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Signal-to-Noise Ratio

Finding—and sticking to—the facts will be especially crucial for investors in the months ahead.

With the inauguration at our backs, it’s a good time to consider how, at a basic level, investors can make their way in the current frenetic landscape. One particularly apt term that comes to mind in the current context is the “signal-to-noise ratio.”

According to Wikipedia, “signal-to-noise” is “a measure used in science and engineering that compares the level of a desired signal to the level of background noise. It is defined as the ratio of signal power to noise power.” We have operated in and will continue to operate in an environment where the signal has been extremely low. It is therefore very difficult to figure out what the true signal is.

Not long ago, I heard a common refrain in my travels: “I can’t wait for the election to be over.” I agreed with the sentiment, and the notion was that all the crazy stuff we were seeing would die down and things would go back to normal.

At this point, I think it’s clear we’re not going back to whatever normal was. To the contrary, the level of partisan rancor concerning the issues of the day remains very high. Moreover, during the election we saw plenty of news that was light on facts and heavy on viewpoint, and that continues. Throw into the mix a new president who thinks out loud in real time and the reality of operating in a very low signal-to-noise ratio world for the foreseeable future is something an investor must confront. I’m afraid these are just realities of the new environment.
Employing a Filter

What can investors do? First, focus on important facts and employ a process for ignoring the noise.

Part of the challenge is that when you look at what the incoming administration has proposed, it’s a very ambitious agenda, focused on substantial reforms—to the tax code, the government’s role in health care, and immigration, among other things. These are truly complex issues. This is evident in all the reporting, noise and rhetoric around the tax code, specifically concerning the border tax adjustment proposal. It has dominated the financial news over much of the past week and is very hard to explain succinctly, so commentators latch onto scary, often misleading headlines. Sorting the facts from the noise is going to take real concentration moving forward.

For us, some of the most important facts are as follows: Of all the objectives in the new administration’s agenda, none is likely to have more impact on markets and the valuation of individual stocks and bonds than reforming the tax code. Given that, we are focused on the process of change, which is crafting legislation and who is working on it. It involves understanding the perspective of the authors and others who might have a meaningful influence, and the timeline to passage and implementation. It’s not clear how much transparency there will be, but I think a starting point for analysis has to be a document that’s been around for seven months: the House Republicans’ budget proposal. The question is, how much will remain by the time we get to the finish line.

Bring the Perspective of a Great Analyst

Second, process all news and information the way a great stock or bond analyst does when analyzing a company. I am fortunate to work with a lot of them here at Neuberger Berman, and they share a common approach. Data, facts and experience all trump opinion. But in markets, of course, opinion does matter. When assessing the viewpoint of a CEO, CFO or sell-side analyst, understanding the messenger’s track record, credibility and biases is paramount. The simple conclusion is that if you can’t check these boxes on a messenger, reject the message.

This decidedly does not mean seeking only viewpoints that mesh with your own—quite the contrary. I am a regular reader of Paul Krugman’s column precisely because he looks at economic and political issues from a viewpoint very different from my own. He expresses his views in a consistent and articulate fashion through time; I know where he is coming from.

Bring Historical Context

Finally, big issues of the day are usually just a point in time that are impossible to understand without a sense of the broad arc of history.

In the aftermath of the financial crisis, Carmen Reinhart and Kenneth Rogoff wrote a well-timed and insightful book called This Time Is Different: Eight Centuries of Financial Folly, which put in perspective the world-changing events we’d just experienced, and everyone in our business either read or should have read their observations.

Similarly, looming tensions with China on trade haven’t just emerged in the last couple years. Nineteen years ago, False Dawn: The Delusions of Global Capitalism, by Thatcherism architect John Gray, predicted that China’s form of capitalism would eventually collide with that of the West.

As for Russia, Putin’s adventures in Ukraine and Crimea are the culmination of more than 100 years of struggle with the West. I’d strongly recommend The Great Game: The Struggle for Empire in Central Asia, by Peter Hopkirk, written in 1992, to understand the dynamics at play.

Looking for that kind of perspective on whatever developments emerge could help investors find the relevant signals and avoid getting caught up in the noise that is sure to resonate throughout 2017.

