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roundtable
montreux
2019
Last year’s big calls
Is there a risk of complacency?
US outlook and the stance of the Fed
Fixed income repositioning
Emerging markets & China
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investment leaders
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spea kers
Our second annual Investment Leaders discussion in Montreux built on 2018’s inaugural meeting with the discussions extended to nine major allocators. This group of top-level decision markers debated opportunities and challenges – and how their key calls might change.
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he super-allocators who make investment calls for international private banks and wealth management firms have a huge influence on assets flows. Their decisions set the tone for professional investors everywhere.
On the agenda were what they got right – and wrong – over the past year, whether complacency is creeping into the market, what the real future of the Fed may be, rethinking fixed income and to what extent global growth will be dictated by the emerging world and, most notably, China.
Here’s what they had to say…
the biggest risks
If we could look back at the key calls you made at the beginning of last year, get a sense of how those panned out over the last 12 months and assess whether you made any major readjustments since, what turned out differently to how you predicted?
Lars Kalbreier
In 2017, we were heavily overweight in equities, and that is something we neutralised in the fourth quarter. In hindsight, we should have been massively underweight in the period beginning last summer and then, on 24 December, go overweight. In terms of regional allocation, we were overweight in emerging markets, which hurt us. A good call was going higher risk at the end of November. That was fairly difficult month, but we had some very strong rewards on the back of that.
We got the bond call completely wrong on where rates were going. We thought rates were going higher in terms of long-term yields. It worked out reasonably well until the fourth quarter. But then it all came undone and we had to reboot that whole analysis and view on the interest rate environment. That was quite difficult for us. We were cautious for most of the second half of last year. So I think that worked out fairly well, especially going into the fourth quarter. A couple of things that worked out well for us in August were we started getting cautious, particularly in technology and energy. Our timing wasn’t as good as Lars’ [Kalbreier] so we didn’t start putting risk back on until January or February. For what 2018 was, I think we were reasonably happy where we ended. And the first part of 2019 has worked out reasonably well for us.
Norman Villamin
We underestimated the speed at which the trade problem impacted the real economy because the impact of those discussions on trade negotiations completely stalled international trade. On the side of risk reduction, we started to de-risk. In 2017 up to this time last year, we were quite risk on, and with a lot of risk in equities. Then, feeling we were going towards the end of the economic cycle, we decided to reduce the risk in the portfolio by selling the most illiquid part of the portfolios. We ended up in the selloff with a reasonable amount of cash, something like 13% or 15%, and since then we have not increased our allocation to equities. But we have played more carry trades such as emerging market debt in local currency because we had the comfort of the central bank telling us they would be nice to us for at least the next nine or 12 months.
Stephane Monier
This time last year, we were pretty defensive, having reduced exposure to risk assets. We probably did so a bit early in retrospect, but it helped in the second half. We were a bit out of consensus with regards to emerging market debt and equities, where we were underweight, but that served us well. What we got wrong was being shy about getting back in, in January. We added some positions, but in retrospect they were not enough. But performance year to date has compensated for the drawdown experienced in portfolios in the fourth quarter of last year. All in all, that defensive stance and our positive view on the dollar – part of the reason we were negative on emerging markets – served us well in the course of last year.
Alan Mudie
We did something very unusual, which is relying less on asset allocation than we normally do. We saw the dichotomy between the political volatility and the economic reality and saw that markets were actually following a lot of the news and not enough of the economy. So we decided to take out many of the big bets. We have remained overweight equities versus bonds, that was fine. We were underweight bonds. We saw that the yield curve was so flat it didn’t make sense for us to take long duration. The bonds we had were corporates. We were in the US and not in Europe so the tactical calls were very limited, but what we did do was be very disciplined. So, we were positive all the way until December and then we gave it back, we ended up at flat, which was very good. This year we didn’t change anything. We remained a little overweight equity, a little bit in the US, a little bit in technology. We think there is a lot of complacency building up for the short term. So long term, we think equities may continue to deliver.
Carlos Mejia
What struck me last year is we had three corrections within a single year, which is unusual. We had a scenario where we were expecting higher volatility, which happened maybe more violently than we thought with sharp trend reversals. The markets were driven mainly by changes in sentiment rather than fundamentals, which represented a better environment for traders than long term investors. Flexibility and reaction were key to performance.
Gilles Prince
Last year it was all about timing. We were too early on our overweight in emerging local debt in the second quarter 2018, but then we had decent gains in the third and fourth quarter. On a 12-month basis, it was right to keep an overweight in global equities despite the temporary pull back in the fourth quarter last year. From an asset allocation point of view we started to reduce the risk in all non-equity buckets. This includes alternative investments as well as the semi-liquid space, which also went down significantly – just look at the hedge fund performance in Q4 2018. At the end of November, we increased global equities. We started with a massive overweight into this year, but already tactically took some profits end of March simply because in the short term, we think the markets are a little bit ahead of themselves.
