Q4 2016 letter

posted in: Events, Markets, Quarterly Letters | 0

Dear Friends,

We hope you have had a good start to the New Year and wish you the best for 2017. As always, in our first letter of the year we have attached a review our 2016 investment themes and a list of our investment themes for 2017.

The fourth quarter of 2016 revolved around politics, with a focus on the US presidential election. In Jan 2016, we wrote there was a “strong possibility one or both major party nominees will be from outside the establishment mainstream”. In retrospect, that looks like an understatement. A series of unusual news stories and the eventual surprising result of the US presidential election led to sharp drops in US equities in early November. Markets recovered quickly and ended the year close to or at their highs. In some ways this is a relief rally, driven by the realization that much of the Republican establishment will support the Trump administration and vice-versa.

The political upheavals of the past few months have not changed the underlying economic realities confronting investors. We are likely at the tail end of a bull-market that is almost 8 years old, and several risks loom on the horizon. Interest rates in the US will continue to rise as the Fed attempts to normalize historically low borrowing rates. This will modify the calculus for investors as interest bearing assets become attractive and rising rates impact the denominator in equity valuations.

The results of the US election have created enormous uncertainty about the US’s future economic policies, particularly with respect to trade. We believe that workers’ concerns about economic insecurity do require political solutions. We are not, however, convinced that protectionist barriers are the answer to job-losses in the US manufacturing sector (the last US experiment with high tariffs, 1930’s Smoot-Hawley Act, likely exacerbated the effects of the Great Depression). Nor do we believe it is in the US’s long-term interests to loosen environmental rules. The incoming administration seems bent on trying or threatening one or both of these approaches.

Roughly 50% of sales for S&P500 companies occur overseas. This underscores the global nature of the world we live in, and the degree to which US businesses rely on foreign operations. The prospect of a full-fledged trade war with major regions or countries should worry investors deeply. Though some investors may have been emboldened by the November/December recovery, we would advise caution given the significant headwinds and uncertainties facing us.

As always, we have published our investment themes for the upcoming year and reviewed our themes for 2016.

 

Regards,

Subir Grewal, CFA, CFP                                                        Louis Berger

