In the last couple of years, much of my focus has been on bottom-up stock selection issues, culminating with the publication of my book Against #shortermism, with a key emphasis on the importance of a long-term oriented corporate culture.
Stocks have certainly been the asset class to be in over the last decade, much as they have been over the very long haul. For individual investors with a true long-term orientation, I cannot stray away from my recommendation to remain heavily invested in global equities for durable wealth creation.
Nevertheless, for “shorter” periods of time than that (say between the next five to 10 years), particularly for professional investors, global asset allocation issues tend to generally play a more important role. Given the meaningful outperformance that stocks have enjoyed over the last decade, mean reversion is increasingly likely to result in some underperformance by stocks as an asset class.
For tactical investors, as well as those who invest for a living, global asset allocation is likely to be more of a performance driver in the next few years. Still, the long-term advice that I have been sharing in the last few years still holds. Thoughtful bottom-up security selection in the best wealth-creating machine in human history (the stock market) is the way to go for individuals with the passion and time to engage in it.
For the next few years, particularly for those not inclined to stock picking, however, ETFs can play a key role in a global asset allocation program. In such an investment process, investors have to pay more attention to top-down factors such as the phase of the economic cycle, interest rate trends, currency valuations, etc. I would still strongly advise investors to do their best to keep their politics out of their investment decision making, as they can only cloud their thinking.
Despite the fact that I will be using the words recommend, advise, advocate, etc., these are obviously not formal investment recommendations. They represent my personal ideas, and how I would tend to position myself if I was now starting a long-term oriented global portfolio from scratch.
My statements obviously do not take into account an individual’s tax status, the specific investor’s risk tolerance, financial situation and goals, etc. As all my Seeking Alpha posts, this note is merely aimed at sharing my general thinking for those who might be interested.
Concerns regarding the flattening US yield curve
There has been much recent discussion in financial circles surrounding the flattening yield curve in US interest rates. Is an inverted yield curve next? An inverted yield curve (where short-term interest rates exceed long-term yields) has often presaged economic recessions.
First of all, I’d like to emphasize we’re not there, at least not yet. The yield curve has indeed flattened as the US Fed has started to remove excess accommodation in monetary policy, and short-term rates have risen. On the other hand, the long end of the yield curve has tended to remain stubbornly low, resulting in a flatter yield curve.
The Fed, even as we go into 2018 and a new chair will take the helm, is very unlikely to actually tighten into an inverted yield curve. The US central bank is ultimately the main ‘culprit’ for yield curve inversions, but this time it would have to play an even more important role, if it were to happen, in my view.
The repeat of the Greenspan ‘conundrum’?
Under the prior chair of the Fed, Ben Bernanke, we had the ‘taper tantrum’. Towards the end of his long tenure, his predecessor, Alan Greenspan, faced the ‘conundrum’, whereby the long end of the yield curve actually declined even as the Fed attempted to tighten monetary policy by lifting short-term rates.
Under still-current chair Janet Yellen, the Fed has started to remove excess accommodation, but even as short-term rates have increased, US, let alone global, long-term yields have remained extraordinarily low (and in some cases even negative).
True, the European Central Bank (ECB) and arguably the Bank of Japan (BoJ) are still pursuing very expansionary monetary policies, so there is plenty of ‘easy money’ slushing around the world to allow much of a rise in US long-term interest rates. The US ten-year Treasury note (10Y UST) now yields approximately 2.4%.
A floor under the dollar and a ceiling over US long-term interest rates?
Global investment flows are unlikely to let the dollar fall much beyond current levels (or let US long-term yields rise much). Over three years ago, I wrote What are 2.3% 10 year US Treasury yields really telling us?, in which I discussed a “growing possibility that the 10Y UST yield will remain lower for longer.” The US benchmark government security continues to hover very close to those levels well over 1,000 days later.
The interest rate differential between the 10Y UST and its German equivalent (the ten-year Bund) hovers around historic wides. This even in the wake of failed coalition talks to form the next German government. Remember my advice on politics? The German economy is quite robust, and nothing that the next few weeks and months might bring on the political front is likely to significantly alter the favorable long-term outlook of German investments, in my view.