Thomas Wille
We were too positive on emerging markets through the summer. We underestimated the impact of the trade war. What we did very well is move to zero allocation on the high-yield side at the beginning of 2018. We were a bit concerned that the high-yield market was too extended, too expensive and we started to build up again in the fourth quarter. We increased that even more after the Fed came into play in December and said they’re making a U-turn, and that’s still the position we have today. We are quite overweight in high yield and we think that’s the place to be if there is no recession.
Philipp Baertschi
We reduced credit massively at the beginning of last year. So CoCos, high yield, which played quite well, but was very difficult after a very fantastic 2017. We did quite a lot of adjustment from a style basis. So really moving from momentum to value, re-engaging in April into the Nasdaq, selling the top, going back to a more home bias. There wasn’t much change on the asset allocation level, but very much on the style, which helped quite a lot to mitigate the Q4 effect. In November, we added equities into Europe, which we thought was attractive and cheap versus the US. So obviously, it was painful year, but very rewarding this year with the exception on duration. Nobody expected a U-turn like we’ve seen from the Fed. We were a bit too short duration, we kept our relative short duration and did not add to it at the beginning of the year. So that is the costly part, the missing hedge from the long end. As some of my colleagues said: when it’s flat what’s really the incentive to go and buy ten years.
Michel Munz
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Carlos, you felt that there was an element of complacency in the market. I’d be interested to know if people generally feel that’s true? Current market sentiment, what do we think about it? Is there complacency out there that we should be concerned about?
When we look at the movements we’ve seen in asset prices, compared to the news flow that we’ve had, I think that they’ve gone very quickly. When I then look at the amount of insurance that people are buying against a possible setback, it’s not there. So, people are not thinking about any possibility of a pickup in inflation anywhere, even though unemployment is coming down across the world, and wage growth is increasing. Everybody believes that a negotiation will be reached between the US and China, and that scenario has been priced in across the markets. You have the gilets jaunes in France, Mario Draghi is going to leave in the final part of the year, and people are not even worried about it. I’ve found that there’s a little bit of a disconnect regarding everything that is happening and what the asset prices are doing. That’s what I mean when I say that people are becoming complacent about what is really happening.
I don’t think the investors are complacent, I think they behave quite rationally. We can see this on the equity flow side, and most investors have actually reduced their equity positions into that rally. I would say investors are still quite concerned about the outlook. I don’t believe everyone thinks we’re in a goldilocks scenario, which is why I wouldn’t say complacency is really there. To me, complacency means that they’re mispricing the probabilities.
I agree with Carlos that there is a level of complacency. Lots of fears which rose in the fourth quarter began disappearing throughout the first three months of the year. The Chinese market was up 30%.
Complacency for me is when investors ignore the bad news and continue pushing prices up until it translates into euphoria with indiscriminate buying and a fear of missing out. In this extreme scenario, a marginally bad news story that has influenced [investor] sentiment could then precipitate markets into a correction. We’re not at that point yet but I definitely think that there is some complacency building up across markets. Short positioning in some ETF securities remains large, expectations are optimistic and risks do not seem to be priced in, and volatility remains low. If we have a correction, we could have a snowballing effect which could lead to an even more pronounced correction. In complacent markets with imbalances, downside risk could be significant.
Maybe this idea about complacency is due to the distribution of the outcome on several problems that we are facing. So, there is the trade negotiations between China and the US, where I would guess that there’s a 25% chance that it gets solved by the end of the year, and maybe a 15% chance that it ends badly. If I take Brexit, I guess everybody thinks we’re going to end up in some sort of customs union, which would be 80-85% probability, while there is a 15-20% chance we could be heading for a hard Brexit, whatever form that takes. The probabilities are really twisted to a favourable outcome. Unfortunately, if this is not the outcome that materialises, then you could potentially have a big correction. So, you have little to win if it goes well and a lot to lose if it goes badly. This leads to people simplifying the situation, becoming a little bit complacent because they go with the favourable scenario, readjusting their strategy and if something happens, Trump tweets and creates a bit of a panic. I believe these unequal probabilities of outcome are closely linked with the idea that people have become complacent.
If we come back to investor positioning, I’m sure everyone around the table has the same experience as me. Speaking to family offices and high-net-worth private clients, I get consistent pushback against the more constructive view we’re taking this year. The people I’m speaking to don’t buy into that scenario. The question I get most often is: when’s the big one? When is the bear market going to happen? So, I’m not convinced that the whole market is actually expressing a degree of complacency. There are pockets of it. For example, we talked about the way that investors are convinced there will be a positive resolution to the trade dispute between the US and China. We looked at individual US stocks, ranking them on exposure to trade with China (or trade with the US in the case of Chinese stocks), and the conclusion of that analysis was that the market had got ahead of itself. The market was trading as if (a) there was a trade deal and (b) the tariffs that are currently in place had been abolished, which is imprudent. It’s too early.
