies with structural growth drivers and an ability to improve their returns and cashflows through self-help, should be well placed to perform well in 2018.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios.

Dividends – the good, the bad and the uncovered

By Clyde Rossouw, Blake Hutchins & Abrie Pretorius

At a glance

  • Investors are becoming increasingly nervous about the outlook for returns and dividends
  • In this environment, we remain focused on companies in full control of their own dividend
  • Valuations appear high, but quality income stocks don’t look overly stretched
  • Prudent stock selection will be required to separate the good from the unsustainable in terms of income

Risks abound despite signs of gradual recovery

As ‘the most hated bull market in history’ approaches its tenth year, with the S&P 500 having delivered over 350% total cumulative returns since its post-crisis lows, investors are becoming increasingly nervous about the outlook for returns and dividends.

Global growth appears to be strengthening and becoming more synchronised, and the first tentative steps towards monetary policy ‘normalisation’ have been taken in the US and the UK. However, the outlook remains far from certain. There are a number of risks that could derail this fragile global recovery, ranging from fiscal and monetary policy error to escalating geopolitical tensions, protectionism and ever-increasing debt levels.

Focusing on covered dividends

Against this uncertain backdrop, as we look forward to 2018, we believe it will be important for equity income investors to focus on companies that are largely in control of their dividend paying ability. Investors cannot rely solely on the fortunes of external factors such as commodity prices, interest rates, or the economy to sustain dividend growth. We have already seen significant dividend cuts in recent years in more capital-intensive areas of the market. These ‘price-taking’ businesses have been funding unsustainable pay-outs through the balance sheet using debt and disposals, not cashflows.

As Quality investors, we focus on sustainable, capital-light, cash-generative businesses that return a proportion of their cashflows to investors as a dividend, and re-invest the remainder to fund future dividend growth. The vast majority of these businesses have continued to grow their dividends. In total they still have better cash cover to support future dividend growth than those in capital-intensive sectors where dividends have been cut.

Figure 1: Free cashflow cover of dividend (2016)

Source: Investec Asset Management, FactSet, as at 31.12.16. Financials sector has been excluded as a meaningful free cashflow figure cannot be calculated for the majority financial companies.

Finding pockets of value

Equity markets have re-rated significantly since the Global Financial Crisis and are no longer cheap. In the context of a low-growth, low-return world, however, we do not believe that the valuations of quality income stocks are overly stretched. Relative to longer-term history, we believe valuations remain attractive given the quality and dividend growth characteristics one is paying for and the yield available on bonds and other asset classes.

Threats do exist to future growth. For example, in consumer staples disruption from the ‘infinite shelf’ of e-commerce is lowering barriers to entry and supporting smaller brand and private label penetration, thereby increasing fragmentation across categories. However, the impact of this and other trends will not be felt evenly across companies. In many cases it provides opportunities as well as risks. Active prudent stock selection will be required to separate the winners from the losers.

Standing by our Quality framework

Overall, while more economically sensitive sectors with global exposure, such as energy and mining, have rallied recently, the sustainability of this rally is uncertain. We believe that carefully selected quality companies, with long-term structural rather than short-term cyclical growth drivers, should be well placed to perform well in 2018. We will continue to focus on finding attractively valued stock ideas with these quality characteristics, which are able to continue to grow their cashflows and dividends into 2018 and beyond.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios.

Structural growth is the key

By Clyde Rossouw

At a glance

  • Investors are becoming increasingly nervous about the outlook for returns
  • Structural, rather than cyclical, growth will be key
  • Valuations appear high, but quality stocks don’t look overly stretched
  • Prudent stock selection will be required to separate the winners from the losers in 2018

Growth strengthening, but risks remain

As ‘the most hated bull market in history’ approaches its tenth year, with the S&P 500 having delivered over 350% total cumulative returns since its post-crisis lows, investors are becoming increasingly nervous about the outlook for returns and dividends.

Global growth appears to be strengthening and becoming more synchronised, and the first tentative steps towards monetary policy ‘normalisation’ have been taken in the US and the UK. However, the outlook remains far from certain. There are a number of risks that could derail this fragile global recovery, ranging from fiscal and monetary policy error to escalating geopolitical tensions, protectionism and ever-increasing debt levels.