Neuberger Berman’s CIO insight by Brad Tank

Rothschild & Co and Compagnie Financière Martin Maurel Have Merged

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The proposed merger between Rothschild & Co and Compagnie Financière Martin Maurel to create one of France’s leading independent private banks announced last June is now successfully complete. The merger will build upon the relationship that has existed between the Rothschild and the Maurel families for three generations. The operational integration of the two private banks Rothschild Patrimoine and Banque Martin Maurel should be finalized in the second half of 2017 so as to create a combined group operating under the name Rothschild Martin Maurel.

Rothschild Martin Maurel will be a leading independent family controlled private banking group operating in France, Belgium and Monaco, with a distinctive market positioning targeted notably at entrepreneurs. The group will have combined AUM of €34 billion, offer a particularly broad wealth management, asset management, financing and corporate finance advisory service and enjoy a greater geographic footprint in France.

Prior to this transaction, Rothschild & Co held 2.3% of Compagnie Financière Martin Maurel while the latter held 0.90% in Rothschild & Co. In accordance with the terms of the protocol signed in May 2016, the majority of the transaction was in the form of an exchange of shares on the basis of a parity of 126 Rothschild & Co shares per Compagnie Financière Martin Maurel share. The Maurel family received shares and reinforced its presence in the extended family concert of Rothschild & Co, of which it was already a member. The transaction was financed 62% by issuing 6.1 million new shares and 38% by external bank facilities of €88.3 million. The significant non-family shareholders of Compagnie Financière Martin Maurel had already agreed to tender their shares to the cash offer in accordance with the terms of the initial protocol.

David de Rothschild, Chairman of Rothschild & Co, said, “The combination of two family controlled businesses that share the same history, the same culture and the same vision of their industry, creates an outstanding company and we are delighted to celebrate this merger today. The transaction is in line with our strategy to accelerate our growth in private wealth and of focusing on annuity style revenues. I am pleased that the Maurel family will maintain its involvement alongside the Rothschild family in the new group.”

“Our two groups embody a family model that distinguish and strengthen us when compared to our competitors. This combination allows us to broaden the range of our offerings to all our clients, especially entrepreneurs, thanks to a strengthened and broader range of asset and wealth management products and services,”underlined Bernard Maurel.

Lucie Maurel Aubert said, “We will be able to develop these offers in Paris and also, thanks to our strong regional presence, in Lyon, Marseille, Aix en Provence, Grenoble and Monaco, while adding the skills of Rothschild and Co in financial advisory and merchant banking. This alliance will enrich our expertise benefitting our customers and our teams and enabling us to meet the challenges of the future with confidence”.

The listing of Compagnie Financière Martin Maurel’s shares has been suspended. With effect from 4 January 2017, the new shares of Rothschild & Co are admitted to trading on compartment A of Euronext Paris and the shares of Compagnie Financière Martin Maurel is delisted from the Marché libre of Euronext Paris.

Brexit: A Difficult But Attainable End-March Timetable

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The UK Supreme Court rejected the government appeal that it could trigger Article 50 without Parliamentary approval. Financial markets posted little reaction with the 2-year and 10-year yields barely moving on the announcement, however, sterling retreated by around 0.5%, which supported a modest pick-up in equities, with the FTSE 100 up 0.25% after the reaction. Responding to the ruling, David Davis, the Brexit secretary, said a bill to trigger article 50 would be published “within days”.

In itself, and according to Axa IM strategist, David Page, the rejection was expected, given the High Court decision. He believes that the sting has been removed from this decision by a Parliamentary vote in December to back Prime Minister May’s timetable by 461-89 on the condition that the government spelt out its negotiating objectives and Parliament got a final say on the vote. “PM May fulfilled the first part of this in her 12-point Brexit plan last week and committed to a Parliamentary vote at the end of the process.”

In his opinion, procedural difficulties may remain. The Supreme Court ruled that an Act of Parliament will be required to trigger Article 50. “There is a risk that procedural challenges and proposed amendments may make the end-March timetable challenging.” The Scottish National Party has already suggested an intention to amend the Act. However, the Court did rule that the government does not need to consult regional assemblies. “This removes one of the larger remaining potential hurdles for PM May’s ambitious timetable. As such, there is a good chance that PM May manages to trigger Article 50 according to her timetable of end March, with only some risk of a small procedural delay to this.” He concludes.

