My 2018 Outlook

Let’s be candid, 2017 surprised all of us.  2017 gave us a BREXIT hangover and a colorful US President.  Yet, the year ended with portfolio gains none of us expected.

What does this say for 2018 and how we should invest?

At a minimum, relative to early 2017, we can be less concerned about the stability of the US genius, and focus instead on the true risks facing the market today.

2018 will present us with unique systemic risks in Asia, the Middle East, and Europe.

At the top of all investors’ worry list is the US-North Korean conflict.  While this has presented us with some surreal Twitter banter, the reality is that both parties are now actually closer now to negotiating 1x1 than they ever have been. 

In the Middle East we have a new Saudi prince seizing power at a pace never seen before.  But for Saudi Arabia’s survival, the change is imperative.  The ARAMCO IPO will be a bell weather for the markets and for the region.  In the interim, I would expect much more instability as the Prince continues to challenge the clerics, his extended family, and his regional neighbors.  Israel’s role and reaction will be crucial.

Europe will continue to be dominated by BREXIT.  Investors and corporations continue to look for clarity and finality with regards to how the entire process will unfold.  Yet, the market has almost fully priced in the effects of BREXIT, so much of 2018 will be more information regarding the details of the negotiations.  Of note, like you, I was surprised by the ingenuity of Britain’s suggestion to participate in the TPP.

These systemic risks aside, that leaves us with market risks.  What should be top of mind for all of us as we enter 2018?

Very simple: The fixed income markets.

The US yield curve is stubbornly indicating that the USA is near a recession.  This doesn’t bode well for the rest of the global economy as the US has been leading the world out of the Great Financial Crisis, and by default the trend of quantitative easing.

Ironically, despite almost full employment, the USA is perilously close to running out of gas.  Why?  Low wage growth.

The US Federal Reserve bet the recovery on job growth, and by default, wage growth (hence all of the discussion around the Phillips Curve).  Yet there has been no appreciable wage growth.  Year over year wage numbers continue at an anemic pace (last at 2.5% YoY).  Conversely, the non-farm payroll numbers look good, and the unemployment rate remains at historic lows.

This is all concerning because while the monetary policy of QE worked in allowing the global economy to survive, it inadvertently seemed to have stalled wage growth.  Fed Chairman Janet Yellen, on multiple occasions, has reflected on the inability for the Fed to see higher wages; and by default any inflation.

One academic observation: inflation is a component of stock returns. Remember, implied within any equity valuation forecast is the rate of inflation.  Today inflation is at historic lows…so where is the market receiving the benefit of higher prices?  P/E Expansion.

In layman terms, PE Expansion is simply the ability for a new investor to pay more for an underlying asset than you paid for it without any substantial change to the underlying fundamentals (sound familiar Bitcoin fans?)

This PE Expansion is what has market experts concerned, hence all of the TV pundit banter regarding “momentum” and “growth” stocks.  This is code for an expensive market and rich valuations.

While I can be cynical of valuations, I have learned in the past that standing in front of “slowing” freight trains doesn’t accomplish much other than a painful outcome.

So regardless of my thoughts about the market, I think it is important to highlight where valuations are on a relative basis.

Geographically, the US market is quite rich in comparison to the European and Asian equity markets.  Of those two, Asia still remains the cheaper of the two.  Hence at year end, we saw a lot of fund flows from the US stock market to Europe and Asian equities.

For investors who have a higher risk tolerance, the emerging markets stand out.  Here however I would caution you to be ready for headline risk especially in regards to some of the systemic risks I described earlier.

Sectors that look “cheap” are energy, consumer staples, and financial services.  Of note, if the US finally does implement its long promised infrastructure package we should see financial service firms benefit.

There is one other key substantive point for you to consider: Volatility.

As you, and other investors are aware, market volatility has remained exceptionally low.  Why?  The central banks.

When one looks at the level of market activity (i.e. purchases of all securities), there have been several key and core investors these past several years: the Federal Reserve, the ECB, the BOJ, and the PBOC.  All four are slowing down their policies of QE.

Who has replaced them?  Retail investors.

Retail investors finally saw that despite their personal misgivings of the political landscape, that the market continued to have a bid.  Therefore, in spite of low fixed income yields investors were left with no choice but to purchase stocks.

As QE purchases slow down, we will need to carefully watch volatility.  It is my expectation that we will see a significant pickup in volatility in 2018.

Therefore, from an equity perspective, geographically we would expect investors to focus on Asia, Europe, and the US equity markets (in that order) and have a sector focus on consumer staples, financial services and energy (also, in that order).

For those of you with a more speculative appetite, look at a) the emerging markets and b) purchasing volatility.

This leaves us back where we started and with the same initial concern: the fixed income market.

My concerns regarding the fixed income market are focused on the US Federal Reserve.  Over the next few weeks, I do not think we will see a quick systemic shock to the fixed income market ahead of my next letter to you; therefore I will end this letter here and allow you the time to reconfigure your equity portfolios.

