James Butterfill Head of Research & Investment Strategy Martin Arnold Global FX & Commodity Strategist Edith Southammakosane Multi-Asset Strategist Nitesh Shah Commodities Strategist Aneeka Gupta Equity & Commodities Strategist Morgane Delledonne Fixed Income Strategist Big picture Implications of the rise of political populism. Page 2 Bond investing in the ‘New Normal”. Page 4 GBP reaches rock bottom. Page 6 Oil stuck in US$40-55/bbl range. Page 8 European equities to play catch- up. Page 10 Thinking outside the box Exploring rising global infrastructure needs. Page 12 Robotics – boon rather than bane to society. Page 14 In sync: gold and the USD. Page 16 America’s infrastructure frustrations. Page 18 A bridge between research and the investment world. Page 20 ETF Securities | The intelligent alternative | September 2016 The unintended consequences of QE The greatest experiment in monetary policy history, quantitative easing (QE), has led to two primary benefits: liquidity and confidence. QE has also led to distortions in the investment world, with bond yields falling into negative territory for the first time in history. Opinions on monetary policy are deeply polarised; with some investors rushing to safe havens signifying concern over monetary policy effectiveness at a time when equity markets are achieving all- time-highs. There is now growing disquiet amongst investors regarding the fate of the bond market, and the risk of the bond bubble bursting. Many investors believe a sharp rise in inflation is probable, presaging a bond market sell-off. Whilst we believe inflation will continue to rise and that central banks are in the early stages of losing their credibility, it is unlikely to rise fast enough to discredit them at this juncture. Bonds have a different buyer now, namely central banks who have a different reason for buying: buying bonds as a monetary policy tool rather than as an investment, keeping rates lower for longer. Monetary policy has also contributed to inequality and the consequent rise of political populism as has been witnessed in party polling in the developed world. We believe that the rise of populist parties, elected or not, is a powerful catalyst for reform, with incumbent parties scrambling to counter the populist wave by implementing similar policies. We expect economic stimulus to shift solely from monetary policy to include fiscal policy with the end result being a rise in infrastructure spend and social initiatives to combat inequality, prompting higher inflation. The eventual unwinding of quantitative easing and unprecedented loose monetary policy is likely to lead to volatility in markets, as was witnessed when the US Federal Reserve initiated its first rate hike in December 2015. The longer loose monetary policy continues, the more volatile the unwind is likely to be as it increases investor perception that central banks are losing confidence in their ability to deliver on their mandate. Furthermore, raising interest rates now is likely to cause pain for the already populist minded electorate. We favour assets which perform well in a moderate inflationary/populist environment, such as equities, inflation linked bonds, precious metals and infrastructure.
Transcript
James Butterfill
Head of Research & Investment Strategy
Martin Arnold
Global FX & Commodity Strategist
Edith Southammakosane
Multi-Asset Strategist
Nitesh Shah
Commodities Strategist
Aneeka Gupta
Equity & Commodities Strategist
Morgane Delledonne
Fixed Income Strategist
Big picture
Implications of the rise of political populism. Page 2
Bond investing in the ‘New Normal”. Page 4
GBP reaches rock bottom. Page 6
Oil stuck in US$40-55/bbl range. Page 8
European equities to play catch-up. Page 10
Thinking outside the box
Exploring rising global infrastructure needs. Page 12
Robotics – boon rather than bane to society. Page 14
In sync: gold and the USD. Page 16
America’s infrastructure frustrations. Page 18
A bridge between research and the investment world. Page 20
ETF Securities | The intelligent alternative | September 2016
The unintended consequences of QE
The greatest experiment in monetary policy history, quantitative easing (QE), has led to two primary benefits: liquidity and confidence. QE has also led to distortions in the investment world, with bond yields falling into negative territory for the first time in history. Opinions on monetary policy are deeply polarised; with some investors rushing to safe havens signifying concern over monetary policy effectiveness at a time when equity markets are achieving all-time-highs.
