Category: Geopolitical

Investing to benefit from the dawn of Eurasia

One of the excellent books I am reading at the moment is Dawn of Eurasia by Bruno Maçães, a former Portuguese minister and current political scientist*. The main premise of the book is essentially that the idea of Europe as a distinct entity from Asia is merely a historical construct, and that the new world order that is coming about – aided by the fall of the wall and the opening up of China – is essentially a Eurasian one.

* note this is not a sponsored post in any way shape or form!

While many of us tend to think of “Americanisation” when we think of “globalisation”, Maçães instead views the future of globalisation as being defined by developments on the landmass that spawned almost all of the world’s great civilizations. In that new world order, the balance between Russia, China, India, the European Union and Middle East will shape much of the world affairs in the future.

Meanwhile, the preeminent power of today, the United States, is increasingly redefining itself as being somewhere in the middle of both sides. Maçães views events like the election of Donald Trump, Europe’s refugee crisis and Brexit through this lens.

Russia, with its Eurasian Commonwealth of Independent States, and China with its Belt and Road initiative have been somewhat faster than many Europeans to see the bigger picture. Particularly the latter, functioning as “new Silk Road” is a project that spans 68 nations that are home to some 62% of the world population and aims to invest in infrastructure, roads, railways, ports and so on, thereby enhancing Eurasian economic cooperation.

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If this all plays out, investors can obviously profit from increasing trade and prosperity throughout the wider region.

Infrastructure projects that are part of China’s Belt and Road initiative will bring direct benefits to places in China and Central Asia like Kazakhstan, Kyrgyzstan and Uzbekistan as they become more linked together and economies start integrating closer. Not only will the European Union be integrated internally, it in itself will start seeking closer integration with other powers.

While there are plenty of flash points and geopolitical issues that remain unsolved (Ukraine, Taiwan, Kashmir, the South China Sea to name just a few), potentially that integration will create a truly win-win situation where all countries involved can prosper.

Portfolio construction: Eurasian stocks and infrastructure

  • The constructed portfolio consists for 70% of stocks from China, Europe, Russia, Pakistan, Kazakhstan (through Depository Receipts listed in London) and ASEAN, coupled with some Indian infrastructure
  • The remaining 30% is filled with the KraneShares One Belt One Road ETF which invests in the primary countries and sectors involved with the initiative: mainly energy, utilities, industrials, materials and financials
CategoryNameIDTERAlloc %
One Belt One RoadKraneShares MSCI One Belt One Road ETFOBOR0.79%30.0%
RussiaVaneck Vectors Russia ETFRSX0.62%15.0%
ChinaiShares China Large Cap ETFFXI0.73%10.0%
EuropeiShares Core MSCI Europe ETFIEUR0.10%5.0%
India infrastructureColumbia India Infrastructure ETFINXX0.85%10.0%
PakistanGlobal X MSCI Pakistan ETFPAK0.91%10.0%
ASEANCIMB FTSE ASEAN40 ETFASEAN0.80%10.0%
KazakhstanHalyk Savings Bank of Kazakhstan GDRHSBK2.5%
KazakhstanKcell JSC GDRKC1A2.5%
KazakhstanKazMunaiGas GDRKMG2.5%
Central AsiaCentral Asia MetalsCAML2.5%

Risk level: high / diversification: low

  • Dividend yield: 2.5%
  • Ex-ante predicted volatility: 11.2%
  • 1 year 95% Value-at-Risk: –15.6%
  • Scenario 2008 Lehman Brothers default period: -18.6%
  • Scenario Interest rates +100bps: +1.8%
  • Scenario 2008-2009: -23.3%
  • Scenario 2010 onwards: +88%

After Donald Trump Leaves: Investing in a Post Trump World

The day of Donald Trump’s election back in November 2016 was quite a fascinating day to watch the markets (come to think of it, the whole second part of that year from June to November was a rollercoaster). Markets initially did not like the news much at all, then at some point during the day the tide turned and everything started rallying: US dollar, stocks, interest rates. That did not stop for quite some time.

It wasn’t so much that markets suddenly turned sanguine about all of the perceived bad aspects of a DT government. The worries about trade disruption and alienating allies were still there. But the prospect of a pro-growth government controlling all three branches had investors salivating and became the overbearing driver of returns. Corporate tax cuts, infrastructure spending, reducing regulations…

But lately the Trump trade has turned upside down

As of late, there is a real sense that that is changing and the worries are gaining the upper hand. The main culprit for the markets unease since early February have been Trump’s tirades on trade, blaming anyone from Mexico to JapanCanadaChina and the European Union for taking unfair advantage of the United States. These countries together represents two-thirds of all of America’s foreign trade and much of its exports.