A case in point dismissing the current flat yield curves predicting economic woes is indeed Germany. The yield curve has been very flat for a long time now (even inverting at points in the last couple of years), without this presaging an economic slowdown. In fact, the German economy has been exceeding expectations, prompting economists and strategists to revise growth targets higher.
The current stalemate in the formation of a new government is unprecedented in the Federal Republic of Germany. In the short run, this obviously brings a new level of uncertainty. Nonetheless, German macro fundamentals remain very strong, particularly relative to much of the rest of the world. The long-term outlook for German assets thus remains quite bright. I would use any near-term weakness to continue to add to long-term positions.
But even Portugal now can borrow at lower rates than the US Treasury for ten-year sovereign debt! Such abundant global liquidity must place a floor under the US dollar (and a cap on the rates the US must pay, even if the Fed were to sharply increase short-term rates, which is in any event not expected).
I currently peg the fundamental value of the US currency (based on purchasing power parity – PPP) at approximately $1.20 to the euro. That, admittedly, does not represent meaningful fundamental upside to European investments based on a currency tailwind. Still, while currencies seldom trade at PPP in the short run, this contributes to my perception that there is not much downside to the US currency.
A year of relative currency stability?
Who knows! I have often written that I have a lot of respect for currency (FX) traders, as I think it’s basically impossible to predict currency trends. Based on my own limited knowledge and experience, the main fundamental yardstick for currency valuation is purchasing power parity. Still, it is very challenging to make assessments of PPP, and currencies trade at those levels for long. Currencies move constantly, trade actively and often overshoot their fundamental PPP value.
All that said, my base case scenario is for currency not to play a significant role in my global portfolio performance next year. My current best assessment is that key major currencies are closer to their fundamental fair value than they have been in a long time.
For instance, I have long been saying that the PPP fair value of the euro is $1.20, and it has recently appreciated from $1.16 to about $1.19. Owning no gold to speak of, I have spent the last few weeks doing a fair amount of research on the yellow metal. Long known as the ultimate store of value, I believe fair value for gold is approximately 1,300 Swiss francs – CHF -- per troy ounce.
Thus, in my opinion, gold is almost at fair value, even as the Swiss currency happens to be at near parity with the US dollar. At this point, for simplicity’s sake, I would say fair value for gold in USD is also $1,300, so we’re basically there.
Curiously, the yellow metal has been particularly stable in Japanese yen terms (surprisingly, even more than in EUR terms, which in turn has been a lot more stable than in USD). Gold has fluctuated relatively close to 145,000 yen in the last few years. In my opinion at this stage, a fair value of 145,000 JPY at 111.5 yen to the US dollar does not seem unreasonable. This leads me to conclude for now that the JPY (a currency in which I have admittedly no expertise) itself is close to fair value.
While the Mexican peso still seems undervalued to me from a PPP standpoint, lingering uncertainty over the NAFTA renegotiation process, let alone next year’s presidential election south of the border, means the currency may no longer sustainably appreciate beyond 18.5 to the USD.
Despite the fact that Banxico (the Mexican central bank) deservedly enjoys a lot more credibility than it did a couple of decades ago, Mexico is still very much an emerging market. Contrary to the few select major countries where a meaningful currency depreciation does not significantly contribute to inflationary pressures, Mexico still sees substantial inflation pass-through. Again, nothing like what we saw as recently as the 1990s, but a weak currency still leads to a pick-up in Mexican inflation.
Even the UK has not escaped inflationary pressures from weakness in its GBP. On the other hand, the US and the Eurozone (notably Germany) certainly benefit from the fact that their markets are important enough for companies in countries with relatively strengthening currencies not to proactively adjust their pricing for currency fluctuations.
While much is made of the return in the S&P 500 so far in 2017, the truth is that for investors who do not use the USD as their functional currency, the performance has been quite a bit more mixed. The relative strength in the EUR, for instance, means that euro-based investors have not seen a meaningful return from US stocks this year.