There is now growing disquiet amongst investors regarding the fate of the bond market, and the risk of the bond bubble bursting. Many investors believe a sharp rise in inflation is probable, presaging a bond market sell-off. Whilst we believe inflation will continue to rise and that central banks are in the early stages of losing their credibility, it is unlikely to rise fast enough to discredit them at this juncture. Bonds have a different buyer now, namely central banks who have a different reason for buying: buying bonds as a monetary policy tool rather than as an investment, keeping rates lower for longer.
Monetary policy has also contributed to inequality and the consequent rise of political populism as has been witnessed in party polling in the developed world. We believe that the rise of populist parties, elected or not, is a powerful catalyst for reform, with incumbent parties scrambling to counter the populist wave by implementing similar policies. We expect economic stimulus to shift solely from monetary policy to include fiscal policy with the end result being a rise in infrastructure spend and social initiatives to combat inequality, prompting higher inflation.
The eventual unwinding of quantitative easing and unprecedented loose monetary policy is likely to lead to volatility in markets, as was witnessed when the US Federal Reserve initiated its first rate hike in December 2015. The longer loose monetary policy continues, the more volatile the unwind is likely to be as it increases investor perception that central banks are losing confidence in their ability to deliver on their mandate. Furthermore, raising interest rates now is likely to cause pain for the already populist minded electorate.
We favour assets which perform well in a moderate inflationary/populist environment, such as equities, inflation linked bonds, precious metals and infrastructure.
2 ETF Securities Outlook – September 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
Implications of the rise of political populism
By James Butterfill – Head of Research & Investment Strategy | [email protected]
Summary
Populist parties are leading the polls in many
developed world countries due to inequality, weak
economic growth and a disenfranchised electorate.
Populist party policies are likely to lead to inflation.
Inequality and QE appear to go hand-in-hand. Is it
cause or effect? We do not know yet.
Protect portfolios from populism by targeting assets
which perform well in an inflationary environment.
Defining populism
Something unusual is happening in modern politics that is
threatening to destabilise incumbent political parties in the
developed world. Populism is a term being used more and more
in the media although there isn’t much consensus on its
definition. An academic paper written by Ionescu and Gellner in
1964 suggested that “populism worships the people”, and
questioned if it had an underlying unity or the name covering a
multitude of unconnected tendencies. In some respects, it isn’t
an ideology but a mode of political expression that is employed
selectively and strategically, targeting issues of mass appeal.
The term populism in today’s context is similar, in that it
reflects a varied demographic, being an eclectic group of voters
from both the left and right. The issues are often viewed as the
ordinary man oppressed by a remote elite to issues regarding
immigration or national sovereignty. The EU Referendum in the
UK highlighted how seemingly arcane issues can rapidly
become a mainstream school of thought. This rise of populist
politics in the UK is being mirrored across the developed world
with many populist parties rising in the polls and often leading
in them.
Populism – why now?
Populist parties in the EU have grown significantly in recent
years. Typically, the agendas of these parties have focussed on a
break from the incumbent political establishment. Populist
parties tend to overpromise, developing simple policies with
mass appeal, irrespective of their ability to be delivered.
Why has this phenomenon begun now? There do seem to be
some key drivers of today’s rise in populism, primarily high
inequality, generated by stagnant economic and wage growth
alongside increasing cultural diversity. But in the UK for
instance, traditional indicators such as the GINI coefficient
suggests the income gap has shrunken, although we believe this
is potentially misleading.
Inequality and stimulus
Though inequality is notoriously difficult to measure, the
traditional metric, the GINI coefficient, has issues in the
populism context as it is insensitive to the differences between
the richest and poorest. Populism is associated with the
ordinary man being oppressed by a remote elite and therefore a
metric for inequality such as the Palma ratio is more
appropriate as it measures the ratio between the top 10% of
earners versus the bottom 40%. Gabriel Palma, who developed
the ratio, implied in his work that globalisation is creating a
distributional scenario in which what really matters is the
income–share between the rich and lower income workers with
ever more precarious jobs in ever more ‘flexible’ labour markets.
Source: Policyuncertainty.com, ETF Securities as of close 09 September 2016
Policy Uncertainty Index (LHS)
Russel 1000 defensives/dynamics
4 ETF Securities Outlook – September 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
Bond investing in the “New Normal”
By Morgane Delledonne – Associate Director – Fixed Income Strategist | [email protected]
Summary
The “new normal” paradigm – slow growth, low
yields and high volatility – requires lower central
bank nominal interest rates than in the past.
