As several global investment opportunities get more interesting and key headwinds continue to dissipate, we’ve gradually been increasing risk in the portfolio. And in some cases, we’re going against the market’s conventional wisdom.
The last two years have been a challenging environment for most fundamental investors, as prices have been generally moving away from fundamental values. But several of the headwinds that have gotten in the way of fundamental opportunities are fading.
We are starting to take larger exposures now because we believe the potential returns justify the risk.
Headwinds Are Fading
Central Banks: For several years, central banks around the globe have implemented ultra-easy monetary policies, which have impacted asset prices. Now, however, central banks are beginning to unwind some of the extreme elements of their rate manipulation, especially in the United States where the Fed is starting to increase interest rates. And that frees asset prices around the world, not just in the U.S., to revert back to fundamental values.
Oil: In the last couple of years, investors had perceived commodity prices to be a real-time proxy for global growth, which caused commodity prices to be a powerful driver of markets and currencies. Currently, growth expectations are drifting higher, and oil prices are relatively flat after coming down from much higher levels. Additionally, we are starting to see correlations fall between importing and exporting emerging markets and currencies. As a result, this risk factor is largely off the table.
Populism: Populist movements have taken hold in many parts of the developed world, evidenced by events such as the Syriza party victory in Greece, Brexit, Donald Trump’s U.S. presidential win, and the Italian referendum result. These anti-establishment movements share common traits, among them a preference for less free trade and less free flow of immigration, both of which create economic growth headwinds.
While populism remains a significant risk factor around the globe that we’ll need to navigate, we believe it’s already priced into some areas, which decreases its influence on those particular asset and currency prices.
Risk on/off: A barbell-like risk on/off sentiment continues to occasionally prevail but its impact on prices has diminished as the market has become more numb to these market swings. That’s why we see 2017 as being less turbulent than last year. There were more global growth fears in 2016, but currently expectations are rising.
Where We’re Re-Risking: Equity Opportunities
Overall, conventional wisdom is pointing to an improving global growth sentiment. Indicators of industrial activity in both developed and emerging markets have been largely positive.
Consensus is that the U.S. equity market offers the greatest performance looking ahead over the next several months. And investors are still worried about geopolitical risks in emerging markets and in Europe, with upcoming Brexit negotiations and French and Dutch elections.
But completely following conventional wisdom is not usually a route to superior returns, as ideas universally believed can also be widely discounted.
Completely following conventional wisdom is not usually a route to superior returns, as ideas universally believed can also be widely discounted.
From our long-term fundamental perspective, we believe that European and certain emerging market equities offer a better opportunity—better compensation for the risk—than the U.S. equity market offers. This contrary positioning to conventional wisdom can increase volatility and may not manifest itself in performance in the short-term, which is why we are increasing risk incrementally and employing downside protection in those markets where we perceive the risk to be greater.
We believe European equities, especially in the United Kingdom, Italy, and Spain, are attractive. We have been increasing our exposures to these equity markets to be more in line with their fundamental opportunities after they experienced populist outcomes that have reduced the amount of uncertainty and risk in these countries.
In emerging markets, we have recently increased our Brazilian equity exposure, given the market’s attractive long-term fundamental valuation characteristics combined with the new government’s pursuit of economic reforms, which the market has responded to positively despite the ongoing corruption concerns.
Within currencies, the dichotomy between developed market currencies (not attractive) and emerging market currencies (attractive) makes the opportunity set somewhat narrow, which constrains the amount of risk that we believe is prudent to take.
But there are currency positions where prospective returns justify increased risk. And some of these exposures are out of favor, according to conventional wisdom:
- Mexican peso: We increased our exposure to the very cheap peso as we believe concerns over President Trump’s anti-trade policies have already been priced in
- British pound: As I’ve previously discussed, the populist wave has already crashed in the U.K., and the pound has stabilized, giving us comfort to take long exposure at current levels
- U.S. dollar: The U.S. dollar continues to be favored as a safe haven by the market (conventional wisdom), but we believe it is fundamentally unattractive—as a result, we have a slight short exposure
Overall, we are starting to take these larger exposures now because we believe the potential returns justify the risk.