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Opportunities and falling knives

13 November 2018

Changes are coming which could present investors with opportunities to add meaningful value to their portfolios. GAM Investments’ Julian Howard highlights a number of such opportunities which are likely to create volatility, dislocations and openings across markets.

Those among us of a certain age will recall the Pet Shop Boys’ 1986 hit Opportunities, in which Neil Tennant exhorted the listener to join him in making “lots of money”. But for the most talented stars of the investment industry, this dream has become elusive of late. Witness the recent performance of hedge funds, with the HFR Global Hedge Fund Index in USD declining 3.5% in the 12 months to 31 October 2018. Unsurprisingly, inflows into the hedge fund sector are subdued and the number of new hedge funds setting up shop has dwindled.

Part of the challenge has been that since the financial crisis, low interest rates have made it hard for managers to generate returns. Over the long term, hedge fund returns have tended to be a function of the yield available from 10-year US Treasury bonds. This is because holding US government bonds has been a stunningly effective trade amid the ‘Great Moderation’ during which they rallied consistently for over three decades. But as those same yields bottomed out, hedge fund returns became more volatile and struggled to relive the halcyon days of the 1990s. The good news is that changes are coming which may not only turn around the fortunes of hedge funds but also present regular investors with opportunities to add meaningful value to their portfolios.

Chart 1: End of the Great Moderation: hedge fund returns a function of US bond yields:

Chart 1: 3 years rolling annualised returns from 31 Aug 1993 to 7 Sep 2018

Source: Hedge Fund Research, Thomson Reuters. 3 years rolling annualised returns from 31 Aug 1993 to 7 Sep 2018. For illustrative purposes only. 

Past performance is not an indicator of future performance and current or future trends

 

In the US, interest rates and yields are starting to rise again after a period of extraordinary monetary accommodation, with Federal Reserve (Fed) chair Jerome Powell declaring the US central bank is still a “long way” from achieving a so-called neutral US interest rate. This steady normalisation puts the investment community on notice that simply being long the US equity index will eventually not be enough to guarantee investment results. Higher US interest rates will create volatility, dislocations and openings across capital markets. It is all too easy to conflate opportunities with outcomes - something the investment industry does far too much - and we should recall the old proverb “there’s many a slip ‘twixt the cup and the lip”. But success in the era of normalisation is likely to be determined by those who can correctly identify and trade areas of under- and over-valuation. Three such opportunities stand out today, all in the equity markets.

The first is in emerging markets. Higher interest rates, a stronger US dollar and rising oil prices have conspired to push emerging market equities down to valuation levels suggestive of decent returns over the long term. Fundamentally, emerging markets remain sound with only a few high-profile exceptions such as Argentina, Turkey and Brazil which are especially vulnerable to US dollar strength. But combine the overall picture of fundamental health with the almost indisputable contention that Asia and the emerging markets will dominate the world economy and it is no hyperbole to argue that the future of global growth is effectively ‘on sale’.

Chart 2: Future of global growth on sale: valuations suggest attractive compound returns from EM:

MSCI Emerging Markets from 31 Jan 1997 to 27 Sep 2018

Source: Hedge Fund Research, Thomson Reuters. MSCI Emerging Markets from 31 Jan 1997 to 27 Sep 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

 

The second, related opening is in emerging market technology stocks, which are trading at extreme valuation discounts to their developed technology equivalents. The representative Invesco China Technology ETF has been in a bear market since the late summer but the underlying moves appear exaggerated. Emerging market technology firms are generally less immune to the prospect of trade disputes, with their old world emphasis on physical goods and the protection of blue-collar workers in traditional industries. And while Chinese internet stocks took another hit on the back of a recent report that China used microchips to hack top US companies, it is hard to see how this will affect their domestic user base. Investors appear to agree, with record inflows into another, internet-specific, Chinese ETF at the start of October.

Chart 3: Tech that out: EM technology stocks at a multi-year discount to World technology:

Chart 3: From 20 Sep 2013 to 28 Sep 2018

Source: Bloomberg, MSCI. From 20 Sep 2013 to 28 Sep 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

 

The third opening is in US value stocks. Put simply, value stocks are relatively cheap and overlooked, in contrast to growth stocks which promise much and are relatively expensive. US value stocks have had a particularly tough few years, redefining the very concept of ‘overlooked’. By way of explanation, studies have sought to show that younger fund managers have studiously avoided these stocks in favour of high profile US technology names. But US value as a style cannot be written off as the investment style of yesteryear. Over time, value stocks have been shown to outperform growth stocks broadly in line with the direction of US Treasury yields, and for good reason. As yields have risen recently with improving US economic prospects, the near-term earnings of value stocks start to look better relative to the long-term promise of growth stocks being discounted at higher interest rates. That value has been left behind amid the hard mathematical fact of rising yields surely offers an attractive opportunity.

Chart 4: Value goes off-script: opportunity to add value – in every sense:

Chart 4: From 31 Oct 2001 to 28 Sep 2018

Source: Bloomberg. From 31 Oct 2001 to 28 Sep 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

 

Across all three opportunities described above, it is perfectly possible for things to get worse before they get better, with the old investment adage of catching a falling knife a very real prospect. In emerging market equities, the US dollar could remain strong and oil might continue to rise, creating further havoc for those highly dollarised emerging markets and in turn dragging their peers down with them. In emerging market technology, regulation in China around e-commerce and video gaming could tighten and the US administration might dream up a way of getting directly at Chinese internet companies in order to retaliate for perceived trade injustices. And as for US value stocks, investors may continue to deny that they will ever turn around in the face of the compelling secular story offered by index-dominating growth champions like Amazon and Apple. All of the above could happen but investors cannot be expected to market time to perfection. Instead, they can aim for the next best thing, which is to carefully compare current valuations with intrinsic growth prospects. Across all three opportunities described, we believe these metrics are compelling.


Important Legal Information
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. Allocations and holdings are subject to change. Reference to a specific security is not a recommendation to buy or sell that security.
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