2017 Themes: The Doldrums

  1. Fed stays the course: We expect the Federal Reserve will continue to raise rates as stated. We expect the Fed-Funds rate to rise above 1.5% over the course of 2017.
  1. Equities Caution: We continue to be cautious on US equities, as we have been for the past several years. S&P 500 is priced at over 25 times last-year’s earnings. Even if we use projections that forecast a recovery in energy sector prices, P/E ratios are over 20. Rising rates erode support for outsized price-earnings ratios. We are also in the eighth year of a long bull market with a number of credit related issues in markets across the world. We continue to advocate for a cautious allocation to stocks and expect to see negative returns for US equities this year.
  1. Artificial Intelligence: Technology continues to come at us hard and fast, but the groundwork has been around for decades. We recall using voice-recognition software to dictate texts almost 20 years ago. It was slow and cumbersome. Modern voice recognition is vastly improved by faster hardware and refined software. When coupled with the ability to search for information and issue instructions to connected devices, this technology can seem very much like science fiction, evoking both fears and dreams. Yet, asking Alexa to lower your blinds is in essence no different than using “the clapper” to turn on the lights. We expect this to be the year that voice activated instructions come to various devices, including cars and household appliances. Companies with effective voice activated solutions will find themselves partnering with manufacturers of all sorts of devices, not simply computer and phone makers. The revenue and earnings implications are less clear. Licensing fees may not amount to much and a large part of the value for technology companies may derive from sales of media and in Amazon’s case, all sorts of goods. We expect performance for companies providing intelligence features in devices to outpace the consumer durables index over the next three years, we will evaluate ourselves annually on this call.
  1. Continental shifts: For much of human history Asia has been the center of the global economy. That changed in the centuries following the European industrial revolution and colonial expansion. Over the past thirty years, rapid growth in China has brought gross East/South Asian annual GDP (ex-Russia) to roughly 25 Trillion USD. This exceeds both that of North America and Europe/Central Asia, both around 20 Trillion USD. The big laggard in Asia has been India, where per capita GDP is 20% that of China. We expect India’s growth rate to exceed that of China’s for the next several years, with the relative difference in per capita GDP falling. Despite the numerous hurdles to doing business in India, we expect investors will begin to pay more attention to companies with exposure to India and an India related strategy. Over the next several years, we expect Indian markets to outperform those in China and the developed world.
  1. European upheavals: This will be a busy year of European politics, there are major elections in France and Germany. Looming over it all is last year’s British decision to exit the Europe zone. Any or all of these have the capacity to inject more policy uncertainty and create market upheavals. Though we believe European stocks to be more attractively priced than US equities, these concerns give us pause. Nevertheless, we expect European stocks to outperform US equities.
  1. Dollar strength continues: We expect the dollar to remain strong against major currencies worldwide. This impacts the returns dollar-based investors can expect to realize from foreign investments.
  1. Drones are going to be delivering much more than bombs: Many of us have been concerned about the impact of automated weapons on conflicts across the world. This technology raises numerous difficult ethical questions, alongside legal dilemmas. Less attention has been paid to the revolution soon to overtake transport and delivery services of every form. Remote operations and autonomous guiding systems are approaching the point where not just driverless cars, but pilot-less planes, captain-less ships and person-less food delivery are about to become a reality. These technologies are going to create immense disruptions for various work-forces across the aviation, shipping and transport sectors. As with so many other technologies, the armaments industry has led the way. But the long-term impacts on our economy, politics and lives will be driven by the commercial applications of these technologies. We expect companies building these technologies to outperform the freight and shipping transportation companies.
  1. Renewable Utilities: Though the incoming administration is not supportive of renewables, we think renewable utility companies or YieldCos will outperform conventional, fossil-fuel based utility stocks. Despite a high likelihood of loosening EPA standards, we think YieldCos benefit from a newer fleet of power plants and stock prices that haven’t recovered much from the energy crash of 2014/15.
  1. Retail Real-Estate: We believe the retail real estate sector will come under pressure from rising interest rates and a secular shift towards online purchases. We expect real estate companies that own large portfolios of malls and brick and mortar stores to underperform other real estate investments.
  1. Optimism about Trump presidency short-lived: We expect any investor-optimism surrounding the Trump presidency to evaporate rather quickly in 2017 as markets find he is unable to follow through on his lofty campaign promises.

2016 investment themes reviewed: “An Uphill Battle”

posted in: Markets | 1

This was a difficult year for our prognostications. We were wrong (or early) on core calls including rising interest rates and an equities bear market, that undercut many other themes that relied on those predictions. Our score was 3.5 out of 10.

