Beyond Bulls & Bears Bulletin May 20, 2019

IN THIS ISSUE: The articles in this issue are as at 20 May 2019.

US/Chinese Trade Tensions Are Testing Investors’ Nerves: The war of words between the Trump administration and China threatens to break out into a full-scale trade war. Franklin Templeton Head of Equities, Stephen Dover, considers the reaction of global investors and puts the current US stock market environment into perspective. And he considers some other issues that are contributing to markets’ cautious sentiment.

Is Your Portfolio Prepared for a Potential Wildfire?: In the decade since the global financial crisis, many investors have either actively steered—or ended up with—a large portion of their portfolios in investments tied to economic growth, namely stocks. However, as global growth begins to slow, Wylie Tollette, Head of Client Investment Solutions, Franklin Templeton Multi-Asset Solutions, thinks it’s a good time for growth-focused investors to do a portfolio check-up.

European Elections: Big Changes, or Business as Usual?: Many observers are predicting that European elections this month will usher a wave of populist representatives into the European Parliament. David Zahn, Head of European Fixed Income, Franklin Templeton Fixed Income Group, believes there may be a shift in political balance, but suggests the ability of extremists at either end of the political spectrum to dramatically alter the direction of the European Union is likely to be limited.


US/Chinese Trade Tensions Are Testing Investors’ Nerves

Recriminations and retaliations have dramatically escalated the trade tensions between the United States and China in recent days, creating volatility in global equity markets.

The situation has been exacerbated because markets had earlier priced in a short-term resolution to trade tensions on the back of emollient words from both sides in recent weeks. The escalation in tension into a potential full-scale trade war between China and the United States clearly creates uncertainty, but when we talk directly to management of companies in China, we feel more positive about the situation longer term. While we’re optimistic that there’s scope for some short-term negotiated settlement to this latest skirmish, that should be positive for the markets, it seems clear to us that there are long-term geopolitical issues between the two countries that have no short-term fix. As a result, we believe investors need to take a longer-term view on China and trade issues.

Changes in Global Markets and Their Impact on Equities

Uncertainty over China, and its influence over the fortunes of the US and global economies, is just one of the issues casting a shadow over investor sentiment. But we believe there are several reasons to continue investing in equities as corporate and economic fundamentals are generally holding strong. We view market volatility as a buying opportunity because we take a long-term view as investors.

China’s Role in the Global Economy

China has become such a large component of the global economic growth, so we think it merits individual consideration. Notwithstanding the tough line that the Trump administration is taking on trade, we think the outlook for China may be more positive than markets are suggesting.

While many observers fear a slowdown in China’s rate of economic growth, it’s important to keep in mind just how big its economy is, and how many tools the government there has to stimulate it.

Already this year there have been signs that the trade tensions with the United States were helping to focus the minds of policymakers and corporate leaders in China, prompting tax cuts and other fiscal liberalisation measures.

China’s Increasingly Domestic Economy

The Chinese economy appears to be in a much more balanced place today than just a few years ago. It is more domestically oriented, which, in our view, makes it more stable and less vulnerable to external shocks.

It’s important to keep in mind that China has largely insulated itself from a dependence on foreign trade. Only 34.1% of its gross domestic product (GDP) today comes from foreign trade, compared with around 50% to 60% a few years ago.1 That percentage is roughly equivalent to a country like the United Kingdom.

Significantly, China’s trade balance with the United States has substantially narrowed. On a current account basis, China is no longer a major net exporter to the United States. It remains a significant net exporter of goods, but also imports a lot of services from the United States. So really, the trade balance for the United States isn’t that significant for China.

China’s Innovation Shines Through

China has shown a formidable ability to innovate, spurred in part by the government’s research and development (R&D) push. China has actually overtaken developed markets such as the United States, Japan and Germany in terms of the number of patent applications filed in recent years.2

Across various industries, China has become the innovator to watch. For instance, rapid improvements in lithium-ion battery production have helped turn the country into the world’s largest electric vehicle market by both production and sales. In China’s pharmaceutical industry, government policies favouring the development of novel drugs over generics have encouraged local companies to scale up R&D expenditures. This could sow the seed for a pipeline of groundbreaking treatments from Chinese drug makers. These are just a couple of examples that highlight China’s pursuit of its own economic destiny independent of US and European manufacturers.

Uncertainty Prompts a Search for Alternatives to Chinese Suppliers

The fact that talks between US and Chinese trade representatives haven’t broken down completely despite the escalation in tensions (at least as of this publication date), gives us some hope that a compromise could be reached over these latest tariffs.