Structural growth will be key

Against this uncertain backdrop, and as we look forward to 2018, we believe a focus on structural rather than cyclical growth will be key.

One cannot rely solely on the fortunes of exogenous factors such as commodity prices, interest rates, or the economy to sustain growth. As has been the case in 2017, particularly in the technology sector, we expect the market to again reward quality companies that prove their ability to deliver sustainable growth in earnings and cashflows, and punish companies across the market whose earnings disappoint.

Figure 1: High quality profits (FCF conversion)

Source: Investec Asset Management and FactSet, as at 30.09.17. Investec Global Franchise Strategy re-weighted excluding cash and equivalents, since inception

Figure 2: Sustainability high profitability (ROIC)

Source: Investec Asset Management and FactSet, as at 30.09.17. Investec Global Franchise Strategy re-weighted excluding cash and equivalents, since inception.

We are mindful of the threats that also exist to the future growth of Quality companies. For example in consumer staples disruption from the ‘infinite shelf’ of e-commerce, is lowering barriers to entry and supporting smaller brand and private label penetration, thereby increasing fragmentation across categories. However, the impact of this and other trends will not be felt evenly across companies. In many cases it will likely provide opportunities as well as risks. Careful stock selection will be required.

Valuations not overly stretched

Equity markets have re-rated significantly since the Global Financial Crisis and are no longer cheap. In the context of a low-growth, low-return world, however, we do not believe that the valuations of quality stocks are overly stretched. Relative to longer-term history, we believe the valuations of quality stocks remain attractive, given the quality and growth characteristics one is paying for and the valuations of bonds and other assets. Again, however, stock selection will be key.

In 2017, investors have been rewarded for successfully picking stocks that have delivered growth. However, perhaps more important to investment performance in 2018, will be avoiding the losers rather than picking the winners. This will require careful management of downside risk, including both business and valuation risk. Again, active stock selection will be critical.

Focusing on the ‘quality’ advantage

Overall, while more economically sensitive sectors with global exposure, such as energy and mining, have rallied recently, the sustainability of this rally is uncertain. We believe that carefully selected quality companies, with long-term structural rather than short-term cyclical growth drivers, should be well placed to perform well in 2018.

We will continue to focus on finding these attractively valued quality companies, with demonstrably enduring competitive advantages that are able to continue to grow their cashflows into 2018 and beyond.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Derivatives: The use of derivatives is not intended to increase the overall level of risk. However, the use of derivatives may still lead to large changes in value and includes the potential for large financial loss. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios.

All-China approach: Opportunities and risks

By Greg Kuhnert

At a glance

  • ‘Old’ economy companies (real estate, infrastructure) have begun to recover, driven in part by reform and restructuring
  • A clear push for a better environment also creates interesting ‘new’ investment opportunities in the old economy
  • ‘New’ economy sectors continue to boom, with the service economy now over 50% of China’s total GDP
  • Chinese debt levels remain a potential risk
  • Going into 2018, Chinese equities offer one of the highest revenue, earnings and cashflow growth opportunities globally

Opportunities and risks in 2018

Going into 2018, the Chinese equity market offers a number of investment opportunities in both traditional ‘old’ areas of the economy, as well as ‘new’ economy sectors such as consumer, internet/tech and healthcare. Overall, economic growth is shifting from investment-heavy industries to more sustainable and shareholder-friendly consumer-orientated areas. Of course, investing in China, as with all investing, entails risks, with high indebtedness at the top of the list.

The resurgent ‘old’ economy

Old economy growth rates began declining after 2011, but have started to recover more recently, especially the real estate and infrastructure sectors. In real estate, home mortgage interest rates have been declining since 2014. Together with other easing policies, such as a reduction in the down-payment ratio and a lift of purchase restrictions, we are seeing a strong increase in pent-up demand for housing.

Infrastructure is another area of growth. An example is high-speed rail, where China has some of the best technologies and products globally. While the growth rate of the real estate sector has moderated from high levels, infrastructure spending has helped fill its void.

Another strategic focus by the Chinese government is to improve the environment. This creates several interesting ‘new’ investment opportunities within the old economy, including gas and hydro power companies in the utilities sector, the electric vehicle supply chain and industrial automation in the industrials sector.

