Wealth Bulletin: How will political risks affect your investments?

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Wealth Bulletin: How will political risks affect your investments?

This week’s expert, Bryan Goh of Bordier & Cie (Singapore), summarises how the previous 7 days’ moves will be affecting your investments.

Published on 5 December 2016

The market is focusing on, almost obsessing about political risk in the world today.

Europe is providing an ample source of angst. The Italian constitutional referendum is a case in point, as is the Austrian election. The Italian referendum has ended with a resounding “No” vote and Italian Prime Minister Matteo Renzi has resigned. The path towards a Euro referendum is not straightforward and will involve the prospect of a new government, itself not entirely clear. So far, the bad surprises have come from Anglo Saxon capitalist economies. While the mood is anxious in Europe, we have yet to see a voter revolt.

Are we over-focusing on politics in Europe? The answer will have profound implications for markets in 2017.

Key Financial Concerns

Macro outlook

Economic data continues to signal improvement. US GDP was revised up to 3.2% and consumer confidence surged to new cyclical highs. NAPM ISM also improved, house prices are growing steadily without signs of overheating, while employment and wage data are steady if not buoyant.

Inflation data in the Eurozone also indicated stability while PMIs continue to improve particularly in Italy and Spain. China’s official manufacturing and non-manufacturing PMIs showed marked improvement (although the Caixin PMI moderated from October).

Japanese consumer data showed some improvement but remains generally weak. Manufacturing data from South Korea is showing the rippling effects of the Samsung Galaxy Note 7 debacle’s effect on whole supply chains in the nation. India’s GDP was weaker than forecasted.

Equities

Equities took a rest from the Trump stimulus-induced rally. Emerging markets saw the worst of it while Europe and India were most resilient. There is a growing, creeping feeling that sentiment in Europe has overshot fundamentals and that there is value and growth in the Old Continent relative to America. We certainly subscribe to this view. Europe’s ills are political in nature and the multiple impending elections are an overhang on market sentiments.

Bonds

Bonds continued their duration-led selloff with 10Y UST and 10Y bund, both 7 bps higher. Italian sovereigns tightened sharply in the run-up to the referendum, and despite the difficulty of the Italian bank Monte dei Paschi to close its capital raising deal as investors began to realise their likely over-reaction to these 2 events. In Asia, JGBs extended their decline.

Globally, credit tightened across IG and HY, trading against equities which corrected last week. However, EM bonds continued to decline.

Our favoured sectors of US RMBS (residential mortgage-backed security) turned in another boring but buoyant return, as did leveraged loans, again beating coupon, and bank capital, rallying 0.9% despite the problems in Europe and the focus on Italian banks.

Stay with these 3 sectors, they are less impacted by retail fund flows and react more to fundamental asset quality than liquidity, no mean feat in the era of central bank policy driven markets. Their predictability will likely prevail even as we switch into a fiscal stimulus regime.

Foreign Exchange

The surging USD took a rest last week but the strength of the dollar is unlikely to fade quickly. Too many factors stand in its favour including the Fed policy, interest rates, inflation, capital flows and growth. Then there are the problems facing other major currencies.

European growth is stabilising, and ECB policy is at least for now at a standstill. They could accelerate it at the Dec 8 meeting but this is unlikely. The EUR is being held back by concerns on the political front, most proximate of all being the Dec 4 Italian referendum, not to mention the Austrian election recount on the same day. Dutch, French and German elections loom next year, and Brexit lurches around in search of some direction.

The BoJ’s policy may have been drowned out by the US election, OPEC and the Italian referendum but policy is still very loose. While the Japanese economy has shown some promising signs of growth, it remains weak and together with the BoJ’s limitless policy, keep the JPY under pressure.

The question may soon arise, and this is not the base case, but one ought to entertain the thought anyway – what happens if Trump becomes increasingly hard line or unhinged as he takes office?

Fundamental factors notwithstanding, currencies are constructs of confidence. Where else might an investor hide, if not in USD? The EUR is dogged by too much political risk, the JPY by a weak economy and a determined BoJ. What other havens can the risk-averse investor find, not to make a buck but to merely seek shelter?

Commodities

On Nov 30, OPEC announced an agreement to cut production by 1.2 million b/d to 32.5 mb/d, a substantial cut. In addition, other major non-OPEC producers agreed to participate in balancing the market with production cuts of 600,000 b/d with Russia bearing 300,000 b/d of the cut.

Saudi Arabia will shoulder the bulk of the OPEC production cuts, reducing output by almost 500,000 b/d, while Kuwait, Qatar and the United Arab Emirates agreed to 300,000 b/d of reductions. Iran, which had resisted cuts and was a risk to the deal, agreed to freeze its production at almost 3.8m b/d, close to its current rate. Iraq, which has disputed its need to cut and was also a risk to the deal, agreed to a 210,000 b/d supply cut while Libya and Nigeria were granted exemptions.

We have been of the view that supply will become constrained in non-OPEC, ex US production due to insufficient capital expenditure on investment and future capacity, primarily due to serious questions about the long-term relevance of fossil fuels. This view supports a gently rising oil price with a cap around 55 – 60USD a barrel where a significant portion, though not all, US shale oil is commercially viable, and will begin both increasing supply and hedging activities. The OPEC Nov 30 deal merely accelerates this agenda. Add to this calculus the strategic implications of the Aramco IPO and the case is further strengthened.

The Week Ahead

Has the US equity market run ahead of itself? Possibly.

While the Trump tax and infrastructure plans are stimulative and apparently positive for equities, US companies have increased leverage significantly in the past few years, taking advantage, indeed counting on, low interest rates. The Trump effect has sent bond yields surging which is surely negative for corporate margins, which is concerning given that corporate margins appear to have peaked. Higher inflation and rates also have implications for equity valuations. With US equities trading at cyclically rich valuations, the risk of derating cannot be ignored.

Has the USD run ahead of itself? Probably not.

Higher inflation, higher rates, a trade policy leaning towards protectionism and the current growth differential with the major developed economies all support the USD. The pace of USD appreciation has been quite sharp and a short-term correction is to be expected. In the longer term, however, the factors supporting a strong dollar are many. They also point to some worrying trends. Non-US companies issuing USD debt will find their debt burdens rising. On an even wider scale, the repatriation and foreign earnings tax policies of Trump apart from supporting a strong USD will likely drain offshore USD liquidity leading to higher effective rates and more volatility in money markets.

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