On top of all this there are the worries about Mueller’s Special Counsel Investigation and whether any of it could eventually lead to impeachment. And don’t forget that by 2020 Trump faces new elections anyway.

So… Does this kill the market?

I read a quote from one portfolio manager in Australia this week proclaiming that the tweet-driven market was driving him insane and he was considering offloading all his US stocks. We are indeed in new territory here and I do wonder if there comes a point where Trump’s playing with the market ends up killing the bull market as a whole. US economic data tells us otherwise, but at some point something will give, right?

Long story short, Trump may be with us for quite some while, or his days may suddenly be numbered. How to invest for when that moment comes around? I see four main themes playing out.

#1 Long US dollar, short euro and yen

When Trump was elected, the US dollar initially rose from 98 to 103 (+5%). Since then however, it has been on a steady downward trend and only as of late seems to have potentially found a bottom around 90 (-8%). What gives?

The Trump “reflation” trade initially made the dollar stronger, but since then I have long suspected that the US administration has deliberately talked it down. While the longer term US government policy is still for a stronger US dollar (as that has certain benefits), in the short term a weaker dollar may help to “rectify” the trade imbalances the United States faces with other blocs and nations. Treasury Secretary Mnuchin seems to think so.

So it is ironic that while we expected a period of US dollar strength after Trump’s election, in fact that period may arrive after he steps off stage, as US economic policy returns to orthodoxy. The euro and Japanese yen are both at relatively strong point vs. the dollar compared to recent levels, so I would short them against USD.

#2 Long Mexican peso

In the run-up to the US election in 2016, Mexican peso declined to nearly 22.0 versus the US dollar. It has since recouped quite a lot and is back around 18, but many economists say its fair value should be closer to 15 or 16. A lot of the worries that have plagued MXN are likely to resolve itself when the new NAFTA deal comes into play, but it may take Trump fully stepping off stage for Mexican peso to regain its strength.

#3 Long US treasuries

Treasuries have become weaker as the rate hiking cycle has continued. Inflation levels are still expected to rise, since we are likely to be at full employment (and throwing fiscal stimulus at the economy at the same time), and on the back off that this trend should keep going for a bit.

At the same time you have to wonder when the next serious market downturn will take place and what is going to cause that. Or even how that is going to impact the position of “Mr Stock Market” Donald Trump. At that point we may reach the peak of this rate hiking cycle and things could turn around, or a flight to quality may raise treasuries all by itself.

#4 Long China and Europe stocks, neutral US equities

There are some reasons to suspect that China and European stocks will outperform their US peers in the event of Donald Trump stepping down. In both cases it will likely remove an irritant to their global trade ambitions, while in Europe’s specific case a weaker euro would likely be good for European stocks.

Portfolio construction: long USD and MXN, long treasuries and EU/China stocks

  • The model portfolio contains some 40% in currency positions, consisting of long USD and long MXN. The remainder is filled up by 20% US treasuries and 40% European and Chinese stocks
  • The volatility on this portfolio is some 6.4%, which is marginally higher than our Core Bond portfolio (4%). Both in terms of upside potential as well as downside potential this portfolio should be able to do well in the specific scenario it is designed for. In case the scenario does not exactly play out as envisioned, long stocks, long EM currencies and long USD should be able to balance things out quite neatly
CategoryNameIDTERAlloc %
Short EURProshares Short Euro ETFEUFX0.95%10.0%
Short JPYETFS Short JPY Long USD ETFSJPY0.39%10.0%
Long MXNMXN cashMXN-20.0%
US TreasuryiShares 20+ Year Treasury Bond ETFTLT0.15%20.0%
China equityiShares MSCI China ETFMCHI0.64%20.0%
Europe equityVanguard FTSE Europe ETFVGK0.10%20.0%

Risk level: low / diversification: high / allocation: 0%-10%

  • Dividend yield: 2.3%
  • Ex-ante predicted volatility: 6.4%
  • 1 year 95% Value-at-Risk: –9.5%
  • Scenario 2008 Lehman Brothers default period: -10.0%
  • Scenario Interest rates +100bps: +0.1%
  • Scenario 2008-2009: -8.7%
  • Scenario 2010 onwards: +50%
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Positioning your Portfolio to Cope with a Trade War

Trade wars and threatening to start them are all the hype at the moment, it seems. Stock markets had a rough patch in late February to early March 2018 when the US President proclaimed on Twitter that trade wars are “good, and easy to win” and proposed 25% tariffs on steel and 10% tariffs on aluminum imports.