Figure 1: Old economy revenue is seeing a significant improvement

Source: Wind, as at 30.06.17.

Within old China, a key investment theme is reform and restructuring, beginning with sectors where returns are improving from cyclical lows and cashflow returns to equity holders are improving. The Chinese government is taking proactive steps to address overcapacity and indebtedness. This results in meaningful improvements in corporate profitability and cashflow.

Coal and steel are two examples where industry capital expenditure has fallen significantly, yet end-demand continues to surprise to the upside. This has created a combination of improving cashflow returns yet cheap valuations, something every equity investor likes to see.

The booming ‘new’ economy

The service sector was more than 50% of China’s GDP as of 2016, from just about 40% a decade ago. This makes the growth more sustainable and shareholder friendly.

Figure 2: New economy contributes more than 50% to GDP

Source: CEIC, December 2016.

We believe that thanks to increasing penetration and high barriers to entry, new economy sectors, such as consumer, technology, internet and healthcare are generating interesting growth opportunities for equity investors going into the new year.

Several sectors are competitive globally. We believe these areas offer the most attractive growth potential, as well as visionary management teams, competitive advantages to the business model, and long-term product and service viability. The superior growth rate and cashflow generation that these sectors deliver over the long term is likely to reward equity holders.

Monitoring indebtedness risk

Despite all the positives, indebtedness remains a risk to the Chinese investment thesis. As the economy transitions from investment to consumption, we are seeing a rise in non-performing loans. China has been taking progressive measures to contain this risk through lowering interest rates, restructuring the debt, and increasing the transparency of the debt market. However, there is much to be done and this is the area where investors need to be wary and constantly assess their risk management processes.

We advocate avoiding those companies with high gearing and large amounts of dollar denominated debt, in preference for those with improving or clean balance sheets, and diversified sales regions.

Looking forward

Going into 2018, Chinese equities offer one of the highest revenue, earnings and cashflow growth opportunities globally. Economic growth is shifting from investment-heavy to more sustainable and shareholder-friendly consumer-orientated areas. Despite a rapidly modernising old economy and a dynamic ‘new’ economy, China still trades at a large discount to developed markets. The international investment community remains extremely underweight Chinese equities, which we think will reverse over time.

A pause or correction may be due in the short term, given how well the market has done this year as some investors may choose to book profits or reduce risk in the light of geopolitical uncertainties. However, we would see that as a buying opportunity. The bottom-up fundamentals of Chinese companies are improving and valuations still look attractive relative to history and other global markets. Corporate profitability is improving due to a broad-based improvement in the economy spanning exports, infrastructure investment, domestic consumption and a pick-up in private investment by corporates. Corporate cashflows are looking stronger and companies are paying down debt.

The government is serious about supply-side reform and this is enhancing returns in the old economy sectors which has been avoided by the market for a long time. The new economy companies continue to grow and thrive as China is moving up the technology curve as it accelerates its investment in research and development. We see the domestic equity market as rich with long-term alpha opportunities, as it is under-researched and is largely driven by domestic retail investors who tend to have a shorter investment time horizon. We believe investors who have a disciplined bottom-up stock selection process and are willing to adopt a longer-term view and stomach the higher volatility will be richly rewarded in the long term.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company. Investing in China: China may have less developed legal, political, economic and/or other systems. Investment in mainland China may therefore involve a higher risk of financial loss when compared with countries generally regarded as being more developed.

Global Credit

More of the same?

By Jeff Boswell & Garland Hansmann

At a glance

  • We continue to believe that the fundamental environment remains sound, reflected in solid company results and low default rates
  • Spreads across most credit asset classes are close to post-crisis lows. However, we believe upside remains if fundamentals remain supportive and markets tighten into pre-crisis levels
  • Market price behaviour is still supportive with positive fund flows, a lack of issuance in a number of credit markets, and central bank corporate bond buying programmes
  • Central banks will continue to be a key factor in credit market performance in the coming years, with the potential for an error in the pace of tightening monetary policy a key risk

2018: What are the drivers?