  1. × Fed stays the course: We expect short term rates to rise by 1% over 2016, and believe long-term rate rises will be roughly commensurate. We believe the Fed’s board will stick with their stated intentions, it would require dramatic events to make them change course during an election year. As we expected, the Fed was cautious in an election year. Our expectation that the board of governors would vote for a series of quick rises early in the year was wrong, the Fed chose inaction during the election year.
  1. × A return to risk: We believe risk concerns will weigh on markets all year… US equities markets will be down for the year, with a strong possibility that we see a decline of 20% or more over the course of the year. Broader US equity markets ended up 10% for the year, and though the S&P 500 saw a decline of over 11% earlier in the year, this wasn’t as much as we were looking for.
  1. ? Oil is red: We expect oil prices to continue to be weak in 2016, oil is likely to see the $20-25 range… Oil bottomed at $26 a barrel and remained below $50 for most of the year, a big departure from the $100 prices in 2014.
  1. ? Emerging markets comeback: We believe smaller emerging market equities will outperform developed markets in North America and Europe which we expect to be stuck in the doldrums during 2016… With total returns of 8.58%, the MSCI Emerging Markets index outperformed most developed markets, except the US (where returns were in the double digits).
  1. ? A Tech-wreck redux: Technology companies have been among the strongest performers over the past few years… However, extremely optimistic valuations for unproven business models have become the norm and we believe the inevitable reckoning is quite likely to occur this year. High profile stocks such as Twitter and LinkedIn suffered large declines this year (LinkedIn was eventually sold), and the Nasdaq composite (7.50%) underperformed the broader S&P500 (11.96%). That said, the broader decline for technology stocks we were expecting did not materialize.
  1. × Commodity economies fumble: Australia and Canada were both spared the worst of the global financial crisis… We believe both will be among the worst performing markets in 2016. Though the Australian market had relatively moderate performance in 2016 (the ASX rose roughly 5%), the Canadian market was one of the best performers (with the TSX up almost 15%).
  1. ? The greenback still rules: We expect upheaval in a number of markets to drive a flight to safety and support USD through 2016. We believe the dollar continues to remain strong in 2016 against Euro and other major currencies. We were right on this call, the dollar has gained over the course of the year, against both the Euro and other major currencies.
  1. × Renewables: We are long-term believers in the prospects of the renewable energy industry and the recently concluded Paris accords should support prices in the sector…We expect renewables to continue outperforming their conventional energy counterparts. We were wrong on this one. Renewable energy companies had moderate to flat performance, with the Nasdaq Clean Edge index ending the year down over 4%, while the S&P Energy index was up over 20% for the year.
  1. ? Presidential election: 2016 is a US presidential election year and an unusual one to boot. We believe the sentiment favors non-traditional candidates who reject the status-quo. There is a strong possibility one or both major party nominees will be from outside the establishment mainstream. In part this reflects a broad decline in deference to the governing class after the financial crisis of 2008 and the decade that preceded it. Recent European elections in France, Hungary and Greece have reflected similar sentiments. If as we suspect, a candidate opposed to the status-quo ends up on a major party ticket, this will create additional uncertainty weighing on markets in 2016. We were right on this call. We thought there was a high likelihood that one of the nominees would be from outside mainstream US politics. We believe there was a low likelihood that a non-traditional candidate would win the election. That outlier scenario was realized.
  1. × Unemployment Rises: We expect headline unemployment in the US to end the year above 5%. The softening in global demand, rising rates (however slight) and lackluster earnings we expect will also impact employment within the US. This is in keeping with our expectations of an economic downturn during 2016. We were wrong on this call, we ended 2016 with unemployment at 4.7%.

India’s demonetization: it’s like pixie-dust for bank balance-sheets

posted in: Markets | 0

20161122_india-rupee-note_article_main_imageMany motives have been advanced for the great Indian demonetization of 2016. These include reducing the informal/untaxed “black-money” economy, removing counterfeit notes from circulation, making terrorist financing more difficult etc. Might there be another, unstated, reason apparent to central bank watchers? A subtle subterfuge to reduce the perceived level of non-performing assets (NPAs) at Indian banks.

By March 2016, Indian banks held 6 Trillion rupees (or 6 lakh crore) in NPAs. This amounted to 7.6% of their aggregate balance sheets as outlined by the RBI in its June 2016 financial stability report, up from 5.1% over six months. That large jump was the result of an Asset Quality Review initiated by the RBI. Indian banks had been using various devices to avoid classifying bad debts as NPAs. The RBI’s re-classification tore down this hall of mirrors. The RBI also projected NPAs could rise to 8.5% by March 2017.
Within two months, Raghuram Rajan had been removed from his post by the present Indian government. Eight weeks after that, Prime Minister Modi announced the shock demonetization of existing Rs. 500 and Rs. 1,000 notes.
Since then, 90% of the demonetized currency notes (14 Trillion rupees) have been deposited into the system. We can reasonably assume the bulk of these funds have remained in the banking system since withdrawal limits are in effect and large cash transactions are being discouraged.
If the denominator for NPA ratios has indeed risen from 79 Trillion rupees to 93 Trillion rupees. gross NPA ratios would fall to 6.4%. Just like that, we have a seemingly magical improvement in the credit quality of bank balance sheets.
Who knew a “digital economy” would have such fringe benefits?
(Also published as a letter by the Financial Times)

What should investors expect if Trump wins?

posted in: Bonds, Commodities, Economics, Energy, FX, Markets, Stocks, USA | 1

First, we think a Trump victory is quite unlikely. That said, the probability is not zero, it’s likely to be around 15-25%. We routinely analyze even less likely events and their impact on markets, so we have considered the reaction of markets if Mr. Trump were to win the general election.