More Turbulence Expected in 2017

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The asset management industry in Asia is set for a turbulent year in 2017, with the impending Donald Trump presidency in the U.S. and its impact on the global economy. For asset managers, the institutional space is becoming more interesting, with a growing trend of outsourcing by institutions.

After a very challenging 2016 in Asia’s asset management industry, what does 2017 hold? That is the question that underpins this quarter’s The Cerulli Edge – Asia-Pacific Edition which highlights key developments in 2016 in eight of the Asian markets we cover, namely, China, Hong Kong, India, Indonesia, Korea, Singapore, Taiwan, and Thailand. We also make some predictions on potential trends in each of those markets for 2017.

The impending Trump presidency and the geopolitical turbulence tipped to come with it will drive global macroeconomic factors in 2017. Although the repercussions remain to be seen after his inauguration in January, one thing that the Asian asset management industry will be closely watching is how his pledge to bring manufacturing jobs back to the United States pans out. This issue will be particularly important to Asian countries as many of them count the United States as one of their top-five trading partners. If the trade faucet to the United States begins to shut, this will inevitably lead to some restructuring as these economies seek and find new exports markets or new export products.

From an asset management perspective, a widespread restructuring will have an impact on asset allocations in Asian markets. However, this will be a long-term process. Any short to medium-term pain felt by Asian retail and institutional investors in the face of such changes would be the price they have to pay for longer-term gains.

Cerulli has observed that retail investors in the region have notoriously shorter-term investment horizons than their Western counterparts. Asset retention is a constant struggle, but likely more apparent in North Asian markets including China. Another commonality is that investor sentiment for financial products, including mutual funds, tends to be driven by stock market sentiment. Consequently, we tend to see outflows from equity funds when stock markets are falling.

In the recent past in Asia ex-Japan, this has led to some funds being diverted to bond funds or balanced funds. However, with growing expectations that interest rates may head higher in 2017, led by rate hikes by the Federal Reserve, bond funds and balanced funds may not be viewed as safe havens for a while. In such market conditions, we may see retail investors go back to their default positions, namely bank deposits. This would put the asset management industry back to square one in the region, after a lot of effort has been expended in recent years to mobilise people’s savings toward riskier financial products.

Having said that, across Asia, regulators all stand firm on investor protection–that is ostensibly one of their highest priorities. Their basic stance is that riskier products should only be sold to accredited or wholesale or high-net-worth investors. Plain-vanilla mutual funds and exchange-traded funds are seen as more desirable for ordinary investors. Further, most Asian regulators share a keenness to develop their local mutual fund industries, and offer incentives to asset managers who show commitment to the domestic market. A prominent example is Taiwan’s scorecard that incentivizes foreign asset managers to set up shop on the island.

Cerulli has also noticed asset managers’ burgeoning interest in targeting institutional assets in the region. Institutional investors are increasingly searching for yield outside their comfort zones, and will typically outsource to asset managers with strategies that they do not have internal capabilities in, including foreign investment and alternative asset investment strategies. Cerulli predicts that outsourced assets will maintain an uptrend through to at least 2020, which will be good news for asset managers in the region.

Byron Wien Announces Ten Surprises for 2017

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Byron R. Wien, Vice Chairman of Multi-Asset Investing at Blackstone, has issued his list of Ten Surprises for 2017. This is the 32^nd year Byron has given his views on a number of economic, financial market and political surprises for the coming year. Byron defines a “surprise” as an event that the average investor would only assign a one out of three chance of taking place but which Byron believes is “probable,” having a better than 50% likelihood of happening.

Byron started the tradition in 1986 when he was the Chief U.S. Investment Strategist at Morgan Stanley. Byron joined Blackstone in September 2009 as a senior advisor to both the firm and its clients in analyzing economic, political, market and social trends.