I would tend to agree on the anecdotal evidence. When you meet family offices, trusts or large clients, they ask: when are you selling? That corresponds exactly to the flows we’ve seen, there’s only been share buybacks. There’s been no real retail flow coming into the market. So, I think it’s more climbing the wall of worry. There’s a part of a recovery from last year’s sharp correction which was undue, and also the fact that we had such a U-turn from the Fed. There, you can argue if there’s some complacency on the back of a dovish Fed. At the margin, I would tend to agree, but from a flow evidence and a client perspective, people are so scared about Q4 repeating itself that no one is reinvesting.
One point we can see is that there’s a lot of misallocation of capital, due to the long period of extremely low interest rates. We don’t know where it will hit, but I think last year was so difficult because of the Fed consistency raised rates and I think that’s a sign. Now they don’t do that, I’m sure if they start again then volatility will rise substantially because there is some misallocation of capital.
When you actually talk to clients they’re cautious because they say: I don’t know what’s going on, I don’t want to put my money to work. I think the clients and the asset owners realise that something has changed. What they don’t understand is what it has changed into and how to model that from an economic standpoint and, more importantly, from a geopolitical standpoint. What the right call for the US and China is to come to an agreement economically, but it’s not necessarily the right call that will take place.
Or is it more due to psychological effects? Many investors were defensively positioned at the start of 2019 and have missed the rally as they were afraid of what had just happened. It became a pain trade not to participate as it was difficult to justify such a violent rally. Investors are just waiting for a correction or a pause to happen so that they have the opportunity to add back to equities.
An important point to mention here is: what are we complacent about? I think one of crucial risks is that the market is still convinced about the omnipotence of the central banks. So the central bank put is very well alive – that is a clear complacency risk. To a certain extent, we have that complacency today, but it can stay there for a long time. Like in the Dot-Com Bubble, prices on the Nasdaq in 1997 were extremely high, and they rose even higher for 1998, 1999 and 2000. On the other side of the coin, we have no euphoria in this market. This ongoing rally is hated by a lot of market participants.
Which is confirmed by the retail flows.
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Somebody used the term ‘a modest recovery’, and I would like to talk about how you see the outlook for the US and what you think the implications are of that battle between Trump and the Fed, how that’s played out and where that has left us.
This is very important for every market participant. Last year, everybody was convinced that the Fed made a communication error at the beginning of the fourth quarter. The only policy error we had last year was a fiscal policy error by the US government. An economy that runs above potential growth and has full employment does not need any further stimulus. I think [Fed chair] Jerome Powell realised that he had to take that Fed as a punchbowl for the White House out of the game. Our forecast is still a slower growth environment in the US towards potential growth. And having inflation under control below 2% still offers a constructive environment for global equities. From our point of view, we will have moderation towards potential growth. The Fed remains accommodative. One area where I am really concerned, which nobody talks about at the moment, is the US deficit. It looks like it is okay to print money every year like there is no tomorrow. When I’m looking at the numbers for 2020 or 2025, it’s insane how huge the amount of debt is – we are talking roughly about $25 trillion or even $28 trillion .
What would happen to the global economy if the US wasn’t spending a trillion dollars? Europe is currently growing at zero, Japan is growing at zero and, last year, China was effectively growing at zero. If you go back to Ben Bernanke when he lectured Japan on the mistakes they made in the post-1989 period, they basically made two mistakes: one, they stopped fiscal stimulus too soon, and two, they didn’t keep cutting rates long enough. That was Ben Bernanke’s lessons for Japan to avoid deflation. I do believe we still have a problem globally, that global deflation is a big risk and if the US is not stepping on that gas, then the risk is that the whole world falls into deflation. So, I understand the point when you look at the US as a standalone, but in the context of the world, isn’t that the right global policy?
When the Germans start fiscal spending, that will be a key driver for Europe.
It’s what we’ve been asking the Germans to do for quite a while now, and they haven’t done it, which is the problem for Europe.
I would say if [US President Donald] Trump had not done the fiscal stimulus, we probably would be in a recession right now. So, it can be a good thing, but on the other hand, it forced the Fed to raise interest rates more than they would have done. So, it creates more volatility in the system.
The mistake was not fiscal. The mistake was the Fed trying to offset the fiscal stimulus. I think that’s actually what Powell realised in the fourth quarter.
Rates are absolutely not the issue, because that was pretty well announced and we had all the dots. We knew how to plan that. That was a communication mistake on the balance sheet reduction, and this is really the big trigger. The futures flow is just massive after just one word. It was before the press conference, after the announcement of rates that everything was fine, and then just because of that word the whole thing started to collapse. That’s why people were badly positioned – because it was certainly not expected. From our perspective, the Fed clearly was too hawkish considering the state of the economy. Unemployment, 50-year lows – but where’s the growth in salaries? There’s none. The global deflation is still to be fought, and actually, the only soldier out there is Captain America.
I never felt that the Fed was trying to offset anything Trump was or was not doing. For me, what the Fed was trying to do was start normalising the amount of liquidity that they have thrown into the system and they were slowly just taking that back.
