LEGG MASON AFFILIATES SEE OPPORTUNITIES AND RISKS AHEAD FOR 2016
PR Newswire - (Baltimore, MD, December 15, 2015)
With many equity markets rising albeit with increasing volatility, and fixed income markets facing rising rates in the U.S. even as other countries remain accommodative, broad financial prospects for 2016 can be difficult to predict.
Amidst this uncertainty, Legg Mason sounded out the chief investment officers and portfolio managers at its eight affiliates, hoping to glean insights of value to retail and institutional investors. The areas they covered are as wide as the markets they plumb for clients each day and fit into two distinct and equally important categories: opportunities; and risks.
"Our managers are always pursuing unique, actionable insights when they invest on behalf of our clients,” said Joe Sullivan, Chairman and CEO of Legg Mason. “Independent investment decision-making, leading to depth and diversity of perspectives, is fundamental to Legg Mason’s multi-affiliate model. Collectively, these expert market views cross geographies and asset classes, expanding opportunities for our clients.”
Link to What to Watch Webpage: http://www.leggmason.com/globalthoughtleadership/what-to-watch-2016.aspx
In terms of investment opportunities, the Legg Mason affiliates foresee strength in:
Brandywine Global OPPORTUNITY: Emerging Market Bounceback
Emerging market (EM) assets, particularly currencies and higher-yielding sovereign bonds from countries with higher perceived risk, may provide the best opportunities in the low-yield environment. This should persist into 2016, irrespective of any rate normalization policies from the U.S. Federal Reserve (Fed) or Bank of England.
For example, Mexico: a story of structural economic overhaul, risk is already priced into its bonds and currency; fundamentals do not warrant current valuations; and it has a credible central bank. Our outlook is also positive on Brazil, India and Indonesia.
Accommodative monetary policy and central bank activism will be crucial catalysts for EM bonds to rally. While falling EM yields are a longer-term theme, currency appreciation is on the horizon. G3 monetary policies should diverge, as the European Central Bank (ECB) announced tentative plans to extend its quantitative easing program, and the Japanese economy has fallen back into recession. This boost in liquidity could find its way to the higher-yielding EM market.
Also, the U.S. dollar rally has possibly reached its peak. Any depreciation in the U.S. dollar should help stabilize commodity prices, another benefit to the EM world.
Clearbridge Investments OPPORTUNITY: Resurgent Consumers
Consumer spending, which represents more than two thirds of Gross Domestic Product (GDP), has been a bright spot in an otherwise sluggish U.S. economy and could continue to surprise to the upside in 2016. The economic backdrop remains supportive of increased consumption. While the pace of hiring has moderated, job creation remains healthy: the unemployment rate sits at a post-financial crisis low; and wage growth is beginning to accelerate. Household balance sheets are in solid shape. Purchasing power is increasing as a result of falling gas prices and generally low inflation.
Cheap borrowing costs, rebounding household formation and available credit are driving an improved housing market, and a record pace for auto sales. Consumer confidence is also trending higher after dipping during the third-quarter stock market correction. Improving demand in select international markets, including China, could also drive consumer stock performance.
Martin Currie OPPORTUNITY: Great Companies Worldwide
Even as countries appear to turn inward economically, companies are globalizing at an increasing pace. So while Europe’s economy might be stagnant and China’s growth slows from its breakneck pace, great companies of all sizes are still finding ways to grow and thrive.
Increasing adoption of Internet-driven commerce and global logistics means the best companies are achieving global scale faster. Many generate growing percentages of revenue from countries other than their own, making headquarters or company listing locations less relevant. Even in troubled regions, stringent stock selection processes can find the strongest companies – those with the best products, dominant brands, skilled management teams and defensible competitive moats — which can do well despite often localized macro noise.
Integrating environmental, social and governance (ESG) analysis can provide another level of scrutiny, as well as transparency and comfort. Selecting companies without regard to the weightings of standard benchmarks can offer the possibility of strong long-term performance.
Permal OPPORTUNITY: Distressed Energy Debt
We believe high-yield bond defaults will accelerate in 2016, particular in the beleaguered energy complex. This will create opportunities in the distressed credit sector, on both the long and short sides.
Credit markets are already more stressed than at the end of 2011, when the stage was being set for a very profitable couple of years. Many commodity hedges that have protected U.S. exploration and production (E&P) companies are expiring in 2016. Commercial banks are adjusting credit lines to the energy sector, and capital markets are tightening.
With oil below $50 a barrel and natural gas at $3/MMBtu, our analysis leads us to believe that defaults rates could be as high as 30% by 2017 in a sector that is estimated to be $250bn. Defaults will extend to the mining sector and could even be seen beyond the commodity complex. Keep your powder dry.
QS Investors OPPORTUNITY: Japanese Recovery
Unlike past failed efforts to revitalize Japan’s economy, “Abenomics” just may work. The implication for Japanese equity markets is a wholesale re-rating of valuations – to the upside.
Abenomics addresses an entrenched practice of focusing on debt minimization rather than maximizing profit. As a result, Japanese corporations have consistently delivered returns on equity (ROE) in the 10 percent range, while Americans generated ROEs closer to 17 percent.
The new Abenomics corporate governance code also discourages cross-holdings of Japanese companies and requires publicly-listed firms to appoint no less than two independent outside directors. Those outside directors have become very real advocates for shareholders.
