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Leading offshore investors talk 2018

In 2018, the search for yield takes Pictet Asset Management's chief strategist Luca Paolini to Russia seeking bonds earning 7.5 per cent.

Famed contrarian investor Michael Hasenstab of Franklin Templeton is worried investors are way too complacent about higher US bond rates. The billionaire Michael Hintze of CQS remains positive on the global outlook, but frets about geopolitical risks.

After a barnstorming 2017, all three high-profile offshore investors are talking to their clients about what 2018 might bring. And the powerful gains of this year have left many feeling "queasy", Keith Haydon, chief investment officer at global hedge fund group Man FRM, says.

Haydon points out that if the $US70 trillion ($93 trillion) global pool of stocks has expanded by 15 per cent this year, then in equities alone we have seen a repricing of asset values of around $US10 trillion, or around three years' worth of real global GDP growth.

"Was this earned or borrowed?" Haydon asks. "Did we really earn it or will we have to give it all back later? When are we assessing our reaction to profits rationally and when are we suffering from hubris? These are increasingly queasy questions."

Make hay

Nonetheless, for now it appears many investors are prepared to make hay while the sun shines.

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London-based Paolini is upbeat about the prospects for the coming year, which place him among the majority of strategists and investors around the world. While not well known locally, Pictet is a massive Swiss-based asset manager with $670 billion under management and a lineage that stretches back to 1805.

Equities should be well supported by the continued synchronised global economic expansion, Paolini says.

"Emerging economies should fare especially well, benefiting from low inflation and a recovery in commodity prices," he says. "Equities may be expensive, particularly US, but as long as corporate earnings are going up they've still got a way to run."

While US stocks may be "expensive" and not offer as much upside as European, Japanese and emerging sharemarkets, Paolini is not expecting a major Wall Street correction in the near term.

"The US market is likely to be driven higher by dollar weakness and Trump's tax plan. Both should support corporate earnings and help mitigate the Fed's planned tightening of liquidity."

But where Paolini is most excited – as are most professional investors – is in the emerging markets. But not where you might immediately think.

Russian bull

"Emerging European equities are one of the few sources of good value in absolute terms, and Russia in particular is likely to benefit from the rebound in oil prices," he says. "Russian equities look cheap, as does the currency, and the central back is supportively cutting rates."

"Russian bonds stand out due to a 7.6 per cent yield, a credible central bank, high real rates, falling inflation and a cheap currency."

But it won't be smooth sailing for fixed-income investors in 2018. Paolini warns that "the era of making easy, low-risk money from bond investing is now over".

"Yields are heading higher, as rising inflation and solid economic growth leads into a gradual tightening of central bank policy. Better return prospects can be found in emerging markets, most of which are enjoying an ongoing inflation-free economic recovery."

Paolini sees a weaker US dollar as a medium-term trend, "occasionally interrupted by partial corrections". This underpins his upbeat view on emerging markets and commodities.

Complacent investors

Famed contrarian investor Michael Hasenstab of Franklin Templeton Investments believes investors should be getting ready for a sharper than expected lift in US bond rates in 2018.

The expansion of the Fed's balance sheet from around $US900 billion in 2008 to nearly $US4.5 trillion has "arguably been the most dominant force shaping global financial markets," Hasenstab says. After "surfing the wave" for so many years, "seemingly complacent" investors need to rid themselves of the idea that bond yields in the developed world can stay low forever.

"These conditions are neither normal nor permanent, in our assessment, and we expect the reversal of QE by the Fed to meaningfully impact financial markets in 2018 and beyond," the Boston-based but globe-trotting Hasenstab says.

Add in "exceptional strength" in US labour markets, rising wage and inflation pressures, ongoing resiliency in the US economy, and a structural shift toward deregulation by both the Trump administration and a Fed under new boss Jerome Powell, and "markets could see sharp corrections to UST yields in upcoming quarters, similar to the magnitude and speed of adjustments that occurred during the fourth quarter of 2016".

And this is the really tricky bit: "The challenge for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets may not hold true in this new cycle of UST declines." Low yields have underpinned high prices from shares to property to junk bonds – will a move higher in long rates undermine all investments?

Hasenstab, who runs Franklin's unconstrained Global Macro fund, is well known for making big bets against consensus. And with all this in mind, he is looking for opportunities in "idiosyncratic" countries which are "more domestically driven and less reliant on global trade". These should be relatively insulated from the broad fall-out of a sharper than expected lift in US long rates.

Indonesia is a country that has "demonstrated that resilience in recent years", while for others such as Brazil and Argentina, the economic risks lie in the internal reforms that are under way.

"Higher rate differentials are also crucial in a rising-rate environment," Hasenstab says. "Brazil and Mexico have short-term yields around 7 per cent, India and Indonesia around 6 per cent, and Argentina around 25 per cent. If US rates rise by 100 or 200 basis points, these countries have more cushion to absorb rate pressures."

Juggling geopolitics

It's been a year of surprises for billionaire CQS boss Michael Hintze: volatility has stayed low despite an array of "potholes" such as shifting monetary policy profiles among major central banks and geopolitical tensions. Also surprising is that despite all 45 OECD economies are growing, and 33 accelerating, rates have remained low.

The good news is the billionaire investor also remains positive on the broad outlook over the medium term, pointing out, like Pictet's Paolini, that the global economy is growing and corporate earnings with it.

Crucially, Hintze, who runs a credit fund, does "not see inflation as a threat".

"While some rise [in inflation] is to be expected, I do not believe we are going back to the 1970s," Hintze says. "We are all familiar with the effect of technology and artificial intelligence on labour and this type of 'substitution' is happening throughout the global economy. It is clearly disinflationary."

Geopolitics remains on Hintze's mind, and as he looks into 2018 he points to many "known unknowns", including potential conflict in North Korea, confrontations across the Middle East and "challenges to stable government in Western democracies and to the US-centric global system".

Hintze believes that in the short term, the oil price could have further upside and stay higher for longer, although the longer term price of oil will remain in a $US40 to $US55 per barrel range.