Quantitative Easing (QE) programmes provide
opportunities to collect roll-down yield at the front
end of the yield curve and nominal capital gain on
long-dated bonds.
Duration risk prevails in the “new normal”
environment, as long as the pace of the global
recovery remains modest.
QE as monetary policy response to the “New Normal”
The 2008 financial crisis reshaped the global financial and
economic landscape, resulting in a “new normal” environment
of anaemic growth, low interest rates and a high level of
unemployment. In response, central banks and governments
have engaged a series of unconventional monetary and fiscal
policies to help restore the banking system and boost growth in
developed economies.
Note: The QE Performance Index is based on a series of monetary and macroeconomic indicators related to the transmission channels. The index displays the pace of the convergence of an economy toward the mandates of its central bank following the first announce of QE - UK (Mar-09=100), US (Nov-08=100), Eurozone (Jun-15=100), Japan (Mar-01=100).
We found that the quantitative easing programmes generally
succeeded at reviving the economy but with a considerable lag
of two to three years and the effectiveness of monetary
transmission increases with the number of successive rounds of
QE. Additionally, our study shows that QE performed best in
more financially integrated economies such as the US and UK.
Overall, QE programmes helped economies to recover from the
financial crisis but only at a modest pace.
Global rate outlook: lower for longer
The “new normal” paradigm requires lower benchmark rates
than in the past. One of the most prominent examples of this is
the decline of the estimated “natural interest rate” (i.e. the
interest rate at which real GDP is growing at its trend rate and
inflation is stable) in the US in the last decade. Historically, the
tightening cycles of the Fed resulted in an average of 380 bps
increase of the effective Fed Funds rate. Now, considering the
shadow rate1 the Fed has already increased its base rate by 337
bps since the end of the QE programme in November 2014, well
before inflation started to pick up. As a result, the Fed would
reach its natural interest rate level by only increasing the Fed
Funds rate by 25 bps or 50 bps.
Overall, the current “new normal” environment requires
negative policy rates as recommended by most policy rules (e.g.
Taylor rule), that conventional policy tools alone cannot
achieve. The use of QE programmes in major advanced
economies has generally been associated with a continuing
decline in the level of the shadow rate — that is, an easier policy
stance. QE also pushes short term rates into further negative
territory, leading to the steepness at the front end of the yield
curves and opportunities to collect roll-down yield.
1 Black (1995) provided a way to calculate the value of the call option to hold cash at the zero lower bound. The shadow nominal yield is the observed nominal yields minus the value of the cash option.
0
50
100
150
200
250
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
QE Performance Index
Source: Bloomberg, ETF Securities as of close 10 August 2016
US
UK JN
Years
EU
Fed QE2Nov-10
BoJ QE3 Apr-13
BOE QE2 Nov-11
Fed QE3 Sep-12
End of QE Oct-15
Start of QE
BoJ QE2 Oct-10
-3
-2
-1
0
1
2
3
4
5
6
7
-4
-2
0
2
4
6
8
10
1990 1995 2000 2005 2010 2015
US tightening cycle began Nov-2014
Source: Wu and Xia (2014), Williams and Laubach (2003), Federal Reserve, ETF Securities as of close 12 August 2016
Fed Shadow rate
Effective Fed Funds Rate
Inflation CPI (rhs, yoy%)
Fed Natural interest rate
5 ETF Securities Outlook – September 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
Lower yields
The movements in global interest rates tend to be more
correlated with each other than before the QE area, reflecting
common global factors (global public and private deleveraging,
ageing populations, reshaping of the banking system). Cyclical
and structural challenges led long term real interest rates to
decline since the 1990s, mainly because of lower inflation
expectations and lower expected return to capital investment.
In general, inflation expectations have been low and stable,
partly reflecting a higher level of credibility of central banks
delivering on their mandate of price stability and partly
signalling that investors are not convinced that future nominal
growth will increase. If they expected higher long term growth
(i.e. higher future inflation), investors would have sold their
long-dated bonds to central banks to secure their profits which
would have resulted in higher long term rates.
