Un repaso a los mercados

Mark Tinker, AXA IM - Martes, 24 de Enero

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The inauguration of President Trump sets the clock running for a different policy era. Lack of predictability is causing risk premia to edge higher again, but the motto of taking Donald Trump seriously (what he does) rather than literally (what he tweets) remains in place. Asia and emerging markets are worried about US trade policy, but not only is this just the start of negotiations, Asia in particular has a future more tied to intra-Asia trade
Policy changes will impact individual stocks and sectors more than simply the cost of capital, this will likely make for less correlation between stocks, an environment that should favour active investment

Financial markets are broadly neutral when it comes to politics. This is not to say that they are indifferent, rather that smart investors recognise the risks associated with aspects of behavioural finance and try and avoid bringing emotion into their investments. As discussed on numerous occasions last year, increased uncertainty will tend to raise the risk premium and vice versa. This is not markets giving an opinion (although many commentators giving their opinion will try and claim the market agrees with them) rather it is simply markets trying to discount the net present value of long term expected cash flows.

We have had a number of meetings with experienced US policy advisers in recent weeks and the general conclusion is an all pervading sense of uncertainty. Washington insiders simply don’t seem to know what rules the Trump administration will play by and this is being reflected in a backing up in risk premia. The Trump trades are being discounted at a higher discount rate, which is why they appear to be fading. The general view is that the separation of powers means that the new President will need to work with Congress and the Senate, who while Republican, may actually be as tricky to work with as occurred under the Obama administration. Meanwhile the delays in the ratification of President Trump’s various nominees may slow down much of what can be achieved in the first 100 days.

Having said that, President Trump is already operating through the channels that President Obama used to enact policy and the powerful message is an unwinding of much of what happened under the previous regime.  President Trump has already said that he will “embrace the shale oil and gas revolution” and “clean coal technology” while still focussing on clean air and water. He has already moved to withdraw from the Trans-Pacific Partnership (TPP) and is going to renegotiate the North American Free Trade Agreement (NAFTA) – although an existing bi-lateral deal with Canada appears to be fine. This means we face a different set of policy risks, likely to be more sector and stock specific as existing advantages are withdrawn and new ones introduced via fiscal policy, whereas over the last few years we have seen monetary policy dominate, making it much more about the cost of capital than the return on capital.

Chart 1 reproduces one of my favourite illustrations of the impact that such short term swings in discount rates can have on the portfolios of investors trying to invest for the long term.

Chart 1: The importance of multiples in the short run and earnings in the long run

Source:  BCG Analysis. TSR: Total Shareholders Return as at 31/12/2013. For illustrative purposes only. CR01751/02-17

The data, from Boston Consulting Group, looks at total shareholder returns in the US over the period up until end 2013, illustrating how much return was down to earnings and how much to multiple expansion. In essence, this is the dilemma for equity investors – not just active, but passive as well – alpha dominates over the longer term, but in the shorter term it can be all about beta. This was the underlying message from my final note of last year when discussing ‘The twelve days of Christmas’ and my comments last week highlighting the dangers of first trying to predict beta events and then subsequently trying to invest on the back of those predictions. Over the long term the real driver is the underlying earnings stream and that is very stock specific, but while we wait for the alpha to come through we need to be able to hopefully capture some beta in some years and look to hedge it out on other occasions. Thus when looking at opportunities, investors need to treat the two separately. If the market puts in a heightened risk premium due to Trump or Brexit or any other known unknown, then this may be an opportunity to pick up some beta, principally by having a longer term time period to take on the higher risk premia. 

Some markets are arguably more efficient than others in this respect and last week I discussed how emerging markets (EM) may offer some beta opportunities given the elevated risk premium in the wake of Donald Trump’s election victory and the perception that a strong dollar and American trade policy is going to be ‘bad’ for EM, when a more nuanced bottom-up approach suggests that need not necessarily be the case. As my colleague Aidan Yao (Senior Emerging Asia Economist) points out, an all-out trade war would not be good for President Trump, or his supporters, not least because, in the case of China at least the majority of the goods imported by the US are for items such as food, clothing and electronics and a large tariff here would simply raise domestic US inflation. Meanwhile if the tariffs were selective it would only shift supply from China to, say Vietnam, doing little for the trade balance. Indeed as discussed last week, the easiest ‘win’ for the US trade balance is actually to export more shale oil.

China is also the US’s third largest customer - after Canada and Mexico - the obvious point about global supply chains being something that is already being explained to President Trump. For now, it probably makes most sense to view statements on tariffs and trade as the starting point for negotiations rather than actual policy. The stated policy is about jobs as well as trade and bringing jobs back to the US. Aidan and team have combined concepts such as import penetration (horizontal scale) and the largest share of imports to produce a graphic highlighting the industries most ‘at risk’ which include apparels, computer and electronics, electrical equipment, furniture and textiles. However, as outlined above there may be good reasons why there is more talk than action in many of these areas.