However, the entrenched attitudes on both sides will make it tougher to find agreements on the wider geopolitical differences. We expect further flare-ups in the future.

The uncertainty created by this situation can make it hard for businesses to make capital investment decisions; we think these trade negotiations will affect sourcing decisions for businesses for years to come. In our view, businesses looking to reduce this uncertainty will likely seek out local suppliers.

China’s Foreign Trade and Current Account Balance

China's Foreign Trade and Current Account Balance

China’s Foreign Trade and Current Account Balance
Sources: National Bureau of Statistics of China, CLSA; US Census Bureau. Latest available data. See www.franklintempletondatasources.com for additional data provider information.

 


Is Your Portfolio Prepared for a Potential Wildfire?

On 9 April of this year, the International Monetary Fund cut its 2019 outlook for global growth to the lowest level since 2009—the tail end of the global financial crisis (GFC).3 As a result, many investors may be wondering if slowing growth is likely to lead to a worldwide recession or repeats of the sort of volatility we saw towards the end of last year.

Although we do not see a high probability of a recession in the near term, we do think global markets entered a new volatility regime in 2018. Before last year, volatility had been relatively low after the GFC, due to measures taken by central banks to stimulate their economies. As that intervention slowly abates, we expect volatility to return to more normal “baseline” levels.

In our view, as overall global growth slows, uncertainty around predictions of forward interest rates, inflation and corporate earnings may increase. Since markets like certainty, we think volatility is likely to be higher in the next few years than it has been over the last few years.

Against this backdrop, we would urge investors, particularly those with larger portions of their portfolios tied to global growth, to consider three activities to prepare their portfolios for the potential return of what we’d consider as normal market volatility.

1. Understand Your Time Horizon

In the institutional world, understanding your time horizon comes down to “asset liability management,” or making sure that you don’t have short-term liabilities and long-term assets, or vice versa. Said simply, what is the money for and when is it needed? If it is required sooner rather than later, one should consider that need in the asset allocation.

Investors nearing retirement with expected cash flow demands need to ensure they are setting themselves up for success by avoiding the forced sale of longer-term, growth-driven assets. Conversely, younger investors with many years before retirement have a longer time horizon. In that case, moderate market downturns might be their friend in terms of adding to their investments at lower price points.

When you need to rely on your investments to meet the short-term obligations of day-to-day living expenses, it’s a real issue if most of your investments are long term in nature. It can turn you into a forced seller during down markets, a sure-fire way to buy high and sell low—the exact opposite of your intention. Alternatively, when one has a long-term goal like retirement, holding shorter-term assets can lead to a sub-optimal outcome in the long term.

Whether you are a pension fund manager or an individual investor, understanding what the money is for and when it is needed should be the first step to improving the probability of achieving your goals.

2. Stress Test Your Portfolio

Before the GFC, many investors thought they understood their capacity for risk. But they learned a lesson. Many found out they had bitten off more than they could stomach once they experienced that risk in real time.

Like dealing with wildfire, the time to establish “defensible space” in your portfolio is before the fire starts. Stress testing your portfolio for more volatile markets—so-called “tail-risk events”—can provide a necessary gut check.

Stress testing can also help identify exposures to the vagaries of economic growth that may be hiding in a variety of unexpected spots in your portfolio. We think investors should assess their exposures not just in equities, but also in corporate bonds, in real estate and in their employment income. Even certain municipal bonds—particularly those tied to economic development projects—are linked to economic growth as an underlying driver.

We think investors should consider all these exposures in their stress-testing scenarios and when understanding and calibrating their actual capacity for risk.

3. Diversify Across Asset Classes

We see the value in diversification across many different asset classes.4 In other words, employing diversification can lead to similar returns at lower risk, or higher returns at the same risk.

Since the GFC, many investor portfolios may have built up exposure to assets tied to economic growth such as stocks, corporate bonds, growth-sensitive real assets and emerging market bonds. We generally advocate for some degree of diversification into other more defensive return drivers like interest rates, inflation and real assets.

Many investors feel that some government bond exposure is usually a rational allocation, despite the relatively low expected returns compared to stocks. Government bonds can provide liquidity and an opportunity for rebalancing after a stock market re-rating, and can help cushion the psychological blow of a dramatically lower account market value. Even very long-term investors like pension plans and endowments maintain an allocation to interest-rate-sensitive assets for these reasons, despite the possibility of lower rates of return over the longer term.