I’m going to come in defence of Thomas on this. I’d agree, actually, that the fiscal stimulus was imprudent. If we think about it, it’s like Fast and Furious. People talked about a sugar rush, a boost to confidence, a boost to growth, but one which isn’t lasting. We had most of that boost last year. This year, growth will still get a modest fillip from the tax cuts, but they’re front-loaded. Last year, we estimated one half of 1% additional GDP growth in the US. This year, we’re expecting 0.2, but that’s coming now – the impact will fade in the second half of the year. My point is that fiscal stimulus will not provide sufficient fuel to power the US economy to grow above its potential this year and next. We’re slowing back to potential. We may even be a bit below potential by the end of this year.
If we go to Japan and look to Prime Minister Shinzo Abe – what was Abe’s mistake? After coordinated QE [quantitative easing] and fiscal stimulus, he was roundly criticised, as the deficit and debt rose sharply. I believe his first mistake came in response to the criticism, when he raised VAT so he could stabilise the deficit. What happened to the Japanese economy? Renewed recession. And what is the criticism now in retrospect? He should have kept his foot on the gas. I struggle with the criticism of US stimulus given the example from Japan framed against Ben Bernanke’s advice. In fact, we’re criticising the Germans for not doing stimulus now and at the same time criticising the Americans for providing the fiscal stimulus that others around the world are unwilling to provide.
I understand your point, but I’d make the supplementary point that the Germans have fiscal flexibility, because of the golden rule. Because of the prudent way they’ve managed their public finances, they have the space to provide fiscal stimulus. The US no longer has that space.
Look at the benefits you get from being the reserve currency of the world. Europeans are happy to buy US debt at positive yield, the Japanese are happy to buy it, the Chinese are happy to buy it. Clearly this ends one day, but it provides the US a capability to fund fiscal stimulus cheaply to buy time to support the global economy, while hopefully others repair their economies. I suspect the challenge is that the repair is not taking place and other imbalances are emerging.
Yes, as long as foreign investors agree to bear the currency risk. But if they want to hedge it, they are very unhappy with the high cost due to the interest rate differentials. The related question is whether the currency stays in its current range and what would be the consequences if it strengthens too much.
Without the fiscal stimulus from the Trump administration, we would already be in a significant slowdown. Let’s be a little bit provocative – what’s so bad about a slowdown?
With the amount of leverage you have in the world, a credit cycle could be very damaging.
I agree, but the day will come when we approach that cliff.
I think the economic concerns are actually secondary in a future recession. It is the potential social problems that are the issue. Many think a bursting of the current bubble will look like Japan post-1989. However, I’m not sure it’s going to be Japan, because Japan had substantial net savings at the time. The world does not have those net savings, and I think this is what the central banks fear.
Fixed income repositioning was a major talking point last year and the year before that, I think, for quite some time. I would really like to get a sense of how that story has developed for you all. Philipp, you also posed the question, ‘how much risk do you take and how late cycle is high yield?’
We were concerned about the amount of leverage, and the Fed started to raise rates consistently every quarter. So, we reduced it to almost zero, particularly on the high yield side. I think it’s also a question of valuation on the one hand, which became very interesting in the fourth quarter, and the other, probably more important, longer-term issue, is the Fed making a U-turn and now being firmly on hold. I think the combination of the two has brought valuation back to fair value. It’s no longer cheap or very attractive, but the Fed on hold still makes this segment very attractive for investors. I’m sure there will be a problem longer term when the cycle ends, but we have been discussing every year now. I don’t think there is any sign that the cycle will end this year or even next year. So, we shouldn’t focus too much on this end-cycle. For now, conditions are quite good, and the reason for this is really fundamental – that default rates are actually now at record low levels. So, if there are no defaults, the segment will continue to do very well.
I have a fairly strong opinion about high yield. I think central banks are artificially supporting companies that probably would be dead if you were in a normal environment. So, from that perspective, yes, default rates will continue to be low because of the strong central bank impetus. You have an environment that is an artificial one and what I am more concerned about is what kinds of investors went into high yield because traditional investors that bought it were most likely institutional investors. Nowadays, because of the search for yield and because yields have come down everywhere, you have quite a lot of investors who do not have a lot of high-yield experience. They just went there for the yield. The problem is that they tend to invest in high yield via ETFs. To me, that is very dangerous. It reminds me of the famous statement by the former CEO of Citigroup, Mr Chuck Prince, in 2007: ‘When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.’ However, when the music stops, some investors who probably still feel confident being in high yield will be rushing through the doors. These are the ETF investors. In fact, we have created a recipe for another crisis by trying to address the crisis we had 10 years ago. That is where I see the risk.
Those ETFs are based on market capitalisation, which means that when you buy them, you lend more money to the most indebted issuers, which is nonsense. And then the other aspect is the liquidity of those instruments. Clearly, it’s okay, but not superb in the current environment – which is still very positive – but when the music stops, I tell you the liquidity on some of the low rated issuers is going to be atrocious.
Wasn’t the fourth quarter, 24 December, a perfect test?