However, next we speak, we will focus on both the fixed income and the currency markets.

In the interim, avoid slowing freight trains, enjoy the Twitter wars, and I look forward to speaking next!

A Game of Fixed Income Chicken

I love "new record highs"

If the market simply moves 1-point higher, we have a record high.  And this becomes news each night.  But what's the data point we are not talking about:

The DJIA needs to be above 32,000 for us to be back on track.

Yes...32,000. How did I arrive at that number?  Take any index benchmark in 2008/2009 and extrapolate an 8% equity return to today.

Is this crazy math that I am suggesting?  No, this is exactly what every pension plan did prior to the Great Financial Crisis.  Each pension then made its financial commitments to its constituents (police, teachers, firemen, etc.) and the politicians adjusted taxes accordingly.

But we never got 8%.  And we are certainly no where near a DJIA of 32,000.

Yet, here we are with "new market highs" and a fixed income crisis on the horizon.  Remember, how will the US pay for Puerto Rico?  That's right, the US cannot.

As you watch TV now, and are experiencing the classic definition of a "wealth effect," you will be coerced into a set of behavior that is irrational: Spend more.  Save less.  Take riskier bets.  On top of it all, why not vote yourself a tax break?  It has no impact on yields right?  Think again.

This is the quandary that the central banks have placed all investors in today.  This game of fixed income chicken will continue as this asset bubble races higher.

But who will call the chips in?  Which sovereign will say "enough?"

We all know that answer.  It was made easier for us this with as one-man-rule took place in China.  Watch as Xi Jinping slowly and methodically tightens the noose around the US credit markets.  His weapon of choice? Trade.
 

Despite our concern, our market view is the same:

1. Long equities, with a focus on Europe and Asia (and, If you can, financials and consumer staples)
2. Short duration (the infamous fixed income pivot)
3. A weak dollar

Have a great weekend!

Where is the US Consumer?

Tick tock...is it all over?
 

First off, we have changed the name of our newsletter to better reflect the full scope of our commentary to UNHEDGED.  Our objective is to provide broader coverage reflecting not only market conditions, but some of the underlying trends, especially in FinTech, that we feel will be of interest to you.  .

Before delving into our commentary, one book recommendation for the summer: The Summit by Ed Conway.  Well worth the read and will create strong sense of deja vu...does history repeat itself: yes.

That said, we continue to remain concerned about the overall condition of markets.  

This week's NFP headline numbers will be the talk of the town, yet the underlying wage data will continue to confound the Fed. Quite simply, there is no wage growth and this belies a bigger problem.

The central bank liquidity trade remains in place.  Pundits are underplaying the significance of the central bank balance sheet pare backs over the next 7+ years.  What does this mean?  A higher likelihood of nothing occurring again.  Remember, if we were to be back on track the DJIA would need to be at 32,000+ to have pension systems back at break-even.

A lower VIX breeds complacency, and that sets up markets poorly for a systemic shock.  

"There are no catalysts remaining, as the Trump slump is real," said one portfolio manager to us this week.  That bears consideration: none of Trump's campaign efforts have happened despite a Republican controlled Congress.  

"There are no market participants...just the Fed, the BOJ, and the ECB," said another prop desk head. "Why do you think Bitcoin has such volatility to it...central banks cannot buy it!"

Here in APAC we are witnessing an interesting phenomenon.  Whist the giants like Ant Financial continue to make progress in FinTech, the ability for the startup community to get past a lukewarm A-round remains extraordinarily difficult. "There is a lack of true IP and scale into a fragmented market," said one VC on background. "The Asian dragons need only watch the innovation in the USA and replicate it to an APAC offering at massive scale leveraging off their existing platform user base."

It has been fascinating to me that there is virtually no investment banking activity, either fundraising or M&A, of any size/substance in the region. What we are seeing are small acqui-hires.  It is all strangely reminiscent to me of the 2001 dot-com companies with more cash on their balance sheets than their market capitalization.  Boards will start reviewing the viability of an exit and monetizing their initial investment(s).

I struggle with defining a continued rationale for a market bid. Instead, I hear of unsophisticated market participants stretching for yield/return and too many conversations about Bitcoin...

Here were my recent comments on CNBC.  In short, be very very careful.

Our long term view has changed slightly in regards to equities:

1. Long equities, with a focus on Europe and Asia
2. Short duration (the infamous fixed income pivot)
3. A weak dollar

The FinTech Tortoise

Prior to my 2014 arrival in Singapore, one could not go anywhere in the financial trade press without reading about robo-advisor “disintermediation” and/or “disruption.”

In the last three years, despite an avalanche of publicity, and massive VC funding, we have yet to see a robo-advisor put an incumbent out of business. Instead, the incumbents are beginning to adopt the very changes that were supposed to put them out of business.

