Year Ahead 2018

1. Looking back to 2017

In my previous ‘year ahead’ briefing the key question related to our current situation among the business cycle. This year did not provided a clear answer for that. In 2017 the global investment universe became more extreme from different perspectives.
So far global equites had a strong year beating all the other asset classes, while the volatility measures reflect limited risk averness. Can we consider these as signs of general market euphoria (which is usually followed by share price decreases)?

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Historical performance of MSCI World index (source: Yahoo Finance)

CE4E9932-0055-458D-A697-E837057F61C5Current value of VIX index is close to its 3-year minimum (source: Yahoo Finance)

The S&P500 index achieved positive returns in each months of the year (after dividend adjustments) which is a clear historical record. The daily prices oscillated within extremely small daily ranges (more than 1% daily movements occured on a few trading days only).

We experienced 5-year record global growth rates with record high set of growth indicators, and the interest rate levels are still low. The global monetary thightening is ahead of us, the short-term Eurozone rates are still in negative territory, while the short end of the US yield curve is at appr. 2%.

C9E06416-5BEC-417B-8181-7A5AB34B214AComparison of US and Eurozone yield curves (sources: US Treasury, ECB; values are in percentages)

The growth stocks were clearly overperforming the value category. Technology, artificial intelligence stocks benefited from the general market hype and were characterised by extreme valuations (even in case of no proven revenue streams of early phase business models). A good example is Long Island Iced Tea which recently changed its name to Long Island Blockchain and the announcement caused several hundred percentages increase in share price on one trading day (link).
On the FX side, despite its clear interest advantage, the USD underperformed against several key currencies, resulting in one of the biggest surprise of 2018 from market perspective.

 

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2. Expectations for 2018

Following several years of cumulative growth gains of the economy, the key question for us is whether there is still some room for the market to grow. The brief answer is yes in general, however the momentum of 2017 may not be repeated and there are signs of certain risk factors which underlines the necessity of strict position limits and risk management approaches.

OECD expects the global economy to grow by 3.7% in 2018 and the 2018 and 2019 forecasts show decreasing rates which can predict a kind of slowdown in mid term.

In absolute terms there is no really favourable asset class, the valuations are at record high levels. Due to the extremely low interest rates, the present and future values of expected cash flows are close to each other practically in every segment.

2.1 Equities

Despite the negative voices (duration of the current US cycle, euphoria on the markets, geopolitics, outlook of the Chinese economy, flattened yield curve), it seems that there is no real alternative of equities for the next year.
The high P/E ratios reflect a reasonable outcome of a low interest rate environment and as long as they are combined with low inflation stock market gains can be expected.

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2.1.1 Regional preferences

The European equity sector – which was lagging behind the US in recovery from the recession – can easily be a top performer in 2018 due to the following considerations: (i) compared to all the other key regions (especially US and the emerging markets) the European stock market P/E ratios didn’t increase that much during the recent years, (ii) the Eurozone unemployment rate is already below its long-term average (which is supportive for consumption), (iii) increasing loan growth rates (with still favourable interest rate environment), (iv) high share of value stocks which sector might perform well in case higher yields will be realized.
The second preference is Japan where the central bank is expected to maintain the loose monetary policy to meet its inflation target. While the ECB, the FED and the other central banks seem to decrease the magnitude of their monetary stimulus, this can be a relative advantage for the Japanese stock market. This policy can result in a weaker JPN which is usually supportive for the equities due to the traditional negative correlation effect. Moreover, the traditionally non-leveraged Japanese corporate sector can benefit from any increase in their debt levels on their exremely low rate regime.
The UK market is not preferred now. As per OECD estimates, the growth rate of UK (1.2%) is appr. half of the Eurozone forecast (2.1%). The lack of clarity about the outcome of the Brexit situation may not go away anytime soon. Therefore it seems to remain as a drag on the UK market confidence. In addition, UK is among markets which are characterised by high number of dividend payers, and in case of increasing bond yields, these companies are underperformers.
No clear opinion on the direction of the US and emerging markets equity sector due to the sharp increase in their valuations.

