ETF Investing With The Global Risk Nexus System
The Tri Polar World (TPW) framework developed by TPWIM provides a differentiated view of global economic development driven by regional integration in the three main regions of Asia, Europe and the Americas (Tri Polar World 2.0, March, 2015 ). Over the past several years, this framework has proven particularly useful in thinking through issues such as Brexit, Trump/NAFTA and China risk-reward.
The TPW framework is underpinned by our proprietary Global Risk Nexus (GRN) scoring system, which analyzes each of the three main regions, as well as the globe, through a four-factor prism: economics, politics, policy and markets. Each of the four factors incorporates several substrata that are scored on a regular basis. Examples include: potential growth rates in economics, structural fragmentation in politics, policy implementation risk and various fundamental, technical and quantitative inputs within the market segment.
Employing ETFs as the instrument to complete the global multi asset investment process represents the simplest, most transparent & low cost way to execute the opportunity set that falls out of the TPW/GRN structure. This is true at both the global and regional level. Incorporating the TPW, GRN and ETFs in a three-step investment process simplifies the complex and frees up thinking time for original idea generation, communication & implementation.
In an ever more complex world of big data sets, disruptive technology, fractured politics, radical policy and yet super mellow financial markets, the GRN system has become a key component in how we stay abreast of, think through and weigh key Tri Polar World issues. Thus it seems appropriate to go through the process in this month’s write-up so that future reference can be met with deeper understanding.
Lets walk through the GRN first in Proactive Asia, then Resurgent Europe and conclude with the Inactive Americas. The global outlook will come next month in the 2018 Outlook. For time and space purposes the global market segment is integrated within the concluding Asset Allocation and Portfolio Strategy section.
Two recent statements regarding economics in Asia really struck home. The first for what was not said and the second for what was. In the first instance, President Xi’s recent Party Congress address failed to enumerate a specific growth target for the coming five years. This breaks with past behavior, frees the Gov. from having to employ subpar tactics to meet an artificial growth target and recognizes that China’s potential growth rate has shifted lower. The new focus on the quality of growth and sustainable development over breakneck and heavily polluting growth seems like the right approach as China matures into a middle-income country.
The second comment was by newly re elected Japanese Prime Minister Abe who called for 3% wage hikes in the upcoming “shunto” (spring wage offensive). This degree of specificity is quite unusual, replaces past vague exhortations and reflects an empowered leader ready to turn necessity (poor demographics) into a positive (higher wages) to drive Japan’s growth profile forward. Japan’s success in ending deflation (2017 Outlook, December, 2016) under Abe and Bank of Japan (BOJ) head Kuroda has set the stage for a sustained period of economic growth.
Perhaps of greatest significance is that both statements reflect economic reality, something often lacking in politicians’ utterances on matters economic.
Asia today has three growth drivers: China, Japan and ASEAN, a combination of ten states with roughly 650M in population and close to $3T in GDP, making it as large as the sixth largest economy in the world. India sits in reserve; combining 70% capacity utilization levels with a youthful demographic, it represents Asia’s growth upside. Asia’s three large growth drivers and a fourth in reserve stand out relative to Europe and the Americas.
A year ago, political turmoil in China represented a potential black swan risk for global financial markets. Post the recent 19th Party Congress, that risk has been replaced by the potential reward of a “new era” in China, one in which China takes a leadership position in global affairs. The vision outlined in Pres. Xi’s address represents a dramatic change from past, more conservative Chinese thinking. It reflects a grand strategy that extends far into the future (2050) and reinforces the existing One Belt, One Road (OBOR) project. Finally, it lays down a marker for the rest of the world that China has a plan to become a “leading world power” and is focused on its execution (China Has a New Grand Strategy, The Diplomat).
Coincidentally, I have just finished reading China watcher David Shambaugh’s 2012 book: China Goes Global, which argues that China is a “partial power”. China has made impressive strides in the intervening five years, particularly in the brand and soft power categories via its tech sector. Today, this brand building stands in sharp contrast to the US in areas such as climate change where China is turning a necessity (choking pollution) into a virtue (global climate change leadership).
China is no longer the partial power it was, nor is it yet a full global power but that is now the clear objective. The fact that this has been written into the new Party Constitution effectively means all future leaders will need to follow this grand strategy. The importance of this change should not be underestimated.
PM Abe’s re election in Japan reinforces the soundness of Asia’s political structure. Like Pres. Xi, PM Abe has already been in power for five years and it is quite possible that he will remain in power through the 2020 Tokyo Olympics. Political continuity can go a long way to reinforcing good decision making in the policy realm. The contrast within the political sphere between Asia and the other two regions could hardly be sharper.
Assessing Pres. Xi’s new policy could be a paper unto itself. Having read several, a number of key points do stand out. The SOE reform focus on mixed ownership recognizes that adding debt to heavily indebted companies is unlikely to be a solution; perhaps injecting private capital and expertise could do better. Of course there is risk to the private companies but from a top down perspective this seems like a step in the right direction. Likewise the significant focus on quality and environmental sustainability. Moving up market represents China’s future growth path.