The DBS rollout of their "DBS iWealth" app is a prime example. To quote Ms.Tan Su Shan, DBS Group head of Consumer Banking and Wealth Management: "Robinhood (a free stock trading app based in USA) had the best, fastest user experience for equity trading... I told my guys about it, and they delivered on the speed and agility of the user experience, of what the best that Silicon Valley can offer."

The same FinTech paradigm applies to what we are witnessing in wealth management vis-a-vis the robo-advisors. Robo-advisors committed the same mistake that most FinTech entrepreneurs made: mistaking the lack of an incumbent response as an inability of the incumbents to compete.

What had occurred was that incumbents were paralyzed by the extraordinary regulatory regime imposed on them following the Global Financial Crisis. Simply put, they could not respond, hence part of the regulatory arbitrage that existed for the entrepreneurs. Therefore, the “FinTech revolution.”

Today, the incumbents have woken up, because now they can compete. In this new, competitive, and realistic environment, a different paradigm is at work.

Robo-advisor entrepreneurs need to be aware of the following:

•   Decide now: client acquisition or client retention? This decision alone will define your business. If you are focused on acquisition you will begin a slow, costly, laborious process and you might create some new IP. That IP might draw the attention of a VC, but that is very doubtful now. Conversely, if you are focused on client retention then you are a consulting firm, not a start-up.

•   Client acquisition costs will kill you. In fact, they can kill you immediately. Any market new comer who has not prepared a complete client acquisition analysis will lose..

•   The robo-advisor IP is not unique, nor is it IP. This is a hard truth many have not accepted. Unlike the math necessary for driverless cars, the math for asset allocation, tax planning, rebalancing, etc. is simply not that complex. 

•   Only product and/or service platforms will survive. The robo-advisor needs to be a “Blackrock” or a “Schwab.” The robo-advisor needs to be either a business dedicated to creating products (i.e. ETFs) or providing wealth management services. Brand recognition and massive platform scale are the factors of survival

Using the DBS/Robinhood example stated earlier, there are strategic variables that robo-advisor need to absolutely consider. In APAC, there are obvious constraints, for example:

•   Can retail accounts buy ETFs in the local market? If not, why introduce a robo-advisor at all? HNW investors in Asia tend to want either separately managed accounts (SMAs) or trading accounts.

•   Are there already dominant market participants with sizable market share? If so, what acquisition tools do you have that provide you with a competitive advantage? If the answer is “none,” then you are a software consulting firm.

•   Is your design/user experience patentable? If not, it will be copied. Look no further than the brilliant design of Robinhood and how quickly it has been copied, and improved upon, by other trading platforms in Asia like DBS.

There will be a significant weeding out process of smaller robo-advisor participants as the B2C models fail due to exceptionally higher customer acquisition costs. Conversely, the surviving B2B robo-advisors must build scalable bespoke solutions for the incumbents; thereby becoming consulting/service providers and not unique IP only.

Who wins? The very firms that were originally meant to be dis-intermediated and disrupted. As with the fable, the tortoise will win this FinTech race.

--

Frank is a pioneer and recognized industry expert in Asia for the distribution of investment products to Private Bank and Investment Banks. Over the last 25 years, Frank has managed multi-billion dollar portfolios and developed expertise in Smart Beta, separately managed accounts, portfolio replication, and factor based investing.

He is a frequent co-anchor and co-host of The RunDown on CNBC with Akiko Fujita. Currently, Frank is a Senior Advisor with Synpulse Management Consulting, a leading global financial services consulting firm.

The Fed Hike and Asteroid 2005 YU55

As investors, behaviorally we have a tendency to avoid the facts. Like whether or not an asteroid will hit the earth on November 8th. Specifically: Asteroid 2005 YU55.

Instead we focus on Fed policy.

As investors, behaviorally, we have a tendency to avoid the facts. Like whether or not this election cycle will be normal. It will not.

Instead we focus on Fed policy.

Will the Fed raise rates in December? “Yes if…”is the standard pundit’s reply.

Ignoring Asteroid 2005 YU55 and the election, we can say, “yes if”:

• We agree that the employment data was strong (it was mediocre)

• We agree that the market’s reaction will be positive/indifferent (we have now had several days of strong selling)

• We agree that Asian markets will react positively (they most likely will not)

• We agree that China will not devalue (now might be a good time for them to do so)

Ask yourself, would the Fed knowingly bring an economic “crisis” to a new Administration before it is sworn in?

Now add on to the above set of variables the almost certain chaos that will ensue from this election. Begin imagining:

• Voter riots/militias

• A disputed election

• Immediate indictments (regardless of who wins)

• We may be really electing the Vice Presidents, not the Presidential candidates

And that’s just to start.

What about the Asteroid 2005 YU55? It just missed us in 2011, but it was a near miss. That is one less thing for you to worry about.

As investors, focus on the next immediate worry: the election.