Chart 2: Industries most ‘at risk’ of a tariff war between US and China

Source: CEIC, US Bureau of Economic Analysis and AXA IM Research as at January 2017

In terms of Chinese retaliation, we suspect that if it happened it would not be for Chinese economic reasons but to put (painful) pressure on certain US sectors. Here again, Aidan and team have combined measures of where China is a major market for US exporters and where the US is a minor percentage of the overall imports, i.e. maximum pain for US minimum pain for China.

Chart 3: Where might China respond?

Source: CEIC and AXA IM Research as at January 2017

Overall we suspect that, while markets will remain nervous on US trade policy, the reality will turn out to be less dramatic than the rhetoric – ‘what he does rather than what he tweets’. The sectors highlighted (on both sides) will undoubtedly put pressure on domestic policy makers to achieve some sort of compromise. In the meantime, stocks in these sectors have obviously picked up risk premium.

There is a further important twist to this new world of stock and sector specific policy risk from an EM and Asia perspective of course, the fact that the benchmark indices do not really reflect either the economies or the underlying opportunity set. This is reflected in the following chart compiled from data from JP Morgan and returns to our notion of beta versus alpha and active versus passive. It shows the percentage of active equity funds by geography beating their benchmarks over time.

Chart 4: Active managers beating their benchmark by geography and time

Source: JP Morgan AXA IM Framlington Equities as at January 2017

The lighter blue bar shows the US, rightly regarded as the most efficient market, and the impact of the Global Financial Crisis (GFC). Since 2010 it has been extremely difficult to beat the US benchmark, not least as quantitative easing (QE) has forced far greater correlation of returns within markets – making it much more about beta than alpha. It is also worth noting (as I have before) that in many cases active strategies may not actually be seeking to outperform a benchmark, but rather to target a lower level of risk, albeit higher than alternatives such as fixed income. For example, an equity income strategy or a fund focussed on factors such as defensive quality may be more absolute return focussed and even if they  underperform a rising market the underlying client does not mind, because they out perform a falling market. Such asymmetry may seem counter intuitive to some (especially those advocating index funds) but is more of a reality than most people think.

This is not always the case in Asia and emerging markets however, where the picture is much more volatile with 5 of the last 9 years seeing more than 50% of active managers in EM outperforming their benchmark and in 2012 almost 90% doing so! This phenomenon is much more likely to be down to the nature of the benchmark itself. 2012 (when almost 90% beat the benchmark) was a strong up year while 2013, when only around 30% beat it, was actually a down year. The distortions of market cap weightings, the impact of several large stocks and subsectors – Samsung, Chinese banks, state-owned enterprises, make it particularly difficult at times.

As noted before Christmas, bond analysts will always forecast a recession, credit analysts a steady continuation of the cycle and equity analysts steady growth and a positive economic cycle. In addition we note that bottom-up stock pickers will always declare it to be “A year for stock picking’. So with that caveat in mind I point to Chart 5, showing the decline in pair wise correlations in the S&P500, indicating the prospect of a return to active management (!)

Chart 5: Conditions improving for active management?

Source: BoAML Global Investment Strategy as at January 2017

Meanwhile, we should not lose sight of the fact that here in Asia, not everything depends upon the US. The opening up of China and the recycling of domestic savings into real assets rather than simply ‘vendor financing’ US consumers via purchases of US Treasuries is a long term trend already well underway. We have frequently referred to the One Belt One Road (OBOR) initiative as China invests in physical infrastructure to connect with the rest of the world. As such, the OBOR initiative can impact countries beyond Asia as well. Last week saw the arrival of the first freight train from China to London, a trip of 7500 miles that took 18 days, between 12 and 14 days quicker than the usual sea-bound route and for about half the price of airfreight. 

This is not exactly new, trains have been running from China to other European cities since about 2008, but it is the first to the UK and is that with the prospect of the UK fully leaving the customs union of the EU as well as the single market (a point made clearer by UK Prime Minister May last week).

It is also perhaps an encouraging sign that, even without grand agreements and pledges, technology, innovation and market forces are still working to improve the environment. The train route is also much better for the environment: the CO2 emissions are around 20% less for the train because of the distance travelled, plus of course the airborne pollution from bunker fuel is largely unregulated and is amongst the worst out there. I have noted before the quote that the biggest 15 ships in the world create more of certain types of pollution than all the cars combined. There are many articles on this, but this one here points out the maths.  

Finally, and while we are on the subject of sustainability, my attention was drawn the other day to a fascinating piece in Scientific American highlighting how advances in technology now means that it is possible to produce potable drinking water from salt water for around 58 cents… per thousand litres. An Israeli company named Sorek has managed to reduce the cost of desalination by two thirds compared to the 1990s so that Israeli households apparently now pay around US$30 a month for their water, cheaper than Los Angeles. This has potentially very positive implications for the Middle East as well as perhaps reducing some of the more apocalyptic notions about wars over water.

As we said last week, long term opportunities tend to arise from new business models and new technology, shorter term ones from market over-reaction. 2017 looks set to give us plenty of both.

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