It was, I would say a small test, yes. We are not yet in a recession.
We feared the same and we sold the entire high yield ETFs by the end of 2017, beginning of 2018 exactly having the same analysis that you did and actually, we were quite surprised how resilient it has been during Q4.
We haven’t had a real crisis. We haven’t been in a recession.
It doesn’t need a recession, just a flow basis, and the flow required is quite massive, and they held pretty well.
Shouldn’t we take some comfort, because last year, when we were talking about high yield, we were quite worried about the loan market, which is even less liquid than the high yield market.
It’s bigger now than the high yield market in the US.
And riskier.
giles prince
One of the things that we saw last year was, as rates were rising, we were worried that a lot of the money was going to need to move, and I was surprised at how easily money came out of the loan market. You didn’t get that dislocation in either the loan or high yield in the fourth quarter.
For example, if you look at some of the credit funds that are invested in subordinated debt – I’ve one fund in mind – but they were running 10 billion in September, October. They went down to 2 billion and now they are back at 2.8 billion. So, don’t tell me there’s not been some movement. People have not taken their loss on this and where it’s very dangerous because the fund I’m thinking about, these are regular people that are investing their pension money in there. So, okay, we have been saved by the Fed in the end, and you know, Mr Powell has been very nice to us when he said he is going to stop raising rates. But I think this is an area that is very dangerous going forward. So maybe, not for the next two months or three months, but I’m pretty sure that two years down the road there will be some sort of accident there.
I was just going to add another note of caution, which I actually made last year, about the poor balance sheet quality of the high yield and the triple-B segment, as highlighted by Nisha. It has continued to deteriorate since last year. Fair enough, in today’s environment, you would expect the default rate to remain as low as it has, and even to decline, but that doesn’t really give me a great deal of comfort looking at the worsening fundamentals. So, from our perspective, high yield, in the US in particular, is an asset to trade, but not to buy and hold.
The other fact to bear in mind is that US high yield is very heavily exposed to energy, which compounded the pain last year. Oil prices reached oversold levels at the end of last year, which, for us, screamed a buy. One of the ways to express that was going back long on US high yield to benefit from both the reduction in spreads and a change in the outlook for oil prices.
What I find interesting is that liquidity was almost not an issue in the fourth quarter of 2018. Over the last two years, it was obvious that the correlation between high yield and equity market had increased significantly, and, basically, you almost see the same turning point pattern for both asset classes. As an asset allocator the central question is about the expected return relative to the risk I have to take. Today we prefer to take the risk in the equity market and not in the high yield bucket.
I agree on the correlation. I totally disagree on the liquidity. Have you tried to trade between 15 December and 31 December 2018? Let’s say, 50 million high yield – good luck.
You could trade the ETF all the time.
I agree. The biggest risk I see is that people are in that segment that should not be there. They were just looking to get those 5% or 6% yields, and today, you are just not getting compensated for the risk you are taking, and I know a lot of people have conservative mandates. They want to have a certain yield, they don’t get it over the govies and they don’t get it with investment grade. So where are they going? They are going down the chain and they should not be in that segment.
Up to a point.
To your question on leverage levels, it’s definitely for me a sword of Damocles. Actually, it goes beyond fixed income and affects equities as well. What we did in our portfolios, also related to liquidity, but not only, was to prefer companies with strong balance sheets, i.e. lower leverage and quality. We know debt ratios are high with a lot of debt just above junk, which is vulnerable to a downturn. We don’t know how and when the cycle will finally turn south, but when it does, we just don’t want to be exposed to these indebted companies’ equity or bonds.
We had diverging opinions last year on emerging markets. So, how should you be positioned in respect of local versus hard currency, debt versus equity – should you be looking at individual countries or should you still be talking about emerging markets generically? What’s the consensus on the China rebound and how does it affect your emerging market thinking?
So starting from the macro end and getting on to the segment and country specific or global allocation. The first thing is that in our mind, everything is aligned in our main scenario for emerging markets to perform, but there are two big caveats. The main risk that we see is the trade tensions between the US and China not ending well, which would be very negative for emerging markets. The second one, which we were just mentioning, is what if at some point the Fed starts to raise rates again? That’s also a negative for emerging markets. We think that if we are to position ourselves between hard currency, fixed income and local currency or equities, our preference is still for emerging markets in local currencies because we think it’s the best risk-adjusted returns that we can expect. Then, historically, we have made the allocation more on a global basis, but we are in an environment where you need to be very selective. We are paying more attention to the country-specific risk, and I think very soon we will go into the country level. Nowadays, a country like China, which belongs to emerging markets, needs to be seen a little bit as an important part of your allocation, and you cannot just mix it in the whole emerging market category.
Especially if we relate it to the trade-war risk. We must consider the size of China, Taiwan, Korea in the MSCI Emerging Markets index, which is about 55%. So, if we want to have a call on emerging markets (EM), we must now have well-informed decisions on China.