When investing in foreign multinational companies, currency fluctuations can impact performance in two important (and opposing) ways. As I have just alluded to, there is the currency translation aspect. For a USD-based investor who buys a German stock, whether the EUR appreciates or depreciates from the time of purchase will obviously affect the USD return from the stock investment in and of itself.
But there is also the impact from the currency fluctuation on the actual multinational company’s financial results. A German-based global corporation will have different operating results depending on whether the EUR appreciates or depreciates against other major currencies.
This can get pretty complicated if one wants to go into the detail of net currency exposure, how much of a company’s revenues are denominated in foreign currency in comparison to its cost exposure, FX hedging operations, etc. Suffice it to say here that, if we are truly to see a 2018 in which there are not large movements in currencies, some aspects of international investing will be relatively easier.
For USD-based investors, I would not advocate hedging out key currency exposure. While I see major currencies not far from fair value, if anything, exposure to currencies such as the EUR may still provide a slight tailwind to the performance of international investments by USD-based investors. Due to valuation differentials, I would recommend increased international equity exposure (including emerging markets) for US investors in 2018.
Another Year of Emerging Market (EM) Stocks
Are emerging markets a good place to be in 2018? I strongly believe so, but stock picking will be key. If the US dollar remains relatively subdued (as is my base case scenario), a meaningful potential headwind for EM stocks is removed. There has been much debate in the last few years as to the effect of US dollar volatility on emerging markets.
The major developed markets tend to generally be less vulnerable to currency fluctuations, particularly if these are somewhat orderly. In the case of EM, there is typically more work to be done regarding the net currency exposure of particular corporations. A strongly rising US currency can have meaningful impacts on many emerging market companies.
Despite the fact that I do see ETFs playing a key role in a global asset allocation program in 2018 and beyond, in the case of EM, I think stock picking will be particularly important in the upcoming year.
Since I started writing here over three years ago, I have been constantly pounding the table on what had been at that time one of the most attractive parts of the global equity market: large-capitalization technology stocks. I still think that is a great place to be for the very long term. However, I expect 2018 to be likely to bring us the beginning of some regression to the mean, and the outperformance gap of US large cap tech is likely to at least narrow in the near term.
I have written favorably on Tencent Holdings (OTCPK:TCEHY), Baidu (BIDU) and Alibaba (BABA). I definitely continue to like their long-term prospects. 2018 performance in emerging markets is probably going to come from other corners as well. Much of my focus in the long run, and since late 2014 in particular, has been on stock picking. This note is my first attempt at global asset allocation in a very long time.
That said, I would not play EM through ETFs, but would overweight these equities through a bottom-up stock selection process. I plan to focus my efforts in the next few months on that task.
2018 global equity portfolio
As I have indicated, I expect 2018 to be a year in which some diversification away from US stocks should provide a tailwind to performance to US-dollar-based investors. As I have also written extensively in the past, nonetheless, the longer your investment time horizon, the less you need to worry about yearly (let alone intra-year) price swings.
I continue to pound the table on German stocks, which remain meaningfully cheaper to US counterparts. The symbols I will put in parenthesis following the name of each German stock refer to their ticker in Germany. Thus, Vonovia (OTCPK:VONOY) has the ticker VNA in Germany (on Bloomberg, for example, it would be VNA: GR). On February 18, 2017 I wrote a Seeking Alpha article on Vonovia. Despite the stock’s solid performance since then, it remains extremely attractive.
The only “trading problem” with VNA is that the stock has a high negative correlation to the yield on the 10-year Bund (the benchmark for the German long-term sovereign interest rate). Thus, on days when the Bund yield spikes, VNA typically falls. Admittedly, a sharp and sustained rise in German interest rates would have an adverse impact on Vonovia’s financial results, everything else being equal, but the trading relationship does seem overdone in the short run.