There will be almost no place to hide from the initial volatility after an unexpected Trump victory. We expect significant turmoil in the financial markets and we believe that in the short-term (days/weeks) there will be few safe havens. Mr. Trump’s economic policies are so unconventional, and his temperament so mercurial, that we expect almost all sectors and asset classes to be somewhat affected by negative uncertainty. Precious metals may be the only asset that benefits from a flight to safety.

Bonds have traditionally served as a safe haven in times of turmoil. We believe bond investors should not remain sanguine if Mr. Trump does win the presidency. As a leveraged developer, Mr. Trump has had a colorful and combative history with lenders. His natural bluster has been intermittently aimed at bond markets during this campaign and the prospect of a Trump administration in control of the US Treasury is bound to spook bond investors. He has suggested he would unilaterally default on US sovereign debt (arguably not a novel position since the Republican congress toyed with a similar position in 2011) and seek to renegotiate principal amounts.

Mr. Trump has made combative comments about the Federal Reserve and its current policies. He has also expressed dissatisfaction with the current low interest rate regime. Taken together, these sharp, unusual policy views create immense uncertainty about how Mr. Trump would manage the credit and repayment of US debt, the government’s relationship with the Fed, and other issues of concern to the broader credit markets. We expect FX markets to exhibit a flight to perceived safety which historically has benefited the Swiss Franc and Japanese Yen. Uncertainty about bonds and rates will also hit real assets heavily dependent on credit markets. We do not expect real-estate to do well.

When it comes to stocks, we expect broad declines in the short term, but some sectors will be harder hit than others. The banking and financial sector is likely to see a steep decline in market sentiment and levels. Mr. Trump has made several negative statements about banks and their business models. Banks are also naturally leveraged and very sensitive to market sentiment. None of this augurs well for the banking or financial sectors.

Given Mr. Trump’s combative stance on trade and trade agreements, we would expect sectors dependent on imports/exports in their global supply chain to be battered. This includes consumer discretionary, technology, heavy industry, materials, and depending on precise global footprint, energy companies. In contrast, consumer staples should play their standard defensive role.

The immediate sentiment towards the defense industry is somewhat more uncertain. Mr. Trump has, at times, advocated a combative posture on national security and war matters. In almost direct contradiction, he has also proclaimed he would reduce the defense budget and the number of military bases overseas in line with his “America First” pledge. Defense contractors dependent on Pentagon contracts for services to troops overseas are likely to see sentiment and stock prices decline. Large defense manufacturers should decline as well since Mr. Trump has expressed skepticism about some expensive weapons programs (the F-35 in particular). The foreign policy and defense team Mr. Trump puts in place will determine how this plays out in the longer-term.

Beyond the initial few weeks and months, we expect much will depend on the composition of Mr. Trump’s administration and his demeanor during the transition. A prospective Trump administration caught up in balancing spending, debt, legislative priorities and political considerations would normally be constrained. However, Mr. Trump is likely to have a compliant Congress, with Republican legislative majorities and both Senators and Representatives eager to please the new force in American politics. It is impossible to make longer-range forecasts of what a Trump administration’s policies would look like, simply because we do not know his true priorities. We would advise investors to be extremely cautious about bargain-shopping in the immediate aftermath of a Trump victory.

Mr. Trump is unlikely to win the election, but in the event he did, we believe markets will react very poorly, at least initially. He is in many ways, the opposite of a traditional conservative politician, disdaining societal norms and conventional politics. Mr. Trump’s election would engender policy uncertainty on a scale not seen for decades, upending long-range business plans and reducing risk-appetites across the board. We would advise investors to exercise caution in the event Mr. Trump wins.