We believe that 2018 could be very similar to 2017, although caution is required, with a finer balance of risk and reward. Below we use the ‘Compelling Forces™’ framework, segmenting credit market drivers into Fundamentals, Valuation and Market Price Behaviour, to examine these themes in more detail.

Fundamentals: Reducing leverage

Given the broader macroeconomic momentum, corporates have being doing well recently, showing good growth in both revenues and profitability. From a credit investor's standpoint, this has reduced the amount of leverage companies are using. This is best illustrated in the chart below which reflects US high yield leverage. While higher than the lows of 2011 and 2012, levels on average do not look overly aggressive and even the energy & commodities sector has rebounded recently.

Figure 1: Leverage of US high yield issuers

Source: JP Morgan, as at 31.10.17.

The rising number of credit rating upgrades (an improvement in the upgrade to downgrade ratio), in both the US and Europe over the last 18 months also illustrates this point.

Figure 2: Credit ratings improve across Europe and the US

Source: Moody’s, as at 30.09.17. Rating drift = (notches upgrades - notches downgrades)/rated issuers.

Indeed, Moody’s is forecasting that default rates will fall below 3% in the US and below 2% in Europe in the coming year (Figure 3). A low-growth environment should support this trend by encouraging management to take a conservative approach and focus on financial strength.

Figure 3: Falling default rates in the Europe and the US

Forecasts are inherently limited and are not a reliable indicator of future results. Source: Moody’s, as at 30.09.17

Valuations: High but hard to judge

Bond spread levels appear fairly expensive versus history, with a number of credit asset classes trading at or close to post crisis lows (Figure 4).

Figure 4: Corporate bond spreads over time

Source: Bloomberg, as at 31.10.17.

However, spreads have not yet tightened to pre-crisis lows. The pre-crisis era was unusual for a variety of reasons, while post crisis we have seen unprecedented support from central banks. This makes it difficult to draw a line in the sand as to how low spreads can go. Given credit spreads are meant to compensate for default risk, to the extent the current favourable fundamental environment persists and default rates remain subdued, we think there is potential for spreads to tighten further.

Market price behaviour: Still seeking yield

Despite tight spreads, investors are still clearly showing yield-seeking behaviour. The low interest rate environment is still pulling investors into the higher yielding segments of the market, thereby pushing spreads tighter and prices higher. Capital flows into investment grade funds have surged recently, clearly supporting this point.

These flows, coupled with new issuance volumes that are below those of bond redemptions in a variety of credit markets (particularly high yield), along with various central bank bond buying programmes, has led to a lack of supply and has driven credit markets higher. This has been a significant tailwind for credit markets over the last year, but it comes with an equal amount of risk should we see any sort of reversal.

Key risk: Central banks tighten too quickly

It’s clear that the synchronised global growth has been created by the accommodative stance of central banks, with ultra-low interest rates and quantitative easing key stimulants to this momentum. The future of policy is less clear, with central banks having worked very hard and used almost every tool in the box to get to this point.

Ideally, they would reduce stimulus. However, we believe they will only do this very gradually, and to the extent that they don’t believe it harms the fragile growth environment. In our view, any signs of slowing growth will lead to central banks deferring further tightening. But with that in mind, central banks could simply misjudge what is needed. As such there remains the potential for policy error should central banks tighten monetary policy too quickly.

Good case for spreads to tighten further

Taking all these factors into consideration, we believe there is a good case for credit spreads to continue their grind tighter in the months ahead, with strong fundamentals and market price behaviour more than offsetting concerns over expensive valuations. The concern is obviously that the absolute cushion at this level is not high should the downside materialise. As such we believe selectivity should be at the forefront of investors’ minds. Nevertheless, we believe that corporate bonds have the potential to continue to produce satisfying returns over the course of 2018.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. which This may lead to larger financial losses than might be anticipated.