We’ve started stripping out China from broader EM, because the problem is that the emerging market call becomes the China call – it’s just too big. So, we basically segregate China out and think about everything else, and then we effectively make overweight, underweight China against emerging or developed calls. Again, I am concerned that the China-US situation is very strategic in nature. So, we’re going to keep seeing these things come back between the Americans and China. I don’t think that’s bad for China in a sense – it’s actually quite good if you’re an equity investor in China because they were going to pull their foot off the stimulus gas. Now, if tariffs go through, they’ll probably put their foot back on the gas and stimulate domestic demand, and we could make a bit of money there. But the flipside of it is that if the renminbi starts weakening, the dollar starts strengthening, with oil prices where they are, and that’s bad for quite a number of the emerging economies and their currencies. So, if we had to be in emerging, I think we would be in hard currency from here. It’s a bit longer in duration, so we’re obviously short duration in hard currency from here. In the emerging equity space, we do like China, and we would use a sell-off to probably put some money to work there.
We’re active in the same way. We stripped out the rest of the world, basically, to be Asia and China in equities. Actually, the rest doesn’t matter anymore to be cynical somewhat. On the other hand, on the fixed income side, I would say that there we stick to the corporate side, not so much on the sovereign. We don’t like the peripheral sovereign, the corporates are much more secure, especially in hard currency, and delivers quite a decent yield. Actually, compared with US high yield, it’s quite stable as well. Last year, when everyone challenged the Chinese position a bit in portfolios, it’s sometimes good to remember your strategic long-term view on China, and that’s why we stuck to it. It was painful, but obviously we had a recovery this year.
I’d like to come back to what Norman was saying about the dollar, because, to me, that’s key for emerging markets and their currencies. I’m actually going to take the opposite side of the trade from you, Norman, on the dollar. We’d expect the bull market in the dollar to be fading in the second half of this year. We’re expecting the dollar to weaken against both developed market and emerging market currencies. There may come a point when we’d be keen to rotate out of hard currency emerging market debt into local currency debt. However, today we still have a gradually strengthening dollar and weak emerging market currencies. The risk reward, we feel, is just not completely in our favour. So, we’re holding off, waiting for more conviction and clarity as to when that turn is going to come. Regarding equities, we’ve downgraded our allocation to China, on the view that the market was ahead of itself, and we’ve upgraded the allocation to emerging markets ex-China, where we see more value and more potential at present.
I think there are very different drivers to the different assets within EM. So, it’s hard to put it all in one. Clearly, for the equity side, it’s Chinese growth that is the big driver. It’s also the biggest component, whether you strip it out or not, and I think that has the best potential in our scenario, where we see a continued pick-up on the Chinese side. We have local currency – the only driver, at 90%, is the US dollar. I don’t have a very strong view on the dollar – it should probably go sideways. Hard currency is mainly a call on interest rates, on US long-term interest rates and there, we see a slight increase, but not too much.
I can throw in a controversial call on that topic. Let us assume hypothetically that China is stabilising now and we have a pick-up in global growth in the second half of 2019. The value might be in Europe when growth is picking up in Asia, especially in China. Europe suffered a lot under the China-US tensions and could profit a lot if a deal is reached.
We actually have it as a strategy.
I’m not so convinced, actually. In the past, the Chinese stimulus was about infrastructure and was related to external demand. It has been very favourable to European markets, for example. This time, it’s more about reviving domestic consumption. So, I’m not so sure it should directly push up commodity prices, and by extension support the European economy. The situation is different, the effect could be muted outside of China.
I’m going to agree to buying Europe if there are positive developments in China. So, in Europe I just fail to see what is a catalyst that is going to push either the economy or the financial markets. For me, if anything is going to push the situation in Europe it is going to come from the outside. I agree with you, Gilles, in that there is a very strong portent to go into domestic consumption in China, but this is something that will take many, many years to actually make a significant difference. So, the Chinese are building the infrastructure to actually have all these interconnections. They have invested very heavily into building roads to go to the ports to do the exporting, and at the moment, they’re actually building the electricity, the roads, the cities, for that domestic consumption to happen.
I would love to agree, but there is not a significant rebound in base metal prices like copper or nickel. They are not rebounding; they are just flat.
I take the other side. If there is a positive surprise in Europe, it comes from inside, because expectations are so low, we see some fiscal stimulus. From outside, I think that what is positive from China will be offset by the US, which is slowing. So, I think the external factors are neutral.
The way we’re looking at Europe right now is, in a sense, how we look at Japan. If the global economy’s coming up, Japan and Europe will be dragged up with it, and so, if it’s cheap enough we’ll play it, but we don’t think you’re going to get that beta that you used to get from cyclical global recovery unless it’s a very big move. That’s not our forecast.