I continue to like Continental (OTCPK:CTTAY) and automakers [particularly Daimler (OTCPK:DMLRY) and BMW (OTCPK:BMWYY)]. Industrial giant Siemens (OTCPK:SIEGY) is another attractive German stock. The German portfolio definitely has a cyclical tilt (even as the DAX index itself is also quite a cyclical index), reflecting in part my belief that the German economy will remain quite robust.
The sell-off on disappointing quarterly results of Sweden-based retailing giant H&M (OTCPK:HNNMY) has prompts me to add this European stock to my 2018 recommended portfolio. The full name of the company is Hennes & Mauritz AB. The ticker symbol for the Swedish listing is HM.B (or HM_B, depending on the platform).
In the US, I would overweight in a 2018 stock portfolio the following of my favorite long-term picks: Apple (AAPL), Amazon (AMZN), Berkshire Hathaway (NYSE:BRK.A) (BRK.B), JPMorgan (JPM) and Starbucks (SBUX). I would also have biotech exposure, at least through Gilead (GILD) and Amgen (AMGN). Given my long-term contrarian bend, I would add General Electric (GE), AT&T (T) and Macy’s (M). All these laggards provide the potential for meaningful upside in 2018.
As I’ve noted, emerging market equities will be a key area to overweight in 2018. I continue to work on specific bottom-up ideas, as I would not advocate simply passive investment through an exchange-traded fund (ETF). In the meantime, a 2018 contrarian play in Brazil would be the American Depositary Receipts (ADR) of BRF SA (BRFS).
I continue to like Itau Unibanco Holding SA (NYSE:ITUB). For 2018, I would also overweight pulp and paper giant Fibria Celulose SA (NYSE: FBR), aerospace ‘Brazilian national champion’ Embraer SA (NYSE: ERJ) and education leader Kroton (OTCQX:KROTY) (KROT3: BR). Unfortunately, soon after my publication (on LinkedIn) of my preliminary 2018 list, ERJ became the subject of M&A talk by Boeing (BA), prompting the Brazilian stock to soar. I still see value in the shares, however, and cannot remove it from my 2018 top picks list.
A small-cap Brazilian company I have historically liked recently had its ‘investor day’. I liked what management had to say, and the stock has been a major 2017 laggard I have not previously recommended. Its full name is Valid Solucoes e Servicos de Seguranca en Meios de Pagamento e Identificacao (OTCPK:VSSPY). I know, quite a mouthful for those who don’t speak Portuguese (and apologies to my Brazilian friends for not using the right characters/correct spelling of the name). It is simply known as Valid, and its ticker symbol in Brazil is VLID3. Again, this is a small-cap company with low stock liquidity, so please be aware of that.
A Latin-American based -- in this case, in Mexico -- major global player in its industry is cement and construction materials behemoth Cemex SAB de CV (NYSE: CX). I would overweight it in a 2018 portfolio. With exposure to Mexican (and other Latin American) banking, but a large Spain-based financial conglomerate, Banco Bilbao Vizcaya Argentaria SA (NYSE: BBVA), should also have meaningful 2018 upside from current levels (just around 8.5).
BBVA is a way for Latin American investors to have some exposure to the euro through a company they may well know or even patronize. I also continue to like Bancolombia SA (CIB), and the stock would certainly be part of my 2018 overweight in EM.
2018 positioning beyond stocks
For long-term investors (in line with my constant advocacy of not putting in the equity market even one cent that one is likely to need within five years), I would continue to advocate making stocks the foundation of a portfolio aimed at wealth creation.
In a typical 60/40 asset allocation, fixed income is supposed to represent a 40% of the portfolio. I would recommend a meaningful underweight to bonds in 2018, and would personally not have a problem not owning any fixed income next year, as it might be when we do finally end up seeing the long-predicted ‘great rotation’ out of bonds and into stocks.
Rather than being particularly concerned about a much-feared ‘yield curve inversion’, my base case scenario remains that there is still meaningful excess monetary accommodation on the part of the key global central banks, the global economy will remain resilient, and the path of least resistance for bond prices is now lower (higher yields). Thus, I would not be a major owner of fixed income.
