Our investment team, responsible for developing trade ideas within our flagship range of multi-strategy funds, provides five trade ideas for 2017.

 

Long emerging market small-cap equities

For much of the last decade, emerging economies have driven world economic expansion. Despite the threat of rising protectionism following Donald Trump’s US election victory, we believe this trend will persist. Growth will continue to be underpinned by rising household incomes, growing middle classes, rapidly expanding workforces, rising productivity and stable inflation.

According to the World Bank, 800 million new consumers will enter the middle-income pool before 2030, by which time over 90 per cent of the world’s middle class will be located in India and China. History suggests that once basic needs have been met, demand will shift towards growth in consumer products and services, housing, infrastructure and healthcare.

Investing in the shares of smaller companies offers the cleanest way to access this growth. Smaller companies are more exposed to their domestic economies than their large-cap peers, and especially to sectors that are likely to benefit from rapid income growth such as retail, healthcare and industrials.

Although emerging equity prices recovered substantially in the second half of 2016, they continue to trade at a sizeable discount of around 30 per cent to both developed equities and their own history. Given the volatile political environment currently enveloping the West, the perceived wisdom that emerging markets deserve a higher risk premium and so a lower valuation than developed markets is becoming increasingly contested.

When it comes to developed markets, it is true that the shares of smaller companies have tended to be been seen to be risky, partly because these firms often focus on a single line of business and also because the shares tend to be less liquid. Historically, over time investors have been compensated for this additional risk by receiving higher returns.

But the reverse applies in the case of emerging markets. Here, small-caps have historically been less volatile and consequently offered better risk-adjusted returns than large-cap equities. That is mainly because a relatively big proportion of EM small-cap shares tend to be owned by domestic investors. That means their price tends to be less heavily influenced by external capital flows. In the current environment that should make them much less vulnerable to higher US interest rates.

While these shares are often relatively illiquid, a robust investment process focused on selecting high-quality companies means there is significant potential for the fund manager who is prepared to put in the time and effort and is willing to invest for the long term to add value through primary research.

Small-cap stocks tend to be covered by fewer analysts than large caps, a phenomenon that holds true for emerging markets as well.  Indeed, many small-cap companies are not followed at all, and the quality of research on those that are covered is frequently poor. This provides a great opportunity for investors to identify market inefficiencies, discover new investment opportunities, and to generate significant returns.

Furthermore, with equity market correlations so high, these shares offer potentially sizeable diversification benefits.

The main risk to this trade would appear to come from a rapidly appreciating US dollar. That could force the central banks of emerging nations to raise interest rates, in turn choking off domestic economic growth.

 

South Korean yield curve steepener

The South Korean yield curve is one of the flattest in the world, with ten-year debt yielding just 47 basis points more than two-year notes. The shape of the curve reflects two factors: rates at the short end are low due to the weak near-term economic outlook for South Korea, while longer-term prospects are clouded by a significant overhang of private-sector debt, unfavourable demographics and the very low level of global ‘term premia’. We think there is an opportunity to profit from the curve steepening by going ‘long’ of two-year, and ‘short’ of ten-year, interest-rate swaps.

The Bank of Korea (BoK) has said the economic outlook remains subdued given weakening consumer spending and investment amid an ongoing slump in export demand. Furthermore, it has highlighted the downside risks to growth given the potential for a sharper slowdown in China and commodity-producing nations such as Australia, which are important destinations for Korean exports.

Headline inflation has been well below the bank’s new two per cent target. Although the weakness in headline inflation is largely down to oil prices, the ‘core’ rate also fell below two per cent in mid-2016 and is close to the post-financial crisis low. The central bank expects core inflation to remain below target for the next two years, with the headline rate only reaching two per cent in late 2017.

Given this backdrop, the BoK has cut interest rates to a historic low of 1.25 per cent, and we think there is the potential for at least one more cut. That should help to pin down the front end of the yield curve.

At the same time, the long end of the curve – having flattened over the past year in tandem with other leading bond markets as easier monetary policy around the world triggered a yield grab – looks vulnerable to a global bond sell-off. Indeed, the recent US-led sell-off has seen the Korean curve steepen in response.

Historically, the Korean yield curve has had a high ‘beta’. In other words, when US bond prices have moved in one direction or the other, the Korean market has tended to move in the same direction but by appreciably more.

The chart below shows that relative to other countries, the Korean yield curve is flat. We estimate the term-premium spread to the US to be two standard deviations from the norm – something that we would expect to see only once every 20 years.

 

Chart 1 showing ten-year government bond yields less two-year yields

Source: Aviva Investors Macrobond as at 4 Dec 2016

In the event global monetary policy remains loose, we would expect this strategy to deliver a small positive return over the next couple of years given the prospect of at least one more cut in interest rates.

The primary rationale for the trade is that it should produce a more significant return as a more reflationary environment develops. The strategy should also work – albeit probably less well – if we see deflation materialise and the BoK cutting rates more aggressively.

The main risk would appear to come from a reversal of the recent rise in global yields on weaker global growth prospects. That said, we would not expect the curve to become inverted, meaning any potential losses should be limited.

 

Long US dollar versus Japanese yen

The Japanese economy remains on life support despite the best efforts of policymakers to resuscitate it. By contrast, the US economy is ending the year in reasonable shape. Furthermore, US growth looks set to receive a sizeable boost next year in the shape of looser fiscal policy, meaning that US interest rates are likely to rise further.

