Now that we are all back in the office an looking toward the year ahead, it would be remiss of us not to include an investment outlook for the year. In this post various investment experts at GAM offer insight into investment themes in their specialist areas and key events to watch out for this year.
7 investment themes set to shape 2018
1. Monetary normality
From a relative perspective, we believe the ECB is more likely to surprise the market than the Fed. Given the fact that the European cyclical economic expansion is less mature than in the US, this would support a convergence of the spread between German and US 10 year bond yields, meaning German Bunds are likely to underperform against US Treasuries. This is a key theme we will be playing in our portfolios in 2018.
2. Strong banks
One major theme for our team in 2018 is the European financial subordinated debt: on-going regulatory pressure is forcing banks and insurance companies to further build up and strengthen their equity buffers making these instruments stronger and safer. But it is important to note that one has to be very selective and manage the portfolio actively, as even some of the big, established companies can potentially fail in a strong sector as we saw last year with the example of Banco Popular.
3. Automation and robotics
One of the top themes for Japan in 2018 will be more work process improvement due to an ever tighter labour market. Companies will be eager to contain cost pressure as much as possible. One way of doing this is by further standardising processes through the application of IT-based solutions – automation, robotics, artificial intelligence, internet of things, etc. – as well as allowing people to work shorter days and weeks, something that is valued very highly.
4. The Chinese consumers
Our top theme for 2018 remains Chinese consumers. One big trend in this and the next decade is China’s economic evolution towards a consumer-driven economy. In our China and Asian growth funds, we continue to focus on companies that benefit disproportionally from China’s economic evolution. These companies – which can be found mainly in the consumer, technology, healthcare and financial services sectors – continue to experience fast growth. In these rapidly growing industries, we are able to find attractively priced names through careful stock picking.
5. The rise of the Millennials
The big theme we will be watching out for in 2018 is: what do Millennials (generation Y – born early 1980s to mid 1990s) really want? Millennials are increasingly becoming the main target group for most luxury companies. In combination with this trend we look at what luxury companies are doing in terms of digitalisation – something which will clearly have a tremendous impact on the industry as a whole. Which brands are adapting to the new reality in the most efficient way? Which ones are able to gain momentum and which ones might fade away altogether? In general, many luxury companies enjoy the extravagance of sitting on a big pile of cash – it will be interesting to observe what they do with it in order to stay relevant in a rapidly changing world.
6. Solid growth
For 2018 we continue to be laser focused on growth. With growth we do not mean a focus on short-term quarterly numbers, but rather growth over medium-to-long term time horizons. We have a good number of companies in the portfolio that are investing now for future success. Being patient and following the long-term plan, while also being able to deliver on the short-term goals, is one of the key attributes of really well managed companies. And these are the exact companies we aim to find and invest in.
7. Eurozone demand recovery
We have two key investment themes underpinning our stock selection process. On the one hand, we have exposure to long-term secular growth trends; this means emerging market consumption growth, transfer from the physical to the online world, and disruption of whole industries through new technology. On the other hand, however, our medium-term focus – the one with more potential to drive returns in 2018 – is our positive and above consensus stance on European domestic demand. We are positioned to benefit from a Eurozone demand recovery through select key holdings in building and construction materials, consumer spending and business investment. We believe the risk / reward profile is highly skewed to the upside, with multi-year recovery potential.
7 key events to watch out for in 2018
1. Accelerating inflation
A key development to watch out for in 2018 is the potential advent of accelerating inflation. It matters most because it is almost entirely unanticipated by markets, yet seems likely from the perspective of macroeconomic conditions. But it is also of great significance because unanticipated inflation will lead to major setbacks in both bond and stock markets, with significant aftershocks in almost all asset classes. It would undermine the efficacy of conventional ‘balanced’ multi-asset portfolios, but potentially serve well multi-asset, multi-strategy portfolios that can go short (eg target return).
2. Central bank policy changes
The positive news is that divergent economic growth stories and central bank policies are likely to create opportunities across global fixed income markets this year. In an environment of rising interest rates and government bond yields, that is also characterised by tight spreads, we believe investors are likely to be more cautious in the type of credit risks they take and spend more time focusing on company-specific fundamentals than they have, or have needed to, since the era of ultra-low interest rates began. As a rising tide lifts all boats, strong demand for corporate credit has led to robust performance and tightening of spreads among both good and lower quality issuers. We feel this will change going forward and, while we believe value can still be extracted from this segment of the bond market, the key will be to marry old-school / accounting-based research with more modern investment techniques such as long / short and relative value trades.
3. A return to ‘normal’ volatility
We have witnessed very low levels of overall equity market volatility during the last 12 months, with investors seemingly unfazed by global events that would have previously caused short-term volatility or rotation within equity markets. The continued expansion of the ECB’s balance sheet has undoubtedly had a smoothing effect, but also caused extended valuations in certain ‘safe haven’ areas of the market. Fund investors have also followed this trend, witnessed by the positive net inflows into ‘low-vol’ or ‘short-vol’ packaged products. What will trigger a return to more normalised levels of volatility? We cannot know for certain, but the impending unwinding of the US Federal Reserve’s balance sheet would seem to offer a real test, particularly to the ‘bond proxy’ equities.
4. US tax reform
US tax reform could be a key event to watch out for in 2018 for the mergers and acquisitions (M&A) market and for the stock market in general. If the reform kicks in, one may expect increased M&A activity, which could be bolstered by additional resources made available by tax savings and possibly cash repatriation measures. On the other hand, a limit on the deductibility of interest expenses is proposed in the same reform, which would limit the use of debt and make certain leveraged buyouts, typical of private equity companies, uneconomic, thus limiting this type of transaction.
6. NAFTA negotiations
In early 2018, we are likely to get more information on progress in the NAFTA negotiations, and arguably a better sense of the US’s policy direction towards global trade. The outcome of these negotiations could have profound implications for emerging markets (EM) in general and Mexico in particular. President Trump’s protectionist attitude remains a major risk for EM growth and any shift towards higher tariffs would have a material impact on all EM currencies. At the same time, elections in Mexico, the reform process and elections in Brazil, internal party politics in South Africa and developments in Turkey could all increase the volatility of EM returns as well.
7. After the hurricane is before the hurricane
In 2018, we expect a 10% increase in risk-adjusted yields in catastrophe bonds and adjacent areas of the insurance-linked securities (ILS) sector. In the year just ending, active returns helped offset losses to deliver a net positive return, despite a string of loss events led by hurricanes Harvey, Irma and Maria (HIM). The ILS market has not fully come to grips with some fundamental realities, which emanate from the fact that HIM insured losses, though still substantial, will be approximately USD 60 billion, not the USD 100 billion widely assumed. In 2018, we expect to adopt a moderately offensive stance in our portfolios by selectively investing in higher yield positions. We also expect 2018 catastrophe bond issuance to break all previous records with USD 12 billion in bonds coming to market.