Real assets are another area where investors have been able to find diversification within a broader portfolio that is dominated by stocks and bonds, in our experience. Many investors may not understand the characteristics and varied risk-factor exposures of the asset class. For example, core commercial real estate that is already fully leased to a reliable tenant likely has exposure to both economic growth and interest rates, because of the leverage embedded in most commercial real estate. The same real estate may provide some hedge against inflation as well, depending on the tenant’s lease terms.


European Elections: Big Changes, or Business as Usual?

As investor attention in Europe focuses on European parliamentary elections this month, there has been a lot of talk about a possible surge in populism and the likely impact on financial markets.

Our view is that there’ll be little change for markets, whatever the outcome. For fixed income investors, the major themes in Europe over the past decade have been politics and monetary policy.

Nothing in the political field strikes us as likely to change enough to prompt the European Central Bank (ECB) to change its accommodative stance. We’d expect the ECB to remain in an accommodative mood for the foreseeable future. Our current estimate doesn’t see eurozone interest-rate hikes before 2022.

European Parliament Makeup

The European Parliament is already quite diverse in terms of the spread of political views represented. We don’t expect that to change dramatically after the elections, although there may be some shift in the balance.

We also don’t expect this election to alter the political paralysis in Europe. In fact, it could exacerbate it.

We’ll likely see more representation from populist and extremist parties than currently. As a result, European politics will probably get a lot noisier and we’d expect more volatility in discussions taking place in the European Parliament. That could prompt more uncertainty about European Union (EU) policy, which could mean Europe continuing to stagnate if it can’t make the changes it wants.

But we don’t foresee a dramatic change in EU policy direction.

We would anticipate a lot more parties in the European Parliament will demand reform of the EU. In our view, Europe does need reform, but whether the new representation in the parliament will push for what we’d consider the right kind of reform remains to be seen.

In addition, new political leadership is expected across the main European bodies. In the coming months, there are due to be new presidents of the European Commission, European Council, the European Parliament and the ECB.

We’d expect those new presidents to be pragmatic in the face of the new political landscape. However, promising reform is a lot easier than delivering reform. Reforms are rarely welcomed by everyone.

If the far right does better than predicted and gains control of the parliament, that could spur more of a change, but Spain’s recent general election result suggests some commentators may be over-estimating the lure of the right-wing populism.

Still, one has to be careful about reading too much into past results as voters have often used European Parliament elections as an opportunity to register a protest vote.

The UK’s Role in the European Parliament

A further fly in the ointment is the fact that it seems as though the United Kingdom will participate in the European parliamentary election. But UK Members of the European Parliament (MEPs) will serve only until Brexit is finalised.

In the United Kingdom, the nascent eurosceptic Brexit Party is polling very well at the expense of the Conservative Party. We’d expect Brexit Party MEPs to be quite disruptive to the EU’s political agenda.

Separately, we think another poor election performance could spell the end of Theresa May’s tenure as prime minister.

Spanish Election Results Reinforce our Positive View

In the light of the Spanish election result, we expect more of the same from Spain. We already thought it was one of the most interesting countries in Europe from an investor’s perspective. And the election result has reinforced that sense.

The country’s socialist party secured the most number of seats and we’d expect it to continue to run the country. That said, we don’t think it will be in a hurry to finalise a coalition government and believe it will wait until after the European parliamentary vote.

A lot of commentators have focused on the apparent success of the right-wing Vox party, which won 24 seats in the election. However, we’d note Vox didn’t perform as well as it had hoped.

From an investor’s perspective, we think the Spanish authorities’ fiscal focus recently has been positive. Spain is one of the fastest-growing countries in Europe, with GDP growing at an annual rate of more than 2% in the first quarter of 2019.5 Its debt-to-GDP has gone up somewhat but its budget deficit is under 3%.6

In our eyes, Spanish bonds are offering a significant premium over those of both France and Germany.

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1. Sources: National Bureau of China, CLSA. Latest available data as at February 2018.
2. Sources: World Bank, World Intellectual Property Organization (WIPO), WIPO Patent Report: Statistics on Worldwide Patent Activity as at January 2019. The International Bureau of WIPO assumes no responsibility with respect to the transformation of these data.
3. Source: Bloomberg, “IMF Cuts Global Growth Outlook to Lowest Pace Since Crisis,” 9 April 2019.
4. 4. Diversification does not guarantee profits or protect against risk of loss.
5. Source: Instituto Nacional de Estadística.
6. Source: Eurostat.

 

 

WHAT ARE THE RISKS?

All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. The technology industry can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants as well as general economic conditions. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in a fund adjust to a rise in interest rates, a fund’s share price may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments. Interest rate movements may affect the share price and yield. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.

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