The BOJ’s yield curve control (YCC) policy has been a success and is likely to become part of other CB’s tool kits in the years ahead. The Peoples Bank of China (PBOC) has also been quite active in dealing with the large build up of domestic debt. Recent comments by PBOC Gov. Zhou about a potential “Minsky moment” in China caused market flutters but the read here is that the reference was meant to demonstrate China’s stability thus making the case that the time is right to open its financial markets. Greater foreign involvement in China’s domestic financial markets while allowing Chinese investors to begin to globalize their portfolios will create two-way flow that is likely to be among the most important financial market developments of the coming decade.
It is hard not to look at Europe and be impressed by how well its economy is doing; especially relative to expectations a year ago when it was all post Brexit doom and gloom. Today, Spain’s most economically important region can declare independence and markets just yawn with Spanish stocks & bonds both up in October. That’s what a strong economic recovery can do.
With EU Q3 GDP running at 2.5% y/y, the unemployment rate finally breaking 9% (8.9%), and strong exports belying worries over unanticipated Euro strength, the economic picture across the whole of Europe is quite robust. Inflation well below the 2% target is the only fly in the ointment, something Europe shares with much of the rest of the world.
Just when one thinks European political risk can be laid to rest along comes Catalonia, superseding the election of French President Macron as well as the return of German Chancellor Merkel albeit in a yet to be formed coalition government. Catalan elections are set for Dec 21st and the failure of separatist parties to unify their list bodes well for Spanish unity. Hopefully the benefits of time will cause both Madrid and Barcelona to find a face saving way forward. Notwithstanding Europe’s recent robust economic recovery, it’s no surprise that the scars of the financial crisis and nearly 10 years of subpar economic activity continue to influence Europe’s political landscape.
Political concerns in the southern periphery coexist with those in Europe’s eastern region where Hungary & Poland push back against some of the perceived Franco German objectives for a deeper European union. The real political question is whether Germany will act in support of Pres. Macron’s well-articulated vision for Europe’s future. Forward momentum in the political space is critical for Europe to retain its Resurgent moniker and not slide back into its old Reactive mindset.
ECB Gov. Draghi has maintained his famous way with words articulating a policy to “downsize” the ECB’s QE program rather than “taper” it. The ECB’s deliberate unwind of QE is unlikely to be finished before Mr. Draghi's term ends in 2019, a perspective greeted calmly by European cross asset markets. In Europe as well as globally, the surprisingly synchronized global economic recovery has eased concerns over monetary policy realignment while also reducing concerns over the lack of fiscal stimulus, now rightly seen as much less necessary than was thought even one year ago.
Regulatory policy, especially around Big Tech, is an area where Europe has been quite active under the leadership of Competition Minister Vestager. Yet, Europe itself really needs to move forward on its Digital Single Market (DSM) project in order to become competitive in the tech space. Tech represents only 8% of Europe’s stock market, well below its weight in the other main regions. In addition, Europe’s financial sector continues to face regulatory scrutiny with a particular emphasis on its NPL problem. Properly addressed, movement here could really improve the banks’ operating environment and perhaps kick off a much needed consolidation process. Q3 earnings demonstrate much remains to be done.
An aging but still reasonably robust US economic recovery could be boosted by a Latin American recovery that began only a few years ago. Latin America is currently working off what appears to be a capacity glut built up during the commodity boom years of 2012-14. This is particularly true south of Mexico, which continues to struggle under the weight of NAFTA and election uncertainty.
Within the US, concerns exist about the ability of the consumer to continue spending as the savings rate has dropped to around 3%, a level last seen in 2007. Unemployment levels close to 4% would suggest budding wage growth and hence further consumption gains but the hours worked canary has yet to sing; the economy will likely need the business side to support it in the guise of a late cycle capital expenditure boom.
The contrast between the politics in Asia and even Europe vs. the Americas is quite stark. The US boasts (if that’s the right word) the first indictments of the Mueller investigation, a hyper partisan environment in Washington and the apparent fragmentation of its two main parties all leading to the potential for political gridlock through the 2018 midterm elections. An early test will come in December when Congress needs to pass a spending bill to avert a Gov. shutdown.
South of the Rio Grande lies Mexico’s Presidential elections next July followed by Brazil’s Presidential election in October. Suffice to say that politics in the Americas look by far the worse of any of the Tri Polar World’s three regions.
The likely next Fed chair, Mr. Jay Powell, is widely seen as a safe pair of hands to implement the Fed’s policy mix of gradual balance sheet shrinkage and rate hikes. For all the Fed related ink spilled, the Fed seems like yesterday’s story with the economy rightfully the real driver of financial markets through the earnings cycle. Furthermore, a flattening yield curve, made flatter as the short end prices in a December rate hike while the search for long duration, safe assets anchors the long end, would seem to tie the Fed’s hands somewhat.
Regulatory policy could impact financial markets going forward. Tech, the stock market’s leadership sector, is under growing pressure to spend more in order to rein in bad actors while also having to defend its business practice as quasi monopolies. A recent FT editorial called for new anti trust legislation to counter Big Tech’s growing tendency to buy up smaller innovators. As yet there is little public support for greater regulation of the social media giants and thus little push on Capitol Hill. Watch this space. Banks, on the other hand, could benefit from regulatory relief, particularly as it pertains to return of capital.