In the next days the headlines on imposing tariffs on Chinese technology became increasingly frequent. In both cases bureaucrats in China and the European Union took note and predictably went into battle mode rather quickly. When tariffs were finally announced, markets swooned again.

trade war refers to two or more states raising or creating tariffs or other trade barriers on each other in retaliation for other trade barriers. Increased protection causes both nations’ output compositions to move towards their autarky position. (Source: Wikipedia)

Coping with the onset of a trade war requires some ingenuity by investors. It requires answering questions such as which sectors are likely to benefit from protectionism and which sectors are likely to get hurt. Or whether the negative impact on the economy as a whole is bad enough to offset or exacerbate the impact on individual sectors. And whether short-term protectionism of a dying industry will really help that over the long run (after all, I am not a day trader).

Every case is going to be different, but here I will focus on the increasing trade issues between China and the US.

China vs. America: who exports what?

As of writing, the looming threat is that of a full-blown trade war between China and the US, with much of the rest of the world spared of Trump’s wrath. Ignoring the day to day headlines of what sectors may be targeted directly, let’s look at what products US-China trade is composed of:

  • The US exported $169.8 billion worth of goods and services to China in 2016, while China exported $478.8 back to the US, making it America’s largest trading partner
  • The main export categories from the US to China were misc. grains, seeds and fruits ($15 billion), aircraft ($15 billion), electrical machinery ($12 billion), machinery ($11 billion) and vehicles ($11 billion). Within agricultural products, soybeans and pork related products stand out.
  • On the other hand, the US mainly imported electrical machinery ($129 billion), machinery ($97 billion), furniture and bedding ($29 billion), toys and shoes. Within agriculture, fruits and juices stand out

So in all one would expect Chinese technology and machinery to suffer, while soybean, pork and aircraft producers could do well and their American counterparts would suffer. Foreign technology producers that export to the US but are based outside of China may benefit while similarly US manufacturing in slowly dying industries may see a temporary boost.

How would financial markets respond to a trade war?

Leaving the economics and politics of it all aside for a second, one thing is fairly clear: financial markets do not like anything that can have a negative impact on trade and global economic growth. When two heavyweights like China and America face off, consequences are likely to be felt in almost every part of the world.

In the period of 26 February to 1 March 2018 the S&P lost -3.7%, though it quickly gained most of that back in the days immediately after as markets processed Donald Trump’s bluster (and it turned out that every country and their grandmother could potentially get an exemption). At the end of March, indices again went down nearly -3% on announcement of tariffs on Chinese technology.

A brief trade war – one move and one counter move – that hits a few specific sectors will annoy markets and hurt for a few days (export-dependent companies in those sectors especially so), and blow over. Risk-off assets like gold and Japanese yen will perform well for a bit before returning to their means, while specific sectors may either be hit or benefit from all the turmoil. A prolonged trade war with tit-for-tat retaliation in a downwards spiral could be a whole different story and could be the cause for the next long term equity bear market.

So how will it all play out if it does happen?

Essentially I’d expect three things to play out during any trade war and all the negative news headlines that trade wars will bring along with it.

  1. Flight to safety: There will be a flight to quality in financial markets, likely short-lived but possibly pushing up or down the equilibrium levels of some safe-haven assets in the medium term. That means that as always, you will see a stronger Japanese yen and Swiss franc, gains in gold and positive returns on US Treasuries. At the same time, the US dollar may strengthen and equities and emerging market currencies will sell off hard. Typically this doesn’t persist for much longer than a few days, unless lasting economic damage and negative spillover to other sectors is expected.
  2. Direct hits: The sectors that are positively or negatively affected will show outsized returns. In this case it appears that US steel and aluminum producers may benefit, as will Chinese soybean and pork producers. In the case of tariffs on Chinese technology, those companies will be directly hit while the tech sectors of countries like Japan and South Korea may actually benefit.
  3. Indirect misses: Companies that are largely dependent on foreign markets, whether these are US, European or Asian companies, will sell off indiscriminately. Companies whose profits are mostly derived from their home markets will go down with the market, but will look relatively better than their peers. It should be noted that many of those companies will be small caps

The difficulty is that it is quite likely that the drag on the economy from tariffs is seen as so significant that the market beta is going to have the overwhelming effect on stocks. You may be able to find stocks that do better than their peers based on the above, but they might still sell off if only to a smaller extent. Even in the case of risk-off assets like US Treasuries there are caveats. China is the biggest holder of these bonds and in case of tit-for-tat retaliations could decide to dump them sparking large losses.