2.1.2 Sectoral themes

In case of increases in bond yields, the financial sector is clearly preferred, based on historical data there is significant correlation between the long-term yields and the returns of this sector. On the other hand, the defensives are usually underperforming in such an environment.

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Comparison of relative performance of European Financials (lhs) and the Eurozone long-term bond yields in % (rhs), source: Yahoo Finance

For mid term, I expect that the corporate digitalization solutions and electric car related equities can remain interesting for investors. According to McKinsey the development of the global IoT (Internet of Things) can result in an annual economic impact amounting to between USD 4 and 11 trillion by 2025; and the industrial/corporate sector could gain the biggest share out of that value.

Which sub-sectors can be the beneficiaries?

  • regarding the increase in EV penetration: utilities already announced related strategies (for example E.ON, Enel), miners/traders supplying key ingredients of battery manufacturing (for example Glencore – supplying close to 30% of global cobalt volume), car manufacturers (BMW, Volvo, VW), technology providers (for example Infineon)
  • regarding digitalization: software/platform developers allocating significant efforts on corporate/industrial digitalization and AI (for example SAP, Siemens, Google, Microsoft, Dassault), cyber security specialists and strategic consultants (for example Accenture)

Even on short term one of the key challenges for the corporate sector is the rapidly growing wage inflation. On this basis subsectors having large exposure to labor costs are not preferred.

 

2.2 FX

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The mainstream opinion is shared in relation to the expected development of key currencies. In case ECB’s monetary policy will be stricter the EUR will appreciate against the USD and other currencies. The sterling is expected to underperform due to Brexit issues as mentioned previously. Weaker JPY is projected.

 

2.3 Bonds

It is definitely not the preferred asset class in case of increasing reference yields and stricter policy. On the other hand, individual stories might be available. One of them can be that the repurchase of own subordinated bonds by European banks to comply with the relevant Basel regulations (in case of ‘must have’ purchases, relatively high gains might be in place for investors).

 

Thanks for reading my thoughts. Wishing a healthy and successful year for everybody.

 

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2017 Performance of Trade Ideas

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Compared to last year, lower number of initiatives have been posted during 2017, the short-term focused technical approach resulted in really few entry points, possibly due to the general market hype.

The top pick of the year, the Aegon position was closed in January and the currently held Equifax shares have similar unrealized performance.

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Realized individual returns in 2017

The highlighted holding period returns are not annualized and are generated from long positions in the equities and do not contain dividend returns received over the holding period. All return values are before fees and taxes.

Year Ahead 2017

Where are we in the business cycle?

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(1) Year 2016 in review

Without any doubt the previous twelve months were the year of surprises from many perspectives. Despite its pre-season odds of 5000/1 Leicester won the Premier League, however there were some solid examples from the investing markets as well. (i) Britain’s decision to leave the EU and the election of Donald Trump as the president of US caused unexpected movements on the market in both directions. (ii) Many called into question the reliability of the pollsters because these events were considered as underdog outcomes based on the surveys. (iii) And the Chinese economy didn’t turned into recession (this was one of the key risk factors of market forecasts) in 2016.

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Historical performance of MSCI World index (source:Yahoo Finance)

As per IMF data, global economy is ecpected to grow by above 3% in 2016 and in 2017 as well. Not a surpise, increasing consumption was fuelled by real wage growth. In general global equity markets were oscillating in a range for almost three years from now (with US outperforming rest of the world).

The top FX story was the strenghtening dollar in 2016.

The extremely lazy global monetary policies pushed down mainly every debt related metrics, which was favourable for borrowers (the improved credit conditions are underlined by falling credit spreads; era of “easy money” with gradually increasing debt levels), on the other hand even nominal returns were hard to achieve on the fixed income markets. Practically real assets and equities were able to generate some noteable returns; the increased demand in these asset classes resulted in significantly increased valuations (US equity market, real estate prices in developed cities).

Additionally the investors could have learnt again last year that uncertanties in connections with politics and elections can have greater impact on the markets. This risk factor can be as significant as “simple” market risks we they are familiar with.