Although the dollar has rebounded sharply in the past two months, against the Japanese yen it remains around six per cent below where it began 2016. With the market arguably still long of the yen following heavy ‘safe-haven’ buying earlier this year, we believe the yen has scope to weaken considerably.

Our central expectation is that it will climb another ten per cent to its previous high of 125 yen, set in the middle of 2015. But it could feasibly reach 140 yen if we were to see the Bank of Japan (BoJ) engage in particularly aggressive monetary easing.

A strong yen is not consistent with the Japanese authorities’ objectives as it will make it more difficult for them to fight deflation.

In September the BoJ introduced yield curve control, an addition to the central bank’s toolkit of extraordinary policies that have been utilised following the financial crisis. This involved a commitment to maintain the ten-year government bond yield close to zero. If bond yields continue to rise in the US and elsewhere as we expect, such a policy seems likely to weaken the yen.

The BoJ’s actions are giving the government an opportunity to finance unlimited borrowing at a very low rate of interest for the foreseeable future. Given the strength of Prime Minister Shinzo Abe’s mandate, and that ‘Abenomics’ has not really succeeded to date, there is a likelihood we will see much more fiscal stimulus in Japan. This would likely put further pressure on the yen. At the same time, we believe the US Federal Reserve is likely to hike interest rates faster than the market anticipates, further boosting the dollar.

The main risk to this trade would appear to come from a renewed bout of risk aversion as was seen around the turn of last year, which led to a sharp appreciation in the yen.

 

Long US High Yield Bonds

The US high-yield corporate bond market, even after an impressive rally in 2016, offers one of the few opportunities for an attractive return in today’s environment of low interest rates, with a ‘yield to worst’ of 6.4 per cent. It should do especially well if Trump’s pro-growth rhetoric were to translate into stronger US economic growth in 2017.

Fiscal stimulus, lower taxes and reduced regulations are potential tailwinds for the US economy. High-yield debt has equity-like characteristics, which means it tends to benefit from a ‘risk-on’ environment but with lower volatility. Returns traditionally are best when the economy is growing, but not so fast that monetary policy needs to be tightened aggressively.

Trump’s victory has stoked expectations of higher inflation and interest rates. But while high-yield bonds are not immune to rising rates, the sector’s relatively low duration make it less sensitive to this threat. In the early stages of rate-hike cycles, credit-spread compression has historically helped to cushion the blow of higher rates. 

Although default risk is historically the largest hazard of investing in high yield bonds, we expect defaults to decline in 2017. That is largely because of the stabilisation in commodity prices, with the price of crude oil having nearly doubled from February’s low. The energy sector, which makes up 14 per cent of the high-yield market, saw a double-digit default rate in 2015 and 2016. But Moody’s expects energy-sector defaults to fall to five per cent by this time next year and the overall US default rate to drop to 4.1 per cent. 

Credit spreads have fallen by more than 400 basis points from the February peak. Yet they remain more than 100 basis points wider than in June 2014, the peak of this credit cycle. With a coupon yield over 6.5 per cent, we would expect US high yield to continue to be in demand from investors hungry for both yield and income.

The main risk to the trade is that US economic growth begins to slow, perhaps because the US central bank raises interest rates faster than we anticipate in order to combat a sharp pick-up in inflation.

Long US Inflation protection

We have for some time argued that financial markets were too concerned about the threat of deflation and that inflation would eventually begin to materialise. In the months leading up to the US presidential election, financial markets had begun to come round to the view that inflation would take root. Donald Trump’s victory has cemented this belief.

The prospect of rising US inflation explains the rationale for one of our favoured trades at present which is to be long of US Treasury inflation-protected securities (TIPS) and short of conventional Treasuries via the ten-year future. Structuring the trade in this way means we can effectively take a view on the amount of inflation being priced into the US Treasury bond market.

While this has been a profitable strategy within our AIMS portfolios for some time, we believe it has further potential.

At the start of 2016, with the market preoccupied with the threat of deflation, the Treasury bond market was pricing in average annual inflation of no more than around 1.5 per cent over the next ten years.

While that figure has steadily risen since the summer, and now stands at closer to two per cent, we still believe this is too low given the recovery we have already seen in oil prices.

Furthermore, the risks are that US inflation will rise further still given the extent of fiscal stimulus Trump has proposed. All told, economic growth could be boosted by as much as one percentage point in 2017 and 2018. With the US labour market already relatively tight – the unemployment rate is just 4.9 per cent – this is likely to fuel both wage growth and inflation. While there are concerns within the market regarding a possible reversal of free-trade agreements, any move towards protectionist policy and potential introductions of tariffs would likely lead to inflation expectations rising, at least in the short term.

Of course, one of the big questions for investors is the ability of Trump to deliver the level of fiscal stimulus the market is now expecting. Whilst his proposed tax changes are likely to be welcomed by Republican lawmakers, tax reform will take time to pass through Congress. As for his plan to boost infrastructure spending, that will require a change of attitude from some members of Congress if it is to come into effect.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 8 December 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

RA16/1069/31032017

Important Information

For professional/institutional/wholesale/qualified investors only. Not to be distributed to, or relied on by retail investors.

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 8 December 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.

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