My reading of the Chinese stimulus is there’s another part to it, which I think is, perhaps, even more interesting: the focus on the small- and medium-sized privately-owned businesses. VAT cuts are going to be of prime benefit to those companies. The corporate tax cuts will be the same. The reserve ratio requirement cuts have been targeted at the small- and medium-sized banks lending to the private sector, and that sector is the prime generator of new jobs in the urban environment in China. It’s actually a very astute set of measures addressing one of the imbalances in the economy. China is over-dependent on the large state-owned enterprises, which, as we’ve all seen, have become over-indebted and extremely vulnerable. Private companies have much less debt on their balance sheets – they could borrow more. They need the banking sector to be geared up to do that, and China is focused on ensuring that happens. I think it is actually quite a positive combination of factors for the Chinese economy.
Never fight a Chinese stimulus programme, because in the past, they have always boosted the economy. This is happening right now, and you are right – it is not the infrastructure now, it is domestic demand, which they are trying to boost, and it looks like they are successful with that. I think that not all the European companies will be benefiting from that, but some consumer-oriented companies are benefiting strongly from that. In fact, their sales growth in China are much higher – exposure to China is stronger than exposure to the US. So then, on the stockpicking side, you will have some opportunities.
If you were a buyer of the Chinese index, you’re not making a tonne of money. And especially if you bought the old index before Tencent and Alibaba came in, you’re really not making a lot of money, and so, can we really talk about strategic promise of China? The difficulty I have when you look at Chinese companies is that they don’t generate attractive rates of return on capital.
Hence, one way to play China is in an active way. For one, because the market itself is not very efficient, so active management really works. The second reason is that you can play it via European, Swiss or US companies that have exposure there. Therefore, you get western corporate governance with exposure to China.
When you look back, the guys who made money from the rise of East Asia in the 1980s and 1990s, they were the GEs, they were the Boeings, who were selling stuff to these people.
Yes, but that has changed. When dealing with China, you always have to go into a joint venture anyway, with a local firm. When you have state-owned enterprises, you can argue, like we had in Europe in the good old days, it’s half state-owned. Look at here in Switzerland, how a Swiss company was in the past and how it is now? It’s completely different companies. Tencent and Alibaba are prime examples of how quickly they can emerge. Where 10 years ago, we would never imagine they would have such world leaders today.
China reminds me a lot of Korea of the 1980s and 1990s. After the Asian crisis, the Korean companies restructured, they started focusing on return and you saw this enormous rerating and true global competitors start to come out of Korea. I think we’re all waiting for that to come out of China, and I guess, to me, that is the strategic call. Under what circumstances does that rerating happen? I’m not sure I’ve seen it yet.
If China wants to play a major role in the global economy, they have to open, transparise, restructure and adapt. They are, for example, facing a lot of pressure from foreign investors on trade.
These trade discussions, what are they? They are a reboot of the relationship the western world is having with China. Trump is in fact helping Switzerland and helping Europe because China has already emerged. If you look at their mastery of technology, if you look at the level of PhDs which are coming out of China, they have already emerged. So now, you need to have a reset of the trade relationships. China does not need to disregard intellectual property law. They can do it. They can afford it and they will still be a very strong economy. So these trade discussions will take a really long time because of the structural changes. It is not a handshake like with Canada or South Korea. If we are able to trade the same rules with China that we have with other western countries, we will be able to unlock much more. Instead of having less global trade, I think we will have more global trade.
My challenge to you, Lars, is this is not a multilateral negotiation, this is bilateral. Donald Trump’s objective, Stephen Mnuchin’s objective is not improving the west’s ability to do commerce with China, it’s making America great again.
I do agree, but the collateral side effect is that China is opening. BMW, for example. Was the first foreign company that was able to increase its 50-50 joint venture to 75%. It is now owning it.That would never have happened if Trump hadn’t put such a pressure on. So, some European companies are in fact benefitting from what is happening right now in China. You are right – Trump is only thinking about the US, he is not thinking about the rest of the world. But in fact, he is involuntarily helping others. A better strategy would have been if he would have rallied the Europeans and done it together.
The WTO, I would argue, is the place to do that. But the other part to the discussion has to be the increasing importance of intellectual property for China. Over the last decade, China has made leaps and bounds in its ability to innovate. What they need is a legal framework to protect the intellectual property they’re generating domestically through their innovative capacity.
That is why they should be very happy. That is why they should be okay with protecting intellectual property, because now it works in their favour.
I think we shouldn’t forget we’re moving from a unilateral world where the US was the dominant power, to a bilateral world with China as counterpower. The world needs to find a new equilibrium. So, for me, it goes way beyond trade. It’s a long-term rivalry, not to say conflict, that is unfolding.
What do you think are the biggest risks out there, and what is the next big call or, to look at it from a different angle, how do we make money in this environment?
I’m going to characterise the biggest risk as policy error on the part of central banks, on the part of fiscal policymakers. I think they need to step on the gas. I do fear they are making the mistake that the Europeans have made, and the Japanese have made before them. We are looking at putting duration on. On the issue of how do you diversify, we saw in the fourth quarter that the average hedge fund manager really struggled in that environment. And what worked? Duration. Given where spreads are, duration seems like a good diversification move.