I admit that, if market interest rates were to rise too rapidly, that would be a negative for stocks too. That is not my base case scenario either. As I noted above, Germany’s Vonovia, one of my top picks, does on a trading basis tend to overreact to interest rate swings.
The company’s fundamentals remain extremely bright, and the net positive effect of a robust German economic backdrop on the company’s results will assert itself in the long term.
Instead of a meaningful allocation to fixed income a la 60/40, I would carry a relatively high cash position to keep some “dry powder” to use any significant weakness in equity prices to add to long-term positions throughout 2018. I would also for the first time ever add a significant holding in gold.
The research I did over the last few months in the area of monetary economics, in addition to quite a bit of reading on Blockchain technology, cryptocurrencies in general and bitcoin in particular, have contributed to me becoming more of a ‘gold bug’ than I ever was.
Gold is the ultimate store of real value. While it is likely that I will always prefer equities as a way to create long-term wealth, the yellow metal (while obviously not generating cash flow) can help investors to preserve real (inflation adjusted) wealth in the very long run.
For 2018, I would (again, at the expense of fixed income) not feel uncomfortable with gold holdings as high as 30% of a global portfolio. Historically, when prompted, I would say 5-10% gold exposure was an adequate range for providing some sort of insurance against other portfolio risks. For most investors, a 10% maximum gold allocation might still be the most prudent.
Particularly if the gold exposure is attained through gold mining equities, I would not advocate more than 10%, due to leveraging effects. For many investors, including myself, physical ownership of gold is not practical. An ETF backed by physical gold, such as the SPDR Gold Shares (NYSEARCA:GLD), is not a bad option.
I am certainly not an expert in gold mining equities, and they tend to be much more volatile than the yellow metal itself. There are, of course, also ETFs of gold mining companies, such as the Van Eck Vectors Gold Miners ETF (NYSEARCA:GDX) or the even more speculative/volatile Van Eck Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ). As its name indicates, the latter ETF is composed of junior mining companies, which makes it quite a speculative investment vehicle suitable only for those with high risk tolerance and a strong conviction in the prospects of gold prices to rise meaningfully.
As for myself, I do not necessarily expect gold to soar anytime soon. As discussed above, I peg the current fair value for the yellow metal per troy ounce at about 1,300 in both terms of US dollars and Swiss francs (and 145,000 in Japanese yen). Because I also see the euro’s fundamental fair value at 1.20 to the dollar, the implied fair value for a troy ounce of gold is roughly 1,083 euros.
In any event, this illustrates that I’m not calling for an imminent fundamental rally in the price of gold itself. Still, I am impressed with the fact that the yellow metal has been quite a bit more stable in terms of euros, let alone yen, than in US dollars. What this implies for dollar-based investors is that even a relatively stable gold in yen or euro terms may also provide a healthy tailwind to returns if the US dollar were to continue to depreciate.
In a year in which little fundamental value remains in many assets, a 2018 positive 5% return in dollar terms (while not much to write home about), may be all most US investors can reasonably expect. Thus, any tailwind should be welcome. Currencies (let alone commodities) often significantly overshoot their fair values as trends last longer than it is often justified. Therefore, it is possible that the euro and/or yen will appreciate enough (or conversely, that the US dollar depreciates enough) so that gold rallies beyond my modest expectations.
2018 may well turn out to be a challenging year, despite my belief that major global currencies are near fair value and should not add a significant source of volatility. Excess speculation in certain asset classes indicate “animal spirits” are back, and volatility could return with full force to global bourses. As always, I would use any significant weakness to add to long-term favorite stocks, as the equity market remains the best way to create wealth over the long run. In the meantime, I wish all of you happy and prosperous 2018!
Disclosure: I am/we are long TCEHY, BIDU, BABA, VNNVF, CTTAF, DDAIF, BMWYY, SIEGY, HMRZF, AAPL, AMZN, BRK.B, JPM, SBUX, GILD, AMGN, GE, M, T, BRFS, ITUB, FBR, ERJ, KROTY, BBVA, CIB, CX.
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