Feb 26, 2018

Tyler Mordy's Top Picks: Feb. 26, 2018

BNN Bloomberg

Tyler Mordy, president and chief investment officer at Forstrong Global Asset Management
Focus: Exchange-traded funds

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MARKET OUTLOOK

This has been a long cycle, particularly for the U.S.: at almost nine years, it ranks third out of 33 cycles recorded since 1854. Yet the attendant bull market has been an unloved one. With the backdrop of a globally synchronized recovery however, risk appetites are finally making a comeback.

Where should investors be focused? It’s been a long and well-earned period of outperformance for U.S. assets. Since 2009, America’s stocks and its currency have trounced their global counterparts. By early 2017, the U.S. dollar index had surged to a 14-year high as investors bet that Trump’s projected eye-watering fiscal expansion would prove a replay of early 1980s Reaganomics. Yet the big surprise since the Trump election is that the U.S. dollar hasn’t been strong. This is remarkable considering that the Fed is hiking rates and has begun shrinking its balance sheet.

We have argued that U.S. equities are set to underperform. Why? Three key outperformance drivers are going into reverse:

In recent years, the Fed was the most aggressive liquidity provider in the world. With the Fed now tightening and almost everyone else on hold, this is no longer the case.
The U.S. has recently benefitted from an extraordinarily competitive currency. Again, this is no longer the case: in a very short period, the U.S. dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, to now being overvalued against the likes of the euro and the yen.
In recent years, U.S. equities were attractively priced. Yet again, this is no longer the case.

Where may the next phase of outperformance direct itself? Europe, Japan and emerging Asia are the most likely candidates. These are regions that have undervalued currencies, that show signs of earnings and economic acceleration and that trade on much cheaper valuations. Who can argue against rotating into better valuations where business cycles have only just begun their expansion phases, where profits have plenty of scope for improvement and where monetary policy is a long way from any substantial tightening?

TOP PICKS

ISHARES MSCI JAPAN ETF (EWJ.US)
Most recent purchase: Feb. 8, 2018 at US$59.49.

After a decade of facing the twin burdens of chronic deflation and an overvalued currency, corporate Japan is now extremely lean and efficient. Aggregate Japanese return on equity has been trending upwards as companies have focused on improving corporate governance while also benefiting from a weak yen. Japan is also a veritable hotbed of companies at the forefront of several technologies reshaping the global economy such as robotics, electric cars and alternative energy. In the words of one analyst, “they make cool stuff.”

Japanese small caps are priced at the frontier of value, if not over the edge – deep into bargain territory. Lower oil prices are also indisputably positive for Japan, which imports most of its energy needs.

Japan is likely transforming itself from a nation of savers to a nation of investors. Contrary to popular belief, Japanese savers have never been wealthier, with a net worth that’s double what it was at the peak of the 1980s bubble.

Finally, and perhaps most importantly, Japan continues to lead the world in unconventional monetary policy. The IMF estimates that the Bank of Japan will run out of government bonds to buy either this year or the next when its ownership reaches 400 trillion yen (the bank also owns 47 per cent of domestic ETFs). Expect further forays into the realm of unorthodox policy. Helicopter money (a true money-financed fiscal stimulus) will likely surface in Japan first. Investors may balk at the efficacy of these policies, but they should also understand they’re immensely helpful in raising asset prices.

ISHARES TR/MSCI EAFE SMALL CAP (SCZ.US)
Most recent purchase: Feb. 8, 2018 at US$63.52.

We have been quite outspoken over the past year about our preference for global stocks outside of the US; identifying this as a central theme for 2017 and beyond. Much of the argument has been American-centric: an overvalued currency, lofty valuations, a hawkish central bank and a turbulent political backdrop are all important contributing factors. But what about the prospects for global stocks? Take the eurozone, which has been mired in seemingly endless turmoil since 2008. The sovereign debt crisis, fiscal austerity measures and a massive inflow of Syrian refugees have weighed on economic and geopolitical stability. As a result, real GDP took over eight years to eclipse the high watermark set in 2008, while the rise of nationalist political parties threaten the future of European integration.

The tide, however, seems to be turning. Poor performance since the global financial crisis has left plenty of slack in Europe and Asia, allowing for an extended period of catch-up growth without a great risk of overheating. With monetary policy still highly accommodative, growth has been spreading across countries and sectors. For the first time in a decade, all 45 OECD members are growing simultaneously. EAFE small caps represent a high beta play on this reversal, as smaller companies stand to make large gains from an improving credit environment and consumer confidence.

ISHARES FTSE/XINHUA CHINA 25 INDEX ETF (FXI.US)
Most recent purchase: Feb. 8, 2018 at US$46.93.

The Chinese leadership is attempting to push through long-term structural reform. It faces a tremendous task in restructuring its banking sector and reorienting the economy away from a capital-investment-intensive, export-driven economy. This creates large potential for a slowdown in GDP and policy hiccups along the way. However, this transition (if executed effectively) will ultimately lead to a much more sustainable growth model. If investors are able to “look past” economic deceleration and high leverage (offset by a stockpile of household savings from a balance sheet perspective) and focus on higher quality future earning streams, the inclusion of Chinese equities in global portfolios could rise significantly.

With the new administration in the U.S. adopting a more protectionist tone and abandoning the TPP, regional neighbours have been forced into a deeper Chinese embrace. As China takes the lead on economic integration in Asia, the development of the Asian Infrastructure Investment Bank and promotion of the Regional Comprehensive Economic Partnership bodes well for long-term productivity gains and geopolitical stability.

Lastly, offshore Chinese large caps trade at highly attractive valuations relative to their emerging and developed market peers. This is partially attributable to a large weighting in Chinese financials which are exposed to a tightening regulatory environment and a high proportion of non-performing loans. However, with FXI’s underlying index trading near a price-to-earnings multiple of 12 times and a price-to-book multiple of 1.4 times, there’s plenty of upside for Chinese equities to re-rate higher. FXI is a frequent target of short-sellers and currently has a short interest of approximately US$730 million.