Because most expectations are derived from current economic
conditions, we expect real long term interest rates to remain low
as long as the pace of the global economic recovery remains
modest. In turn, central banks will be forced to keep long term
nominal interest rates low. QE programmes have been efficient
tools to achieve this goal through the purchase of long dated
bonds, leaving opportunities for nominal capital gains.
Higher volatility
The massive stimulus from central banks have also distorted the
fixed income market. By continuously pushing asset prices
higher (and yields lower), the global economy and market have
become increasingly reliant on these interventionist measures.
As a result, any changes in market expectations on the future
policy stance results in high levels of volatility – as investors
fear a sudden stop of this bull trend. A series of market events
such as the “Taper tantrum” in the US in mid-2013 and more
recently the UK Gilt rally2 and the Japanese government bonds
(JGBs) sell-off are glaring examples of how sensitive the market
is to changes in QE anticipation. This continued shift between
“risk on/risk-off” periods has increased the overall volatility in
fixed income.
The environment of “new normal” – slow growth, low yields and
high volatility – favours duration risk, but limits the unsafe
“search for yield”. With the exception of the United States,
developed economies are likely to continue to provide monetary
stimulus until growth and inflation rebound, offering
opportunities for nominal capital gains in long-dated bonds.
2 Investors repriced lower the Gilts yield curve after the BoE increased the gilt
purchases target by £60bn, while investors sold-off long-dated JGBs is a response to rising doubts around the size and the duration of the Japanese QQE ahead of its upcoming review in September.
Source: Bloomberg, ETF Securities as of close 09 September 2016
Gold ($/oz, LHS)
Real interest rate (%, RHS, Inverted)*
18 ETF Securities Outlook – September 2016
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
America’s infrastructure frustrations
By Maxwell Gold – Director – Investment Strategy | [email protected]
Summary
Market and political factors are currently favourable
to support additional US infrastructure investment.
Due to continued budget deficits, private capital will
most likely need to supplement public infrastructure
spending.
Renewed investment in US infrastructure should
help drive US growth, labour and commodity
demand.
America is showing its age
US infrastructure is in dire need of an upgrade as its quality
currently lags levels seen in other developed economies3. Many
of the US’s aging assets (roads, bridges, airports, waterways,
and mass transit) continue to deteriorate due to the lack of new
investment. In 2013, the American Society of Civil Engineers
(ASCE) conducted their Report Card for America’s
Infrastructure and assigned a grade of D+ (defined as poor) to
the US national infrastructure. They also estimated an
additional $200 billion in annual spending over the next eight
years was needed to bring the nation’s infrastructure up to par.
This is partly a result of three decades of underinvestment with
a 23% drop since 2003 in real capital spending across the two
largest infrastructure categories: transportation and water.
While overall federal infrastructure spending has remained
3 World Economic Forum. See “Commodity demand to increase with rising global
infrastructure needs”
fairly steady at 2-3% of annual GDP since 1956 it has also seen a
slowing trend since the post-war period.
Recently, there have been signs of changing attitude in US fiscal
spending towards its deteriorating infrastructure. In December
2015, the Fixing America’s Surface Transportation (FAST) Act
was passed and allocated $305 billion over the next five years
for highway and transportation4. This, however, is only a small
step in the right direction as the projected funding gap is
estimated at over $1.6 trillion across all segments (see table).
Investment gap in American Infrastructure
Billions (USD) Total Needs
Estimated Funding
Funding Gap
Roads/Bridges/Transit $1,723 $877 $846
Energy (Electricity) $736 $629 $107
Airports $134 $95 $39
Dams/Waterways /Ports $131 $28 $103
Rail $100 $89 $11
Other $811 $306 $505
Total $3,635 $2,024 $1,611
Annual Investment $454 $253 $201
Source: American Society of Civil Engineers 2013 Report Card for American Infrastructure. Other = public parks & recreation, schools, water & wastewater, hazardous & solid waste, ETF Securities as of 23 August 2016.