Byron’s Ten Surprises for 2017 are as follows:

Still brooding about his loss of the popular vote, Donald Trump vows to win over those who oppose him by 2020. He moves away from his more extreme positions on virtually all issues to the dismay of some right wing loyalists. He insists, “The voters elected me, not some ideology.” His unilateral actions throw policy staffers throughout the government into turmoil. Virtually all of the treaties and agreements he vowed to tear up on his first day in office are modified, not trashed. His wastebasket remains empty.
The combination of tax cuts on corporations and individuals, more constructive trade agreements, dismantling regulation of financial and energy companies, and infrastructure tax incentives pushes the 2017 real growth rate above 3% for the U.S. economy. Productivity improves for the first time since 2014.
The Standard & Poor’s 500 operating earnings are $130 in 2017 and the index rises to 2500 as investors become convinced the U.S. economy is back on a long-term growth path. Fears about a ballooning budget deficit are kept in the background. Will dynamic scoring reducing the budget deficit actually kick in?
Macro investors make a killing on currency fluctuations. The Japanese yen goes to 130 against the dollar, stimulating exports there. As Brexit moves closer, the British pound declines to 1.10 against the dollar, causing a surge in tourism and speculation in real estate. The euro drops below par against the dollar.
Increased economic growth, inflation moving toward 3%, and renewed demand for capital push interest rates higher across the board. The 10-year U.S. Treasury yield approaches 4%.
Populism spreads over Europe affecting the elections in France and Germany. Angela Merkel loses the vote in September. Across Europe the electorate questions the usefulness of the European Union and, by the end of the year, plans are actively discussed to close it down, abandon the euro and return to their national currencies.
Reducing regulations in the energy industry leads to a surge in production in the United States. Iran and Iraq also step up their output. The increased supply keeps the price of West Texas Intermediate below $60 for most of the year in spite of increased world demand.
Donald Trump realizes he has been all wrong about China. Its currency is overvalued, not undervalued, and depreciates to eight to the dollar. Its economy flourishes on consumer spending on goods produced at home and greater exports. Trump avoids punitive tariffs to prevent a trade war and develops a more cooperative relationship with the world’s second largest economy.
Benefiting from stronger growth in China and the United States, real growth in Japan exceeds 2% for the first time in decades and its stock market leads other developed countries in appreciation for the year.
The Middle East cools down. Donald Trump and his Secretary of State Rex Tillerson, working with Vladimir Putin, finally negotiate a lasting ceasefire in Syria. ISIS diminishes significantly as a Middle East threat. Bashar al-Assad remains in power.

Also rans:

Every year there are always a few Surprises that do not make the Ten either because he does not think they are as relevant as those on the basic list or he is not comfortable with the idea that they are “probable.”

Having grown weary of Washington after a year in the presidency, Donald Trump moves the White House to New York from April to December and to Palm Beach from January to March. He makes day trips to the Capitol on Air Force One for legislative and diplomatic purposes.
The Democratic Party is sharply divided on strategy, with Bernie Sanders and Elizabeth Warren arguing for a shift to the left and others wanting to remain in the center. A lack of leadership gives rise to widespread speculation about sharp losses in the 2018 congressional elections.
Donald Trump’s intimidation tactics prove effective in discouraging companies from moving some U.S. manufacturing abroad, but he fails to bring jobs back. The wage differential is just too great. This becomes his biggest first-year disappointment.
Trump’s first major international confrontation comes, not unexpectedly, from North Korea. Kim Jong-un threatens to set off a nuclear bomb in the mid-Pacific, calling it “a test.” Trump’s advisors try to restrain his desire to punish the country severely.
India comes back into the investment limelight. Its economy grows at 7% and corporate profits for established companies are strong. Its stock market leads other large emerging countries, along with China.
Trump’s efforts to get out of the Iran deal fail. The other countries signing the agreement believe Iran’s weapons-grade nuclear production has been restrained and force the U.S. to remain a participant.

Investors’ Preferences Shifted to Favoring Stock Funds over Bond Funds

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Investors ended the year by favoring passively managed U.S. equity funds over actively managed funds by a record margin, placing an estimated $50.8 billion in passive funds in December. On the active side, investors pulled $23.0 billion out of U.S. equity funds during the month. Morningstar estimates net flow for mutual funds by computing the change in assets not explained by the performance of the fund and net flow for ETFs by computing the change in shares outstanding.