Finally, inflation linked assets like TIPS and commodities may do well as trade wars tend to increase prices.

How likely is this theme to actually play out?

It is very hard to say how trigger happy the American government is really going to be when it comes to this matter. Perhaps it is all a negotiating tactic, or perhaps not. It is equally unsure how other countries will respond. They want to be tough, but that toughness may come at the expense of their own economies.

While Trump is increasingly surrounded by hardliners which may push him to take action, we also know that Trump cares deeply about the stock market. All in all I therefore assign a low 10% to 20% probability to this actually affecting markets in a significant way. I would put a max of 5%-10% in below sub-portfolio for the duration of Trump’s obsessive focus on trade imbalances.

Portfolio construction: risk-off, commodities and trade shielded equities

  • I constructed a portfolio consisting of 5 ETFs, focused on dealing with a China-US trade war without positioning too specifically for how that would play out. This portfolio is 30% long US and China small caps, has 45% classic risk-off assets such as long JPY and US Treasuries, while the remaining 25% is put into inflation-sensitive commodities
  • The below table shows the portfolio characteristics. We are looking at a dividend of 2.3%, while the volatility is estimated to be 6.0% on an ex-ante basis
CategoryNameIDTERAlloc %
US Small CapiShares Russell 2000 ETFIWM0.20%15.0%
China Small CapGuggenheim China Small Cap ETFHAO0.75%15.0%
Long JPYETFS Long JPY Short USD ETFLJPY0.39%30.0%
US TreasuryiShares 7-10 Year Treasury ETFIEF0.15%15.0%
CommodityiShares Commodities Select Strategy ETFCOMT0.48%25.0%

Risk, diversification and allocation

  • Risk level: high
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 10%-20%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 2.30%
  • Ex-ante predicted volatility: 6.0%
  • 1 year 95% Value-at-Risk: –8.3%
  • Scenario: 2008 Lehman Brothers default period: -12.0%
  • Scenario Interest rates +100bps: -0.9%
  • Scenario 2008-2009: -5.7%
  • Scenario 2010 onwards: +87%

 

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Preparing your Portfolio for a Hard Brexit

At 29th of March 2019, the United Kingdom is meant to exit the European Union. Whether the “Brexit” will be a soft one or a hard one has been on everyone’s minds ever since the 2016 referendum was narrowly won by those who wanted to leave the EU.

Since the day of the referendum, British asset prices have gyrated. The British Pound Sterling dropped from 1.50 right ahead of the referendum to close to 1.20 at the start of 2017, since recovering back to around 1.40. Similar numbers were seen for UK government bond yields, while UK stocks have been on a generally upwards trajectory.

In case of a soft Brexit, expect more of the same and no further big shocks, though with some sectors faring better than others and some outright profiting from the new dynamics. In case of a hard Brexit however, brace for volatility in any UK related assets.

First things first: what dates matter for Brexit?

The key dates in the Brexit process to keep in mind are the following ones:

  • March 2018. Target date for agreeing on a transition dea
  • April 2018. Target date for trade negotiations to start
  • October 2018. Target date for agreeing on a withdrawal treaty
  • 29 March 2019. Britain exits the EU and the transition period starts, possibly lasting all the way to the end of 2020

What are the risks and opportunities of a hard Brexit?

Whether in the longer term Brexit is a good or bad thing for both the European and British economy is still very much open for debate. Clearly the markets were not happy on the day of the referendum itself, but given that assets like GBP, UK GILTS and equities have either strengthened or at least undone much of the damage since then, it’s not unfair to say that an ambitious free trade deal – which is currently being aimed for on, as one presumes, both sides – would soothe many longer term concerns for the British economy. Currently a soft Brexit is being priced in.