Pricing and populism bode well for US public works spending
The present economic and political climate is primed for
increased US fiscal spending on infrastructure. The current
interest rate environment remains near record lows highlighting
that borrowing and financing costs are currently cheap,
therefore an opportune moment for the next political
administration to invest in infrastructure. Additionally, since
rates are expected to remain lower for longer, this may extend
the window of opportunity for policymakers to enact on more
infrastructure projects.
Commodity prices remain well below their average prices in
2003 (the start of a commodity bull market) which saw the
beginning of a marked decline in US real capital spending. The
reduced costs across key building and construction materials
and fuel for machinery and vehicles presents an attractive
opportunity for the US to enter into projects to rebuild its
infrastructure.
The growing rise of populism in global politics is also increasing
public support for economic growth through infrastructure
4 U.S. Department of Transportation Federal Highway Administration
Investments may go up or down in value and you may lose some or all of the amount invested. Past performance does not guarantee future results.
The CDS (credit default swap) model is a long-short bond model
that uses regional CDSs as a trade signal, taking a short
exposure to the regions with a high CDS and vice versa.
The ETFS contrarian model uses inventories, positioning, roll
yield and price momentum, as trade signals. When all these
indicators had a positive impact on price, the model is taking a
short exposure to that commodity and vice versa.
Third and last rule, the resulted weights from all the above is
then adjusted to reflect the team’s latest market analysis. For
this first edition, this third rule has not been implemented and
will start from the next quarterly report and onwards.
Model performance
Whilst underperforming the 60/40 benchmark, the tactical
portfolio is outperforming its strategic benchmark by 0.4% per
year since January 2005.
*Based on monthly data in USD from Jan 2005 to Jul 2016. Volatility and returns are annualised. Max drawdown defines as the maximum loss from a peak to a trough based on a portfolio past performance. Max recovery is the length of time in number of years to recover from the trough to previous peak. Risk free rate equals to 1.5% (a simulated combination of the IMF UK Deposit Rate and the Libor 1Yr cash yield). Source: ETF Securities, Bloomberg
The tactical portfolio has the lowest volatility compared to the
benchmarks, improving the Sharpe ratio by 30% on average.
This has been persistent over the period (see chart below). The
tactical portfolio also provides higher protection from the
downside risk and recovers faster to its previous peak.
A closer look to Q2 performance shows that the tactical
portoflio outperformed both benchmarks by 0.7% per year on
average. Interestingly, the three asset classes when taken
individually have lower return than when combined in the
tactical portfolio, highlighting the benefit of diversification.
August 2016 positioning
The below chart shows our positioning in the tactical portfolio
compared to the strategic benchmark, based on the output of
the aforementioned model recommendations as of July 2016.
The equity bond relative trade model reduced the allocation in
equities from 55% in the strategic benchmark to 45% in the
tactical portfolio for August and increased the allocation in
bonds from 35% to 45%. We are taking the view that if the
volatility index remains stable compared to its historical
median, the portfolio should keep a 50/50 split between equity
and bond. This has been the case since June 2014.
The portfolio allocation in commodities as an asset class is fixed
at 10% as mentioned previously. Within the asset class, the
weight of individual commodities is the same as in the strategic
benchmark as none of the commodities have all four indicators
during July aligned in one direction or the other to justify a
change in commodity positioning for August.
The ETFS CAPE model is underweighting the US, France, the
Netherlands, Italy and Denmark for the third consecutive
month as the CAPE ratios stand above their respective 10-years
median by 56% on average. On the other hand, the model is
overweighting Canada, Spain, Brazil, India and Russia for the
fourth consecutive month. The CAPE ratio of these countries is
30% below their respective 10-years median on average.
For bonds, the CDS model is increasing the portfolio allocation
in US sovereign debt as the CDS of US sovereign debt fell below
its lower band as of last month. On the other hand, the model is
reducing the portfolio allocation in emerging market sovereign
debt as the region CDS crossed upwards its upper band in July.
As opposed to actively managed investment solutions that tend
to persistently underperform their benchmark, our tactical
portfolio outperforms its strategic benchmark by 0.4% per year
since 2005 and has enhanced the Sharpe ratio. We expect the
team’s input in the portfolio weighting methodology to further
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