What will happen in 2017? Although we strive for one-handed answers, our current investment universe might not allow it. In the next section I will summarize my thougths on the key themes.

(2) Key investment themes

(2.1) US monetary policy

Majority of the investors already priced in the effects of Fed’s “gradual” rate hiking policy. Undoubtedly the recent US macro figures are supportive: in H2 inflation increased moderately and GDP data confirmed economic growth. The monetary tightening is expected to result in – finally – remarkable US yields and further appreciating dollar in 2017.

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Historical US Treasury yields for different maturities (source: US Treasury)

The key question for the next decades whether this momentum might be new inflection point of US historical yield graph and a new upward trend could start. And why is this important? Because the increasing US bond price curve was one of the most important fundamentum of the last three decades from investors’ perspective.

Additionally the yield curve became more steepener, which – together with the stimulative fiscal regime (see next section) – is supportive for economic growth.

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Long – short term US yield differences (source: US Treasury)

(2.2) Fiscal support

This would be quite a new policy item on the post 2008 developed markets. Based on Trump’s announcements tax cuts and increased spendings in infrastructure and defence segments are expected in the US. An additional potential impact which could put an upward pressure on inflation and growth (causing further monetary tighthening). In Europe such magnitude of fiscal easing seems to be less certain.

(2.3) Eurozone monetary policy

Most probably ECB will change the QE and will follow the FED in central rate hike (at least back to positive territory) – with a certain time lag. It would be very hard to imagine that Eurozone could do the opposite strategy compared to US on long term. Very intersesting to see the significant differences between the two yield curves for all maturities.

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US and Eurozone yield curves on 30 December 2016 (source: ECB, US Treasury)

(2.4) End of deflanatory threats

Based on OECD forecasts the expected inflation rates for US, Eurozone and OECD countries are 1.9%, 1.2% and 1.8% respectively. The relatvely long era of disinflation seems to over.

(2.5) Special risk factors might completely reshape forecasts

  • European elections: The Eurozone election calendar seems to be very complex in 2017 (the Netherlands, France, Germany). Similar to pre-Brexit odds the base case for investors might be the “no surprise” outcome, however increased level of volatility is expected.
  • Equity valuations: compared to historical limits, this asset class is definitely not cheap. Additionally the stricter monetary policies are not necessarily supporting equites.
  • Real estate bubbles: extreme price levels already in central cities of developed world.
  • Current stage of the business cycle: In the theory the increasing level of inflation and the stricter monetary policy could be the early indicators for an upcoming economic slowdown (mid or long term). It is worth to mention that the current business cycle is 7 years old already.
  • Chinese growth related considerations similarly to 2016 forecasts. FX reserves are in a declining trend and CNY depreciated significantly against the dollar.

(2.6) Asset allocation ideas

  • Due to the existing stimulative monetary policy and growing economy, European equities can outperform this year. Long position in the related instruments (Eurostoxx or other index derivatives) seems to be reasonable.
  • The US equity market can easily grow further, but the “gradually” restrictive monetary policy might put a downward pressure on it. Not necessarily a clear picture for US equities, but countinous monitoring of technically oversold securities is proposed.
  • Do not have a clear opinion about gowth vs value stocks. In the light of potential slowdown in mid term, investor might turn to the value stocks.
  • Due the uncertainties related to Brexit, having no clear opinion on UK equities.
  • The strengthening dollar and the rising bond yields are not really supportive for emerging market equities. Isn’t a clear picture.
  • Bond funds might not overperform due to the downward pressure on bond instruments.
  • With really small bets certain emerging markets with recent shocks (i.e. Turkey) can be tapered. Remember on post-Brexit reactions or the Russian stock market opportunities, when investors could utilize the short term volatilities.
  • Corporates with outstanding USD debt obligation having no sufficient dollar income as natural hedge seem to face increasing debt service costs. Rather avoid of these assets.
  • On the FX side everybody’s favorite is the USD, but further upsides might be limited in case other regions will start to follow restricting monetary policies.