Fiscal policy is also front and center in the US; some sort of tax cut package is likely to be passed by Spring in order for Republicans to have something to run on in the 2018 mid term elections. Sizable tax cuts would seem to be more a case of because we can than because we should, especially given early reads suggesting a $1.5T increase in the budget deficit over the coming decade. Yes, tax cuts could give the aging recovery a booster shot though arguably the most acute need for fiscal stimulus was several years ago.
C suite policy may hold the key for the US economy in the year ahead. Certainly the feeling in the room must be much better than a year ago when Brexit and the election of Donald Trump meant great uncertainty. Today, the US and global economy continues to expand, Brexit woes have been contained to the UK and Pres. Trump is somewhat of a known entity, all of which could perhaps set the stage for a late cycle cap ex boom that could drive the economy forward.
Asset Allocation & Portfolio Strategy
As noted previously, the only bad asset allocation decision this year has been to not be invested (More of the Same Please, June, 2017). With a 60-40 Global Balanced portfolio up over 10% ytd, it’s been hard to be wrong though somehow global macro hedge funds are flat. Equity has outperformed fixed income, non-US equity has outperformed the US, credit has outperformed sovereign and commodities/ alternatives have been relatively uninspiring.
Equity markets in particular have been able to climb a towering wall of worry including the Mueller investigation in the US, North Korea saber rattling in Asia and Europe’s politics, not to mention the prospect of QE switching to QT. Even the apparent revival of the great man theory of politics: whether it be Trump saying I am the only one that counts, or Putin coyly refusing to say whether he will run again or Pres. Xi not putting forth a successor or Crown Prince Mohammad bin Sultan purging his rivals, together with the increasingly authoritarian tone in political language haven’t spooked financial markets.
Why not? As discussed in previous pieces, it would seem that investors are correctly focused on what the most synchronized global economic recovery in decades means for corporate earnings and hence stock prices. Q3 earnings to date have been quite robust, especially in the non US Developed Markets where Japan for example is enjoying year on year EPS growth of roughly 15%, with valuation at a significant discount to the US. It is hard to see a major equity correction with robust earnings growth, easy financial conditions, Central Banks that promise to go slow and investors (such as those macro hedge funds noted above) who need to get invested prior to year-end.
An early stage, low inflation, synchronized global economic recovery supports Equity over Fixed Income. The Global Risk Nexus work noted above clearly favors Asia and Europe in terms of both politics and early cycle economics relative to the Americas. Within the market structure component stronger earnings growth and cheaper valuation further support the non US DM versus the US where tax cuts seem in the price. Mexico, long a preferred market, has been reduced as it unfortunately now seems plausible that Pres. Trump could sign NAFTA termination papers in the hopes that Canada and Mexico will give concessions during the six-month pre termination window. This dangerous game would follow the Iran certification playbook; the combination of NAFTA and election risk means Mexico’s risk-reward has deteriorated.
In terms of specific opportunities, hedged Japan equity (DXJ) remains a (currently overbought) favorite as does unhedged European equity (EZU) (Peering Through the Mist, August 2017). As economic recoveries broaden and deepen small cap stocks seem interesting in the US and abroad (VSS) especially given the heavy weighting attached to Industrials.
Within FI, credit remains preferred over sovereign and US over non US. In doing some work on non-US fixed income ETFs two interesting opportunities popped up. One is European HY (HYXU) and the other is China RMB denominated fixed income (DSUM). Why would one invest in HY that yields barely 2% (as EU high yield does)? Because the spread over Gov. is roughly 240 bps, well above 2007’s all time tights of 180bps while defaults are falling and the supply/demand dynamic remains favorable. Across the Pacific, DSUM offers a 4% + yield and a play on potential RMB appreciation which seems plausible given China’s high interest rates, desire to move up market and growing importance within global indices.
Commodities remain of interest given the synchronized global recovery plus supply concerns across a number of items. The last commodity up cycle was driven by China demand; the current one may be supported by China supply constraints. Last month we highlighted a broad commodity ETF (DBC) (Fall Forward, October, 2017). Here we note a large cap global energy ETF (IXC) that sports a 3%+ divided yield and represents a good play on a reduced US rig count, a likely OPEC production cut extension and Saudi upheaval. In addition sentiment towards commodities remains bleak with commodity funds closing left & right and CTAs short. Blackrock, for example, just shut its commodity fund because there were no longer enough underlying managers – the crème de la crème – to fill the portfolio).
A major investing challenge today is the one-way nature of markets, be it tech stocks and the S&P on the upside or Mexico and GE on the downside. GE for example, was down 10 days in a row recently. Perhaps the lesson is not to be afraid to buy even after things have moved up because they are likely to go higher and don’t be afraid to sell down because it’s going lower. This lesson won’t hold forever but could well last through year-end.
Jay Pelosky, CIO & Co-Founder
TPW Investment Management
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