Emerging
Market Debt

Emerging market fundamentals remain intact

By Peter Eerdmans & Werner Gey van Pittius

At a glance

  • Emerging market fundamentals remain intact
  • Generationally low inflation still supports falls in bond yields (rise in prices)
  • Emerging markets will need to navigate through the US Federal Reserve’s (Fed) rising interest rate cycle
  • Western populism remains a threat
  • The asset class still looks attractive going into the new year, which we currently express through an overweight in emerging market currencies

Factors suggesting positive returns in 2018

We expect another strong year for local currency emerging market debt into 2018, based on the following factors:

  • Emerging market real effective exchange rates (REERs)1 are inexpensive compared to history, in other words, currency values are not stretched
  • Real yields are still attractive and the mid-cycle recovery is helping drive strong offshore inflows to support currency markets
  • Rebalancing in current accounts post the ‘taper tantrum’ of 2013 leaves emerging market economies much better positioned to deal with any prolonged period of volatility across capital markets
  • The asset class remains, in our view, underappreciated and under-owned by investors, thus leaving plenty of room to appreciate further into the upcoming year.

Emerging market economies continue to recover

The recovery across emerging markets post the recessionary period of 2013-15 is ongoing and strengthening in some key markets. Overall economic growth continues to surprise, with the pick-up most obvious in manufacturing, industrial and commodity-exporting countries.

Current account balance holding up

Encouragingly, increasing economic activity data has not resulted in a worsening in countries’ current accounts2, nor in demand-side inflation pressures. In our view, this indicates that this growth rebound is fairly early in the economic cycle. Currently, global investors reflect this economic improvement through a sustained increase in fund flows into a number of emerging markets countries’ equity markets, including Brazil, South Korea, India and Russia. These factors together provide a tailwind for emerging market currency markets.

Unprecedented falls in inflation

The sheer scale of falling inflation across some of our key markets is being supported by independent central banks adopting credible inflation targeting policies. This trend has supported the fall in absolute yields (and a rise in bond prices) across emerging markets, however, real yields (inflation adjusted) in a number of markets remain attractive.

Into 2018, we expect this cycle of disinflation to be somewhat less of a tailwind as markets reflect this trend in valuations and central banks’ easing cycles start to mature. Nevertheless, the asset class continues to offer plenty of attractive relative value opportunities. We expect some select countries such as Mexico, Argentina and Nigeria to begin lowering interest rates next year.

Figure 1: Global growth picking up steam

Source: Haver Analytics as at 12.10.17. Time periods shown covers the period for which we have reliable data.

Figure 2: The dispersion in real yields creating relative value opportunities

Source: Bloomberg & Haver Analytics September 2017.

Who’s afraid of the big bad Fed?

Despite the solid investment case for emerging markets, rising interest rates in the US and an unwinding of the Fed’s balance sheet clearly creates risks for global bond markets. While the possibility of a more aggressive tightening path remains front of mind, we currently think aggressive tightening is unlikely. Developed market central banks are wary of disrupting the economic recovery by tightening too early. Indeed, the current absence of inflation risks makes it unnecessary for now. In addition, as current accounts have healed (in aggregate), emerging markets do not rely as much on foreign flows than they did going into the ‘taper tantrum’ in 2013.

Figure 3: Current accounts much more balanced which creates a natural airbag for currency markets

Source: Haver Analytics, Investec Asset Management, as at 30.06.17.

Populism or pragmatism?

The threat of populism in the West has eased substantially as President Trump has relaxed his campaign rhetoric and election outcomes in Europe have turned more positive. However, we will carefully monitor what lies ahead for 2018 and the potential impact this could have on select currency markets. In particular, the North American Free Trade Agreement (NAFTA) renegotiation remains a core risk and none of the three sides (US, Mexico and Canada) have shown much interest in compromising.

North American Free Trade Agreement

However, we expect common sense will inevitably prevail, given the benefits of the free trade agreement to all sides, alongside the importance of the voting electorate in the border states of the US.

Other material changes in US trade policy appear unlikely, with Trump now focused more on corporate tax reform. Emerging market countries with large trade surpluses with the US now also appear more willing to operate on a more level playing field after being put ‘on notice’ by President Trump.

 

What it all means: Positioning portfolios for 2018

We reflect our positive view on the asset class through an overweight allocation to emerging market currencies and are more neutrally positioned in hedged local currency bonds. So far this year, emerging market currencies have lagged the rally of other emerging market assets. REERs have only risen marginally due to the strength in the euro and robust global economic growth creates a favourable environment for the asset class. Hedged local currency bonds appear more fairly valued overall, although the asset class still benefits from significantly higher real yields than developed markets.

