A number of major political and economic events shaped financial markets in 2016, forcing investors to navigate a landscape of heightened volatility. But with uncertainty likely to continue through 2017, GAM’s investment managers have identified some unique investment opportunities that go against the grain.
Wind turbine manufacturers sold off aggressively in the aftermath of Trump’s election, due to fears that revenue growth may falter if the US pushes for a more relaxed attitude towards climate change. But we are confident that the market has overreacted and that turbine revenue growth prospects remain intact, with growth driven by emerging markets. The better efficiency offered by the new turbines makes wind increasingly competitive against more conventional forms of energy.
The index of the UK’s largest companies, the FTSE 100, has underperformed its mid-cap counterpart the FTSE 250 for over a decade. The longer this divergence continues, the greater the potential opportunity that opens up.
The perception that the biggest companies are too cumbersome to be acquired goes some way towards explaining why they have languished. However, digging a bit deeper it becomes clear that the operational performance between the groups has varied significantly – earnings per share of the FTSE 250 companies has more than tripled since 2000, while the FTSE 100’s has gone nowhere. This is quite astonishing, especially as most of the variation has come over the past five years. The disparity ultimately is due to the poor performance of commodity-related sectors, and banks to a lesser extent. These are highly cyclical sectors where profits are prone to mean-revert. At this juncture, the FTSE 100 is trading on lower long-term valuations and has greater scope for an earnings recovery – a potent cocktail for a long-term value investor.
Domestic eurozone cyclical stocks should do well next year. Among the excitement of the recent US presidential election and dramatic headlines concerning Italian banks, some very decent economic data sets out of the eurozone seem to have been missed. A continuation of strong economic releases, good PMI data and a positive credit impulse all seem to have been overlooked in the rush to extrapolate from Brexit and Trump, and a broader desire to engage in amateur political punditry. The Citigroup Economic Surprise Index indicates that eurozone economic data continues to surprise materially to the upside, while credit impulse indicates that the rate of change in credit formation remains positive. Both indicate that the European economy remains on a firm economic expansionary track, while the credit impulse gives us confidence that this will remain the case for a while at least.
Avoid US inflation-linked securities. If serial inflation really is an imminent threat beyond base effects, causing headline inflation to rise more than 175 basis points in the next nine months, then shorting nominal bonds will generate more attractive returns. If a rising US dollar and disappointing growth quash any inflation surge, then breakeven steepeners will be perceived as too high.
Rising Bund yields generate an entry opportunity into the German residential sector. Market speculators generally expect a further rise in yields, depressing investor appetite for German residential real estate. Most investors focus on the relation between interest rates and valuations of residential companies but neglect an important factor – demand. At the moment, residential demand amounts to 400,000 new units each year in Germany, but only 250,000 are built, and of these 250,000 no more than 60,000 are in the affordable price bracket. One key event for this contrarian trade is another possible prolongation of easy monetary policy in Europe beyond March 2017. A prolongation until the end of 2017 would mean no drastic rise in interest rates, and hence a benign environment with no major yield compression effects for residential companies.
If Trump’s election rhetoric does not manifest in hard realities, such as a Mexican wall, then the market has over-discounted the negative. As such, both domestic recovery plays as well as Mexican export trades to the US will benefit from the relief rally. Politics is important to both Mexican export trades and for global supply chains from Mexico selling into the US.
Contrarians will go short UK rates versus long Canadian rates (expressed via 10-year forward-starting swaps). Canadian rates are currently trading at 50 basis points over the UK and have averaged around 10 basis points below the UK over the past 10 years. UK 10-year real rates are set to become increasingly negative as inflation rises over the coming months. With 10-year rates unchanged, UK real rates will be around -1.5% a year from now, while Canadian real rates will be close to zero (on unchanged nominal rates). To reduce this differential, UK nominal yields will need to rise by more than rates in Canada. A pick-up in UK inflation is fairly inevitable given the sharp weakness in the trade-weighted value of sterling. In addition, UK growth continues to surprise to the upside. The UK versus Canadian rate differential at this point on the maturity spectrum is close to record-wide levels. A relatively poor fiscal position in the UK as well as a weak current account also offers little comfort to the economy. In Canada, growth has remained sluggish and the central bank may cut rates again. Non-energy export growth (a key barometer for the central bank) remains very disappointing.
Watch sales are recovering faster than perceived by the market. Current market sentiment towards Swiss watchmakers is negative. We think the comparison base is easy and we are already starting to see an improvement in momentum in Hong Kong, a market where the past two years have been challenging with high inventories.
One of the clearest contrarian opportunities for 2017 is the US currency. ‘King dollar’ has been the most popular position on the planet since its bull market truly commenced in 2014. However, the US budget deficit is already deteriorating, a cyclical phenomenon normally only seen around recessions. This is before an unavoidable acceleration in structural entitlement spending, and coincides with unprecedented foreign selling of Treasuries. Yet Trump, the self-styled ‘King of Debt’, is aiming to significantly cut taxes and increase spending, which will further increase the structural deficit. The question has to be asked: Who is going to fund this, and what interest rate will be required to do so? Despite the pervasive bullishness, the fundamentals of the currency look poor; a combination of obvious interest to contrarian investors.
Automotive-related Japanese companies that have a large exposure to the US are our contrarian buy for 2017. It seems there are increasing concerns about US auto sales after the steady long recovery since the financial crisis. Despite prevailing headlines on subprime auto delinquencies, the incentives industry-wide seem contained – employment situations are healthy and households are still on a deleveraging phase. Combined with a weaker yen and attractive valuations, this makes us think automotive-related companies in Japan with a large exposure to the US have a solid investment case.
US renewables market
Roberto Cominotto, investment director for energy equities
We are looking to buy US renewable energy companies on weakness. Investors fear that the Trump administration will negatively impact their growth outlook. However, US renewable installation growth has three drivers: First, renewable targets on a state level; second, renewable targets on corporate level and; third, tax credits on federal level. Only the third driver could potentially be impacted by the new administration. But even here, a significant change is unlikely. Wind and solar tax credits were originally introduced by Republican administrations and extended by a Republican-controlled congress for five years in December 2015 and are therefore unlikely to be revoked.
The oil market is the most down-beaten commodity market. Not only does oil show negative carry and negative momentum, but it is also the commodity exhibiting the highest volatility. Therefore, it seems to be time to bet on something unexpected – namely rising oil prices.
Biotech companies are trading at record-low multiples, dragged down by the US election campaign. The Republican sweep bodes well for the sector in 2017, with less regulation around drug prices, a potential reduction in the corporate tax rate, including a repatriation bill, and a pick-up in M&A activity.
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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.