To me the biggest risk is something that nobody is expecting anymore: the resurgence of inflation. An inflation shock could lead to the belief that central banks are behind the curve. Central banks might start to panic and be forced to increase interest rates in an environment that has been created artificially, and where some companies in fact should not be surviving. That could be the straw that breaks the camel’s back. How do you invest in that? Inflation linked bonds could do well. Certainly, you would not like to be in high yield.
For me, the biggest risk is the inefficiencies of monetary policy and, potentially, the social disruption they create. It favours the rich that can borrow, but not necessarily the average person that lives on a salary. So we need to modify those monetary policies in order to accommodate some kind of social cohesion. In terms of investment, I will give you two sides. In the rosy scenario, emerging markets will do well going forward, and if you are very worried, I would put gold as the balancing effect. Gold is a good investment when people have lost faith in monetary policies and in the financial system.
For me, hedge funds and a lot of these real assets are actually less interesting than they could be. Gold is not going to be the one that diversifies if we go into a big recession or crisis. If anything the correlation between gold and the equity markets have been increasing. Gold is the one to have when you have a massive disruption in the market that you’re not expecting, and you buy it quickly. The biggest mistake is going to come from the policy side, due to central banks either being too subordinated to the politicians or completely independent and ignoring. In that environment, I also want to have volatility, shorting equities and long duration bonds.
For us policy error is one of the biggest issues. We did face it somewhat, in Q4 last year. It was a massive U-turn, but it doesn’t mean we’re out of the woods and should we print new highs on the S&P? It gives more a green card to Powell to finally finish his rate hike cycle and that could be very badly taken by the market. You know, with some better CPI numbers and then you’re pushing a bit on that edge, that’s certainly one thing that we’re fearing a bit, but I would say how to protect the portfolio and for me, there could be a full trade war and that would obviously be cramping the global economy. There I mean long duration; the dollar should be a good hedge as well. We haven’t mentioned much currencies, but dollar should be a very, very good hedge. On the other hand, we’re also pushing into private equity. We are more or less out of hedge funds, traditional hedge funds, we have some long-short equity and one macro manager, but it’s a very tiny exposure.
The biggest risk I see is rates going higher. I think that will be the eventual trigger for a recession and it will be very hard for the Fed or any other central bank to time that right. I think the problem with that is we usually only know whether it was an error in hindsight. I would rather watch the yield curve and the inversion of the yield curve. I think that will be a big signal to reduce risk in portfolios. What is important is calling the extremes, and I think that’s also how to make money in this environment. I think it’s important not to make the big mistakes as it might happen that you go overweight into a situation like the fourth quarter. But then please don’t sell at the bottom like in December. I think the same would be true today. You might be underweight or not exposed enough to risky assets today, but I wouldn’t buy today as we are already quite high, quite advanced. We reduced equity risk last week. We are slightly underweight in equities and I think that is the way to make money. If there are opportunities to go back in and on the side, I think carry is very attractive. High yield emerging market debt to some extent, I think just clip the coupons.
The biggest risk remains a policy error. I would agree with you guys there, but if I add a further risk, it is the further rise of populism globally. What to buy? It is tricky. I would say let us do a barbell positioning, buy equities on one side and buy long-term treasuries as a constant source of income. Gold is good for a trade, but not necessary for an investment. If you have the possibility, buy private debt, and private real estate as a true source of diversification. I would still be cautious with semi-liquid investment like listed private equity.
One of the risks is the resurgence of geopolitical risks, which could spark a spike in oil prices, pushing up inflation, interest rates, and so on… Even with all the risks mentioned, I wouldn’t be too pessimistic by looking at the economic situation but rather construct a robust portfolio. I would typically have a barbell portfolio with, on one side, risk off assets such as US Treasuries, gold and cash, and on the other side, equities. But being invested in the current situation is for me a must. Regarding illiquid assets, there is one thing that is striking me with private equity. It’s the vast amount of money pouring into those investments and the bifurcation of liquidity preferences. A lot of investors are ready to commit money in a late cycle environment to new private equity funds with very high expected rates of returns while attractive deals are few and equity valuations high. On the other hand, the same investors are fearful of liquidity risk in traded markets. It seems inconsistent to me and motivated by the search for yield. New investors could face some disappointing returns as too much money is chasing the same deals. Private investments should be part of a long-term programme started years ago.
One thing that hasn’t been mentioned is debt. The overhang of debt, compared to the ability of the global economy to service and to repay that debt. I think this is a structural issue that will remain with us for years, if not decades to come. I’d also make the point that if we did have a resurgence in inflation, I would view that as possibly good news longer term. Higher inflation would improve the ability of the global economy to begin to grow fast enough in nominal terms to mitigate the impact of the size of the debt burden we face today. So longer term, perhaps we should hope for inflation and not fear it. In terms of diversification, I agree with those around the table who have mentioned gold. We still hold gold and, as shown in December, it does trade very differently to other assets in portfolios. We think that will hold true for the long term. Finally, an opportunity that hasn’t been mentioned around the table is our non-consensus long position in Eurozone equities, which I’ll leave for your consideration.