We prefer currencies that benefit from the current boom in industrial, manufacturing and commodity sensitive economies. We are generally more conservatively allocated to those countries which overstretch themselves by running large current account deficits. These countries remain particularly susceptible to prolonged volatility as they rely heavily on external financing.

Local currency bonds offer plenty of relative value opportunities, given diverging inflation and central bank interest rate cycles. We generally prefer countries where inflation is low, central banks are either lowering or keeping interest rates stable and where yield curves are steep.

1 The weighted average of a country’s currency relative to an index or basket of other major currencies, adjusted for inflation.
2 The sum of the balance of trade (goods and services exports less imports), net income from abroad and net current transfers.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. This may lead to larger financial losses than might be anticipated.

Fundamental drivers to provide support

By Victoria Harling

At a glance

  • Robust earnings should continue, underpinning credit spreads in 2018
  • We do not expect aggressive re-leveraging
  • Political developments that generate uncertainty, including multiple elections, a debt restructuring in Venezuela and tensions in the Middle and Near East could generate opportunities
  • The underlying strength in economic growth should also provide support
  • Technical demand from institutional investors is strengthening
  • Although returns may be more muted than the phenomenal run of recent years, we see plenty of opportunity to generate alpha in the asset class

Positive fundamental drivers should continue

In 2018 we expect the global business cycle to continue providing a solid backdrop to support robust emerging market corporate earnings. 2017 saw the first structural improvement in revenue growth since 2014 and the first earnings growth since 2013. We expect ongoing revenue growth to underpin corporate credit spreads into 2018.

During the 2013-16 recession in emerging economies, we saw companies proactively reducing debt in order to revive financial health. Unsurprisingly, in 2017 we did not see widespread dramatic improvements in leverage, but instead saw marginal declines. This is consistent with the normalisation of business models, where cashflows were dedicated to capital expenditure and dividends as investment resumed on a muted basis.

Developed market companies have begun to spend more on capital expenditure (capex), but we have yet to see emerging market companies want to use higher leverage to fund capex, though we are watching for this in 2018. However, we think leverage remains front of mind for most corporates and many are cautious about overstretching themselves, despite the fact that emerging market companies retain more conservative leverage and financial metrics compared to develop market peers. As a result, we do not expect an aggressive re-leveraging in 2018.

Figure 1: Emerging market companies remain under-leveraged1 relative to the US

Source: BoA Merrill Lynch, as at 31.10.17. Note: Chart shows average leverage metrics in different rating buckets, comparing emerging markets and the US.

Political tensions provide opportunities

Emerging market companies’ conservatism is due in part to some political headwinds. This includes elections in Brazil, Mexico and South Africa, a debt restructuring in Venezuela, geopolitical tensions in the Persian Gulf, heightened tensions between Turkey and the West, and the risks from NAFTA renegotiations for Mexico.

All of these potential headwinds create the possibility of heightened volatility for companies operating in these jurisdictions, especially if we see downward sovereign credit rating pressures weigh on the ratings of these companies. However, to the extent that corporate spreads follow government bonds, we see these potential temporary setbacks presenting potential opportunities.

Where do we see value in 2018?

All of the above is consistent with expectations of central banks delivering the current set of interest rate hikes under the scenario that inflation remains contained and growth strengthens in a moderated fashion. However, 2018 has the potential to deliver a faster pace of growth and for associated policy mistakes, which could cause a significant repricing of risk assets.

With this in mind we turn our attention to valuations of the asset class. While headline spreads and valuations look relatively tight compared to history, in the context of stretched valuations across other asset classes and the supportive global macroeconomic backdrop, spreads could move tighter. Equally, spreads of the asset class as a whole do not reveal the full picture, with mixed value across geographies and sectors. We see 2018 very much as a year for bottom-up credit selection as a means of generating alpha. While most value sits in some of the more risky pockets of the asset class; we see particular value in select investment grade, long duration assets in jurisdictions with some form of political risk. These pockets of value are likely to suffer if a more aggressive central bank hiking cycle comes to pass. However, we still feel the risk reward profile is attractive in select names. The underlying tailwind of global growth should provide a cushion and help drive spreads lower in these companies, even in times of global bond market volatility.