Investors’ preferences have shifted to favoring stock funds over bond funds, amid growing optimism about the U.S. economy and continued rising interest rates and inflation. The overall inflows tally for U.S. stock funds hit its highest monthly total since April 2000, at $27.8 billion. Taxable bond funds saw overall net inflows of $14.6 billion in December.

December 2016 saw overall outflows from alternative strategies of $4.4 billion, with full-year outflows of $4.7 billion. This marked the worst showing for alternative funds since 2005 and is a significant reversal from 2015 when they took in $13.3 billion.

Morningstar Category trends for December showed bank-loan funds as a leading category with inflows of $6.0 billion on the active side and $1.4 billion for passive strategies, continuing a recent trend of growing interest in these funds.

Vanguard dominated the flows landscape in 2016. The firm took in $277.0 billion in total new money during the year, finishing at $3.4 trillion in long-term assets. American Funds saw $4.9 billion in active outflows during 2016, while Fidelity Investments offset some of the bleeding on the active side with $37.2 billion in passive inflows.

Among index-fund and exchange-traded funds, SPDR S&P 500 ETF took in the most assets at $14.3 billion for December 2016, followed by three Vanguard funds with offerings for U.S. stocks, international stocks, and U.S. bonds.

PIMCO Income, which has a Morningstar Analyst Rating of Silver, is the top active individual fund in terms of inflows; the fund took in $1.5 billion in December and $13.7 billion for 2016. Bronze-rated Franklin Federal Tax Free Income bucked the trend for outflows in December among active municipal-bond funds, seeing inflows of $1.4 billion.

China Banks To Avert Crisis in 2017 But Risks Are Rising

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2017—China’s banks are increasingly exposed to policy and other risks, but a crisis is not imminent, S&P Global Ratings said in its report, “Is This The Year For A Chinese Banking Crisis?”

“A banking crisis is likely to be avoided yet again in 2017, in light of another year of GDP growth exceeding 6%, and a change in the credit mix to relieve asset quality. However, the current trajectory is not sustainable,” said S&P Global Ratings credit analyst Qiang Liao.

Credit growth in China has surpassed economic growth for several years running, a dynamic that is gradually depleting Chinese banks’ once-ample funding bases. While overall deposit levels still exceed outstanding credits, the banking sector’s funding and liquidity buffers are thinning.

In 2016, Chinese banks accelerated their lending to the public sector and households, as new loans to the riskier corporate sector slowed. This change in the debt mix has helped keep a lid on nonperforming loans as a proportion of the total. However overall economic leverage continues to rise, diminishing funding buffers and making banks more vulnerable to tail risks.

“Crisis or not, we maintain and re-emphasize our negative credit outlook on China’s banking sector,” said Liao.

“Tail risks for Chinese bank credit profiles include policy risks related to China’s exchange rate, shadow banking, local government debt and corporate bond defaults, a property market correction, and external shocks,” Liao added. There is wide divergence of credit quality within the banking sector.

“We believe public confidence in China’s smaller institutions is much lower than for the megabanks and national banks. It’s not yet apparent if the smaller banks could withstand a stress event, such as a run on deposits,” said Liao.

“Given that many of the smaller Chinese banks are still aggressively expanding credit, and may lack sophisticated risk management, they are more likely to be caught off guard if market conditions rapidly weaken,” Mr. Liao added.

The article notes that smaller Chinese banks are still aggressively expanding credit, but may lack the sophisticated risk management to cope should market conditions rapidly weaken.

Gold in Presidential Transition Years

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We get a lot of questions on how gold will perform in 2017. While we have no crystal ball, we thought the tidbit below might be of interest to you as you evaluate whether adding a gold component might provide valuable diversification to your portfolio.

Please consider the chart below:

Enlarge

Since Nixon took the US dollar off the gold standard in 1971 there have been seven Presidential transition years, i.e., years when a new president was inaugurated. Those years were 1974, 1977, 1981, 1989, 1993, 2001, and 2009.

Looking at the data, gold achieved above average returns during those calendar years, +14.8% in Presidential transition years vs an overall average of +8.4%. Perhaps equally important is that those have been years when the S&P 500 greatly underperformed its average over that same time period, -0.9% in Presidential transition years vs an overall average of +9.0%.

