Shaping a Portfolio for 2017: interest rates and currency

To a great degree, changes in interest rates and changes in currency substitute for each other in an overall macroeconomic sense.  A rise in the world value of the US$ is equivalent to an increase in interest rates, in that both act to slow down overall US growth.  A decline in rates or in the dollar acts as stimulus.

What is 2017 likely to bring?

interest rates

Ignoring the mid-year lows, one-month T-bills began 2016 at a 0.17% yield and are now at 0.39%.  The 10-year bond opened the year yielding 2.24% and is closing at 2.46%.  Over the same period, the Federal Reserve has raised the overnight money rate by 0.25%.

My guess is that the Fed will raise the overnight lending rate by at least 0.50% and possibly by 0.75% in 2017.  The latter would likely translate into a rise in the 10-year to something just below 3%, the former to a yield of 2.75% or so.


I think the chances of the larger rate rise are greater if the dollar remains around today’s level.  As I’ve written recently, I think the US stock market is already trading as if long-dated Treasury bonds were yielding 4%–where I think the endpoint of restoring rates to normal will be.  That’s something that probably won’t occur until 2018.

In addition, the US stock market has typically gone sideways during past times of Fed tightening.  What would be unusual this time around would be if Congress follows through on a large, growth-stimulating, public works spending program.  This would, I think, minimize any negative effect rising rates would have on stocks.

effects on the S&P 500

If the past is prologue, the main effect of rising rates and rising currency will be on the relative performance of sectors.

The more interest rates rise, the more attractive bonds will become vs.stocks whose main appeal is their stream of dividend income.  So income stocks would be negatively affected.

The more the US$ rises, the weaker the US$ growth of foreign operations of US multinationals will be.  Import-competing businesses would be hurt as well.  Purely domestic firms would be relatively unaffected.  My guess, however, is that the bulk of the dollar rise on a more functional national government has already occurred.



Shaping a Portfolio for 2017: emerging markets (ii)

Ex China, emerging markets are a motley crew.

MSCI Emerging Markets Index


The MSCI Emerging Markets index consists of 23 countries.  At about 28% of the total, China is the largest component.  After that come, in order, South Korea at 15%, Taiwan at 12%, and India and Brazil at 8% each. The rest average 1.6% apiece.


The biggest sectors are IT and (mostly state-controlled) Financials, at about a quarter of the index each, and Natural Resources at 15%.

individual stocks

The five largest individual components of the index, comprising 15% of the total are, again in order:  Samsung Electronics, TSMC, Tencent, Alibaba and China Mobile.  All of these can be bought as individual stocks either in Hong Kong or in the US.

my take

To my mind, the most foreign investor-friendly country of the bunch is mainland China.  The rest are either not open to foreigners or are subject to the heavy hand of government control.  A big virtue of the index is that we can obtain exposure to 22 problematic places for foreigners to invest in one package and in a highly liquid form.

The big question is whether we want this exposure or not.  The merits of individual countries/securities aside, this has typically been a good thing when the world economy is expanding rapidly and when trade is in a high-beta relationship with overall growth (as it has been throughout almost all my investing career).  It has typically been a bad thing when the world is in recession.

At present, I don’t see the positive case as particularly compelling.  In addition, the high-beta relationship between trade and growth which has worked to the benefit of emerging nations for decades has been showing recent signs of breaking down.  So it’s at least thinkable that the payoff from taking the risk of investing in the more frontier-ish of these countries will be less than in the past.  Personally, I’d prefer to own developed markets + China right now.




Shaping a Portfolio for 2017: emerging markets

Let’s divide emerging markets into two categories:  China and the rest of them.


Measuring using Purchasing Power Parity, China is the largest country in the world.  It’s much faster growing than other large economic areas, like the US or the EU.  It’s also accessible to foreigners in several ways:  through Hong Kong-traded stocks, through China-centric mutual funds and ETFs and for individual mainland equities through connections among the Hong Kong, Shanghai and Shenzhen stock exchanges.

I have conflicting thoughts about China today.

The country is currently going through a transition from GDP growth through low value-added, export-oriented industries to expansion through consumer-oriented domestic demand.  This is never smooth sailing.  At the same time, two of its biggest export markets, the EU and Japan, have undergone massive currency devaluations.  This makes the transition more urgent–and potentially much more choppy, since China-sourced products are now much more expensive there.

That’s the near-term bad news.

On the longer-term positive side, the inward, anti-trade turn being signaled by the incoming Trump administration will, I think, mark the shifting of the mantle of world leadership–with its attendant pluses and minuses–from the US to China.  (To be clear:  although I think this may be the signature result of the Trump administration, I don’t think Mr. Trump intends this outcome;  he’s just clueless.  And the real cause is policy failure by the two major domestic political parties over the past decade or more.)