What is also sure however, is that markets do not like surprises, and currently a hard Brexit would firmly fall into that corner, despite it being frequently talked about. On a macro level, a nasty Brexit surprise or an outright hard Brexit announcement anywhere between now and March 2019 would mean an instant weakening of GBP against all of the majors but predominantly USD, JPY and EUR. It would also lead to gains in UK GILTS and US Treasuries, while emerging market currencies may suffer as part of the stereotypical flight to quality. But any moves not directly related to the UK are likely to be short-lived, if June 2016 and other similar stress events are any guide for the future.

Assets to avoid in case of a hard Brexit

UK stocks with mostly domestic exposure. UK stocks with mostly domestic exposure will not do well if economic conditions deteriorate, while UK stocks with large EU exposure would be hard hit. Agriculture, services and manufacturing are simply best avoided

UK Property. If demand for commercial real estate falls as global business vacate the UK for continental Europe, property prices and REITs will naturally drop.

GBP vs majors. Pound Sterling is likely to weaken against USD, EUR and JPY in case of a hard Brexit

So what should you invest in?

UK stocks with non-EU international exposure. Stocks with significant international but non-EU exposure will be expected to do well in case of a hard Brexit and weakening GBP.  Examples are the mining and telecom sector.

UK GILTS. GILTS are seen as a safe haven asset, and post the Brexit referendum went up in value as rates declined. If that trend persists you will see the same thing, with subsequently things moving back to the way they were. Of course, if the Brexit news is sufficiently bad you could see the UK’s safe haven status being put to question, but no one really foresees that.

European financials. with banks, asset managers and insurance companies potentially moving jobs and activities out of the UK into continental Europe, and some competitors potentially not being able to serve the mainland anymore from London, European financials may gain new business.

How likely is this theme to play out?

I’d say the chance of a hard Brexit at the moment is somewhere between 25% and 50%. I actually reckon that most people underestimate the probability of this happening. If you are a British investor I’d say the key thing you need to do is diversify internationally as much as possible.

If you’re a non-British investor the safest thing may be to stay away from British assets as a whole. Why run the risk? If however as an international investor you want to position for UK assets that should be able to weather the hard Brexit storm, below portfolio will meet your requirements. I’d allocate anywhere between 0% to 5% to this theme and hold on to it until mid-2019.

Portfolio construction: long mining/telecom, Europe financials, GILT, short GBP

  • The hard Brexit portfolio contains British mining and telecom stocks, as these have relatively little UK exposure and thus would benefit most from a weakening GBP
  • European financials should benefit in case the position of the City of London weakens, while GILTS will strengthen as a safe haven. While other safe havens will likely mean revert, GILTS could be expected to stay at the stronger levels for a while longer
  • As all of these assets except for European financials are GBP denominated, you’d have to hedge out some of the currency risk. The short GBP ETF serves this purpose (ideally you would use a derivative such as an FX forward here instead so that it doesn’t eat up cash allocation, but this does the job too)
CategoryNameIDTERAlloc %
Short GBPETFS Short GBP Long USD ETFSGBP0.39%30.0%
UK mining stockBHP Billiton PlcBLT-20.0%
UK mining stockGlencore PlcGLEN-12.5%
UK Telecom stockVodafone PlcVOD-12.5%
UK GILTSiShares Core UK Gilts UCITS ETFIGLT0.20%10.0%
European financialsiShares MSCI Europe Financials ETFEUFN0.48%10.0%
UK telecom stockSky PlcSKY-5.0%

Risk, diversification and allocation

  • Risk level: medium to high
  • Diversification: medium
  • For risk and total return since initiation see Portfolios
  • Probability of this theme playing out in the next 3-10 years: 25%-25%

Portfolio characteristics (full look-through, from USD perspective)

  • Dividend yield: 2.45%
  • Ex-ante predicted volatility: 10.0%
  • 1 year 95% Value-at-Risk: –15.1%
  • Scenario: 2008 Lehman Brothers default period: -15.3%
  • Scenario Interest rates +100bps: +4.4%
  • Scenario 2008-2009: -7.7%
  • Scenario 2010 onwards: +49%
  • Scenario Equity up +10%: +9.6%
  • Brexit replay (23 June 2016): -3.7%*
  • Brexit replay (23 June-23 July 2016): +0.9%*
  • Brexit replay (23 June-23 Sep 2016): +5.4%*

* European financials were hard-hit, as were Sky and PLC (all returning worse than -11% on the day). My premise behind all of the above is that in case of a hard Brexit, over the longer term the benefits to these holdings would become apparent. In the second longer Brexit scenario this becomes apparent.

 

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