In particular, we still prefer Latin America and EMEA (Europe the Middle East and Africa) over Asia, and long duration bonds in commodity-related and transport and infrastructure companies where the potential for significant appreciation still exists. For those who believe we will see higher inflationary-led growth, we see short duration credit as a defensive income play. We expect this part of the asset class to remain well supported. However, we caution that any follow-through on China’s deleveraging plans may cause this demand to slow.

Demand for yield provides tailwind

Finally, from a technical perspective, we have talked for many years about the structural under-ownership of emerging market credit. 2017 was a year where this narrative started to correct. We have seen a shift towards adoption of the asset class by European investors and life assurance businesses where select absolute yields still deliver the required liability matching profiles needed for a given level of credit risk.

We believe this theme will continue into 2018. This appears to be a structural change rather than a tactical allocation, given default rates are set to remain low. We believe that the emerging market credit rating downgrading cycle has bottomed and has upside from here. With this in mind, it is telling that as the asset class evolves, there is a record amount of cashflows being generated from this asset class, supporting future issuance and driving technical demand.

Figure 2: Emerging market corporate bonds still offer an attractive spread compared to developed markets

Source: BoA Merrill Lynch, as at 31.10.17.

Alpha opportunities remain

After two phenomenal years of above-average returns, 2018 should bring more balanced returns in line with the lower yields on offer. Nevertheless, we see enough attractive opportunities to potentially deliver returns above the market, in line with our long term alpha targets.

Additionally, we see the likelihood of yields repricing to higher levels as relatively low given the strong technical demand which is encouraging new investors into the asset class.

1 Leverage – the value of a company’s debt divided by its equity.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivative counterparty: A counterparty to a derivative transaction may fail to meet its obligations thereby leading to financial loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses. This may lead to large changes in value and potentially large financial loss. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates and/or inflation rises. Liquidity: There may be insufficient buyers or sellers of particular investments giving rise to delays in trading and being able to make settlements, and/or large fluctuations in value. This may lead to larger financial losses than might be anticipated.

Natural Resources

Supply constraint comes to the fore

By Tom Nelson

At a glance

  • Supply will continue to be as important a driver of commodity prices as demand
  • Natural resource companies continue to get financially stronger
  • Physical precious metals provide portfolio protection
  • Building upon the renewables opportunity
  • Environmental, Social and Governance factors are very important for active managers in the natural resources sector

Follow the supply

We believe supply will continue to be as important a driver of commodity prices as demand. Demand continues to appear solid with the synchronised improvement in global economic growth, however there are specific factors that affect supply and will need to be closely monitored. Examples include the effect of supply cuts from OPEC and non-OPEC on the oil market, and China’s deliberate measures to improve environmental and safety performance – not to mention profitability – which has led to significant reforms and reduced output in coal, steel, cement and aluminium. Equally, in agriculture we are seeing less production capacity being added in the fertiliser sector.

The plan is working

Natural resource companies continue to get financially stronger. The environment of improving commodity prices, company cost-cutting and asset sales has enabled companies to generate stronger cashflows than the market expected. This has led to debt reductions and more sustainable dividends. The focus on ‘value over volume’ is now the rule rather than the exception, and as share prices move higher this becomes a virtuous circle. We must remain acutely watchful here: the long-term track-record of capital conservatism and shareholder-friendly strategy is mixed, and was notably poor in the latter part of the last recovery. We must look to disciplined natural resource companies with a management team that can allocate capital effectively and control debt levels.

We need to hold management teams to account and ensure that value creation and corporate returns are prioritised over growth and expansion. But it is very noteworthy that less than two years after the dark days of January 2016 Rio Tinto is getting close to a net cash position and Total has just produced its best quarter of free cashflow generation since 2011 when oil was moving above $100 per barrel.

Figure 1: Equities faring better than direct commodities

Source: Bloomberg, as at 31.10.17.

Beware the speculator

Fundamental research and analysis of physical commodity markets is frequently derailed in the short term by financial or external factors. Currency moves, geopolitical factors and weather can all supersede the fundamentals of supply, demand and inventory levels. Most noticeably in 2017, speculators, especially in the oil market, have played a large role in determining near-term oil prices.