One plus will likely be a greater desire  by foreigners to own Chinese stocks and, because of this, a gradual PE multiple expansion for them.  A potential minus will be more pressure on Beijing to loosen Communist Party control over its financial institutions and its currency, which will subject the renminbi to the speculative ups and downs of currency traders.

My bottom line:  I mostly see bumps in the road for China in 2017.  I’m keeping a small China position, comprised of mutual funds and Macau casino stocks.  But I feel no strong urge to buy more.

Shaping a Portfolio for 2017: Japan

The central economic thought of the Abe administration has been to orchestrate a massive depreciation of the yen through interest rate declines and large-scale deficit spending.

The idea was/is that this would create enough inflation to break the deflationary spiral that has plagued Japan for the past quarter-century.  The threat that a yen tomorrow would be worth less in real terms than a yen today would, arguably, cause consumers to shift from saving to spending.  Yen depreciation would also give a boost to Japan’s flagging 1980s-style export-oriented manufacturing businesses, whose interests Mr. Abe represents.  Those firms would then increase hiring and boost wages, which would reinforce an upward spiral of nominal GDP growth.

The depreciation part of this plan has worked shockingly well, with the yen losing almost 40% of its value vs.the US$ of the past few years.  Tons of tourists have poured in.  But Japanese consumers, faced with enormous increases in the price of imported things like food and fuel–that is, facing a sharp fall in their standard of living–have not opened their wallets.  And, headed by the same managements that drove once world-beating  Japanese industry into the ground over the past 30 years, companies have saved the largesse of yen depreciation rather than modernizing business practices, raising wages and increasing hiring.

Mr. Abe has been calling for industry to change its ways.  At the same time, however, the laws the Diet put on the books during the early 1990s to effectively prevent involuntary change of company control from ever happening remain in effect, making his words ring hollow.

Worryingly for Abenomics, the yen has been strengthening against the dollar for most of 2016, gaining about 17% from February through September.

What could cause this?  Economic theory says that in cases like Japan the currency eventually begins to revert to its former level, leaving the country with no lasting effects other than higher inflation–and more government debt.

Currency markets seemed to have been saying that Japan had run out of time to make structural reforms and that Abenomics had failed.  For what it’s worth, that’s what I think is going on.

The dollar rally that has accompanied the Trump election victory has reversed almost all of that move, giving Japan at least a temporary respite.  My guess is that we should emphasize “temporary.”


As an investor, however, it seems to me that it doesn’t matter much whether my view of the Japanese economy is on the mark or not.  Even if the currency remains weak, I just don’t see a positive reason for investing there, other than in special situation companies.





Shaping a Portfolio for 2017: Europe

EU and UK

I started out to title this the EU instead of the more generic Europe.  But then I realized we have to treat the UK as a separate issue, even though it exhibits many of the same structural characteristics as the rest of Europe.  So I changed my title.

Two factors about Europe stand out to me as an investor:


–the euro, which cost $1.40 each as recently as 2014 and which went for as much as $1.15 earlier this year, is now trading at $1.04.  A pound sterling, which cost $1.71 in 2014 and $1.45 prior to the Brexit vote, now goes for $1.22.

A 26% decline in the euro vs. the US$ and a 29% fall in sterling are immense moves.  While they represent a catastrophic contraction in national wealth for the individuals and nations affected, they also act as a big boost to the global competitiveness of Europe-based multinational firms.

EU warts showing

–in June, the UK voted to leave the EU. That prompted Scotland to revive its efforts to secede from the UK and become its own (EU member) nation.  Italy, in many ways the Japan of Europe, just rejected reforms that would have put government finances on somewhat better footing and allowed it to address the problems of its woefully weak banks.  Angela Merkel, the political leader of the EU–as well as of Western democracies, many would say–appears to be in deep trouble in Germany because of her stance on immigration.  Greece continues to resist fixing its economy.  France only looks good by comparison.

My stock market experience is that, with the possible exception of Japan, politics rarely matters.  Better to focus on company by company prospects than media headlines.  However, this is a real mess.

my take

My overall economic view is that Europe is about two years behind the US in recovery from recession.  That would suggest domestic enterprises are in for another year of struggle before we see strong signs of general economic growth.  Currency weakness should strongly accelerate the pace of improvement.  The ongoing efforts of traditional political/economic elites to preserve their place of privilege without regard to the cost to their countries should retard meaningful progress.

To my mind, Europe remains a special situations market.  I think the best course for equity investors is to be underweight and play the currency rather than the economies.  That is, to remain with multinational stocks based in Europe which have significant non-European sources of revenue.  Hotel companies with US presence, and which also stand to be beneficiaries of increased tourism in a now-cheap Europe, seem to me to be particularly well-placed.