The S&P 500 on average was negative for those seven calendar years of Presidential transition. The average return in Presidential transition years is +14.8% for gold and -0.9% for the S&P 500.

One possible theory as to why this might make sense is policy disappointment of a new incoming administration, the high hopes of the newly elected administration may be tougher to achieve in practice, leading to weakness in equity markets. In addition to policy disappointment may be a general sense of policy uncertainty as the rules of the game potentially change under a new administration, which might boost gold as a safe haven.

One caveat is that seven transitions is a small sample size; the reason we limit ourselves to transitions since 1971 is because before gold was pegged to the dollar in one form or another for much of US history.

Column by Axel Merk

Global Investors Rose Their Cash Levels in December

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The BofA Merrill Lynch January Fund Manager Survey shows investors geared up for stronger growth and inflation, but are still reluctant to slash cash.

“Ahead of the US presidential inauguration, investors are positioned for stronger growth and inflation, but are not willing to turn fully bullish with China-related risks on the horizon,” said Michael Hartnett, chief investment strategist.

Manish Kabra, European equity quantitative strategist, added that, “Fund managers have returned to Europe amid improvement in the macro outlook, but UK remains the most underweighted region.”

“USD/JPY and Japanese stocks have been bought as inflation assets,” noted Shusuke Yamada, chief Japan FX/equity strategist. “Whether the post-election market trend reaccelerates or unwinds, these two asset classes are likely to be among the most impacted.”

Other highlights include:

Investor expectations of global growth improve to 2-year highs (net 62% from net 57% in December), while global inflation expectations remain elevated, with the fifth highest reading on record (net 83% from net 84% last month)
The percentage of investors expecting “above-trend” growth and inflation is at a 5.5-year high (17% from 12% in December)
Investors continue to identify Long USD as the most crowded trade (47%), while the highest percentage since April 2003 thinks that the Euro is undervalued (net 13%)
Big jump in percentage of investors expecting corporate earnings to rise 10% or more in the next 12 months (improved to net -22% from net -47% last month), the most bullish reading since June ‘14
However, cash levels rose to 5.1% from 4.8% in December, well above the 10-year average of 4.5%
The three most commonly cited tail risks are trade war/protectionism (29%), US policy error (24%), China FX devaluation (15%)
In January, investors said they were buying Eurozone, tech, equities and REITs, while selling industrials, EM equities and commodities
Allocations to Eurozone equities rose sharply to net 17% overweight from net 1% underweight last month
Allocation to Japanese equities remains unchanged from December at net 21% overweight, but optimism has room to grow

AlphaSimplex Group Anticipates Average to Elevated Volatility for 2017

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In closing a year of remarkable geopolitical events, there are still many unknowns that will only be revealed when the dust settles from the major elections and referendums across the globe. Natixis Global Asset Management and one of its leading affiliates focused on alternatives, AlphaSimplex Group, LLC. talk about volatility Ahead.

Downside risk is currently elevated at above average, appoints the firm, although not at extreme levels for international and emerging market stocks. For U.S. stocks, the measure is slightly below average. This may seem counter-intuitive given the modest gains delivered by stocks thus far in 2016 and the relatively positive market reaction to the U.S. presidential election results. But perhaps it isn’t all that surprising.

Recall the rollercoaster stock market of the first quarter of 2016, when investors became concerned about the slowdown in Chinese economic growth. Almost a year later, points out Natixis affliates, the health of the Chinese economy continues to be a global risk. Add to that the wildcard of the direction of U.S. and Chinese trade relations post-election. Other concerns weighing on global markets include rising interest rates in the U.S., a weak European recovery weighed down by immigration complexities and a refugee crisis. Mid-year, Brexit also added a pint of uncertainty to the world order.

“Against this backdrop, it appears the only certainty is persistent uncertainty. This uncertainty has contributed to a relatively wild ride in the U.S. stock markets over the year, where we have seen a trough to peak move in the S&P 500 Index of over 20%.2 While we do not view global equity risk at extreme levels, we do believe investors should proceed with caution”, conclude AlphaSimplex Group´s team.