Speculative positions in oil futures increased sharply following the November 2016 OPEC supply cut announcement. In the 12 weeks from the end of November to 21 February 2017, the NYMEX non-commercial futures position grew from 288,000 contracts net long to 557,000 contracts net long. This was the largest net long position ever recorded on NYMEX, by comparison, in June 2014, when the oil price was above $100/barrel, the net long position was 460,000 contracts.

NYMEX non-commerical futures position ballooned between end November 2016 and end February 2017

Source: Bloomberg, June 2017.

By June, the NYMEX net long position had fallen back to 329,000 contracts, substantially lower than the position in February. Market sentiment deteriorated sharply in the second quarter, with the oil price falling to 2017 lows of below US$45 per barrel, and tipping the oil price into a technical bear market. At the same time, the dollar was weak, demand for oil strengthened, geopolitical risk increased, OPEC’s commitment to the supply cuts was reiterated, and inventory levels fell. Quite simply, the animal spirits of traders were too exuberant in February and too despondent by June.

Physical commodities still have a role

Although we continue to find better opportunities in natural resource equities than in physical commodities, physical commodities still have a role to play in investor portfolios. Commodities have historically offered a good defence against inflation, as well as providing diversification. Moreover, physical gold and precious metals can act as an insurance policy against mounting fiscal, currency and broad market risk.

The growing role of renewables

The energy sector is being disrupted and we believe there is a significant structural growth opportunity in renewable energy. Our 2015 paper, ‘Our energy future – creating a sustainable energy system’ forecast that 5% per annum was an achievable growth rate out to 2050, with both solar and wind closer to 7%. The Bloomberg New Energy Finance ‘New Energy Outlook 2017’ (June 2017) estimates that wind and solar will account for 48% of installed electricity generation capacity by 2040, compared with 12% today.

Our interpretation of the Energy Transition rests on two central premises:

  • The speed of the transition is exceptionally difficult to forecast, as we are seeing in the wildly divergent forecasts for the adoption of electric vehicles.
  • Multiple sources of energy will have an important role to play in the transition. The market and the world’s opinion makers are too fixated on the demise of ‘old energy’, which we think is exaggerated, and are not focused enough on the opportunity presenting itself in renewable energy.

Environmental, social and governance taking a more central role

Environmental, social and governance (ESG) will become more important in 2018 and the focus on climate change and other ESG issues will only intensify from here. We are acutely aware of our responsibility as active shareholders in the natural resources sector.

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 our fundamental stock analysis and has been for a number of years. 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.

Reasons for optimism

Well-managed natural resource companies are enjoying the tailwind of improving commodity prices and much-improved capital allocation. There is ample reason to believe that this can continue into 2018.

There are three risks to this view:

  • Corporate or company risks, likely around an abandonment of the ‘value-over-volume’ philosophy, which would lead to cost inflation, excess supply and deterioration of returns.
  • Demand risk, in the form of a global slowdown, lower GDP and reduced demand for materials.
  • Market risk, a negative market event which trips equity and fixed income markets into a sustained sell-off, taking everything with it.

General risks

All investments carry the risk of capital loss and past performance is not a reliable indicator of future results.

Specific risks

Geographic/Sector: Investments may be primarily concentrated in specific countries, geographical regions and/or industry sectors. This may mean that the resulting value may decrease whilst portfolios more broadly invested might grow. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Developing market: Some countries may have less developed legal, political, economic and/or other systems. These markets carry a higher risk of financial loss than those in countries generally regarded as being more developed. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. bankruptcy), the owners of their equity rank last in terms of any financial payment from that company. Commodity-related investment: Commodity prices can be extremely volatile and significant losses may be made.

Important information

This content is for informational purposes only and should not be construed as an offer, or solicitation of an offer, to buy or sell securities. All of the views expressed about the markets, securities or companies reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients. The information or opinions provided should not be taken as specific advice on the merits of any investment decision. This content may contains statements about expected or anticipated future events and financial results that are forward-looking in nature and, as a result, are subject to certain risks and uncertainties, such as general economic, market and business conditions, new legislation and regulatory actions, competitive and general economic factors and conditions and the occurrence of unexpected events. Actual outcomes may differ materially from those stated herein.

Issued by Investec Asset Management, issued November 2017.