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.

currency

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

countries

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.

sectors

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.

China

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:

currency

–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.

 

 

 

 

 

Shaping a Portfolio for 2017: the US

For the first time in ages, the US economy is pretty straightforward to analyze.  The US stock market, on the other hand, has many more twists and turns than usual.  Happily for me, the economy is today’s topic.

all macroeconomic plusses

From a strictly macroeconomic view, it’s all plusses:

–the economy is at full employment

–the US is growing at close to its long-term potential of 2% a year.  It may have a somewhat faster spurt in 2017

–inflation is under control

–consumer spending is strong

–business capital spending is beginning to accelerate

–corporate tax reform may make domestic-oriented businesses more profitable

–badly needed infrastructure spending, blocked by Republicans because Mr. Obama was in office, will likely be begun once Mr. Trump is inaugurated.  While this may not seem fair,  it’s reality

–having expansionary fiscal policy in play will allow the Fed to raise interest rates faster than it otherwise would (even the most ardent supporters of the primacy of monetary policy were beginning to realize that eight years in interest-rate intensive care is not healthy)

–the US$ is rising; demand for government debt–which offers foreigners an above average yield + the possibility of  currency gain–is strong.  Demand from American citizens will likely improve as coupon yields rise.

broad stock market implications

To sum up, the US economy will likely expand in 2017 by, let’s say, 2.5% – 3.0%.  Add in 2% inflation and the result is, on the high side, 5% nominal growth.  If we observe that the S&P 500 contains the best and brightest of the US, earnings for the S&P could rise by 10% in 2017.  The absolute earnings number could also get a big one-time boost from a lowering of the corporate tax rate.

tax reform earnings gains:  how big?

My back-of-the-envelope guess:  half the net earnings of the S&P come from the US.  Let’s hypothesize (i.e., make up a number) that half of that figure is fully taxed.

(An aside:  if I were still working, I’d either ask a junior person to go through a database–or 500 annual reports–and figure the number out or call a brokerage house that surely has already done the grunt work.)

Let’s also say that the top Federal tax rate is also cut in half.  This would imply something like a 12.5% boost to the level of S&P 500 earnings from the fully taxed half + probably a much smaller number from the other half.  Even if this doesn’t turn out to be uncannily accurate, we can assume that the boost to earnings could  be more than 10% and less than 20%.  So +15% sounds good to me.

oil

One complication:  oil.  Accounting for natural resources is weird, and hard to figure from the outside, no matter what the circumstances.

Oil exploration operations may decide to have throw in the kitchen sink-style writeoffs of projects that are unprofitable at current oil prices.  It’s certainly what I’d do. That might make 2016 income statements for the oils as ugly as 2015 ones were.  But, with potential losses jettisoned, 2017 numbers would likely turn out to be surprisingly good.

 

 

Shaping a Portfolio for 2017: a look back at 2016

The first step in formulating an investment strategy for the coming year is to check back to see how well you did in forecasting what would be happening in the current year.

Here goes.

I thought that the best economy in the investable would be the US, that the EU would begin to rebound from a poor 2015 and that the emerging/frontier markets should be avoided.  Ok so far.

I thought that eps growth in the US would be +6% – +7%, that interest rates would remain ultra-low, that PE multiples would neither expand nor contract, and that individual stock selection, rather than industry or sector selection, would be the key to success.   Mostly ok.

 

Actually, if the year had ended on November 1st, my year-ago thoughts would have turned out to be pretty accurate.  Yes, I didn’t foresee that Britain would vote to leave the EU, but of course that referendum didn’t need to be called in 2016 and the June date for voting was only set in February 2016.  And I didn’t anticipate the January-February market swoon that started the year off.  That doesn’t bother me so much, either.

So until the approach of Election Day, I was doing about as well as anyone would have a right to expect.  The S&P was up 4% for the year on Halloween–vs. my +6% – +7% for the full year.  Interest rates remained ultra-low.  It appeared a colorless candidate favoring maintaining the status quo would (barely) beat a tacky reality show star, a political neophyte radiating bigotry and trailing a cloud of dubious business dealings, in the race for president.

Then Donald Trump won the election.

Since then, +4% on the S&P has become +11%.  The US$ has risen sharply.  Stock picking has become less important than sector selection–favoring energy, industrials, materials, that is, the areas that benefit the most from accelerating economic growth.  Tech and dividend stocks have been on the outside looking in.  The promise of large-scale infrastructure spending suggests the Fed will be free to raise interest rates next year at a faster pace than I imagined possible.  Rates have, of course, already been going up in anticipation of Fed action.

As a result, the A I would have awarded myself two months ago is probably now a B.