Looking at the return on equity (ROE) for the TOPIX, a market-based proxy of "Japan, Inc.", it's clear that things are indeed improving. So just imagine what Japanese equities would look like if the current P/E of 13.7 for the TOPIX was re-rated to the S&P 500 P/E of 16.6 – an increase of over 21 percent.
RARE Infrastructure OPPORTUNITY: Payouts Rising with Interest Rates
After a long period of structural decline, infrastructure investors face a world of rising yields. Such a scenario does not need to be feared, but understood and managed. When expectations of an interest rate rise build, market sentiment drives share prices of regulated infrastructure assets down. This is often due to sentiment rather than fundamentals. This presents an opportunity for those who understand how they operate to buy high-quality assets with strong, sustainable dividend yields at attractive prices.
Infrastructure investors expect increasing interest rates to be reflected in future cash flows. Returns on regulated assets allowed by regulators depend on how interest rates and costs of capital develop. When interest rates rise, to facilitate future funding of capital investment, regulators need to increase allowed returns. Such rises do not happen immediately. Yet over the medium and long term, regulated asset returns should rise and fall in line with the cost of capital.
Royce & Associates OPPORTUNITY: Fed Retreat Returns Normalcy to Small Caps
We saw the last couple of years as a hinge period: the gradual sunsetting of interventionist Fed policies, coupled with the steady growth of the economy, would restore small cap markets to something closer to more familiar historical patterns of performance and volatility. We have patiently held many companies in cyclical sectors that boast attractive characteristics the market has not yet fully recognized, a phenomenon we expect will change as the economy heats up.
The end of this run of monetary excess should coincide with a return to historical norms, in which profitable companies outperform unprofitable ones. Premium-quality companies, measured by ROIC (returns on invested capital), are in many cases cheaper than in several years. Based on EV/EBIT (enterprise value over earnings before interest & taxes), high ROIC companies are selling at a discount to low profitability companies – or with no earnings at all.
The key reversal we expect is for share prices of higher-quality small cap businesses to rise, better reflecting their intrinsic value. Earnings growth should be sufficient to drive investment returns; multiple expansion is not required, as it usually is in the growth segment.
Western Asset Management OPPORTUNITY: High-Yield Energy Bonds
The high-yield energy sector most likely will remain volatile into 2016. Company actions (such as slashing capital budgets, executing asset sales, shrinking headcount and reducing production) and broadening global growth will gradually result in oil prices moving higher by the end of 2016.
The high-yield exploration and production (E&P) industry offers attractive risk/reward investment opportunities. Valuations within the asset class cheapened significantly in 2015, in particular within the E&P industry. While some companies will not be able to sustain low energy prices, we believe defaults will be less than half of what valuations imply.
When it comes to global investment risks, Legg Mason’s affiliates are focused on:
Brandywine Global RISK: Strong U.S. Dollar
Our outlook relies on weakening G3 currencies, namely the U.S. dollar: continued strength remains a key risk. A strong dollar would continue to distort crude oil prices – and commodity prices generally – and ultimately detract from EM growth. Furthermore, the dollar could potentially rally, drawing liquidity away from EM assets.
While Fed rate normalization will be measured and gradual, any temporary market aberrations could potentially scare the Fed off course from its expected trajectory. Since 2015 was characterized by hesitation from the Fed, contributing to market uncertainty, any additional indecision could negatively affect investor confidence and disrupt any rally in risk assets.
We expect, U.S. growth to pick up, helped by lower oil prices, and the tailwind of reflationary policies across the globe should help boost global growth. In the event that global reflation takes quite a bit of time, the long end of the U.S. Treasury curve may offer a less severe reaction.
Clearbridge Investments KEY RISK: Commodity Rout
It is difficult to see meaningful upside for global growth until the prices of oil, gas and other commodities stabilize. Should prices fall further, current recessions in Brazil and Russia will likely worsen and spread to other commodity-exporting countries in emerging markets. Continued commodity weakness would also signal declining industrial production and infrastructure investment in China, further exacerbating concerns about its growth rate.
EM sovereign wealth funds have become significant investors in the U.S. and other equity markets. The drag of stubbornly low crude oil prices has led to forced selling by Saudi Arabia and Kuwait, to meet domestic budget requirements. This unwinding has been a source of heightened market volatility that could subsist, should commodity prices fail to find a floor.
Martin Currie KEY RISK: Retirement Shortfall
As the developed world’s population continues to age, the need for investors to provide for their own happy retirements has grown – along with demands for asset managers to provide solutions. This is no easy task in a low-growth, low interest rate world. Bond markets historically have been go-to places for low-risk income, but valuations and liquidity are challenged by low rates, as is concentration risk.
Investors who need to diversify while maintaining income are looking toward asset classes such as property, infrastructure and equities. These companies are increasingly attractive on a global basis, with higher payout ratios, relatively low debt loads and balance sheets in better shape than those of many countries. They can offer the ability to build portfolios of highly attractive businesses with yields above those for sovereign and corporate debt, and can bring income and capital appreciation higher than the inflation that erodes investors’ long-term purchasing power.
Permal KEY RISK: Global Uncertainty
Rampant uncertainty is a primary risk in today’s interconnected world. Look around the globe and spot uncertainty on every continent: central bank direction, the speed of China’s slowdown, Russia’s ambitions, ISIS’s rise, Europe’s growth path and political direction, U.S. elections, Brexit, more. Uncertainty fosters increased volatility and decreased liquidity as investors head for the door. This can create asset price inefficiencies which lead to longer-term opportunities.
QS Investors KEY RISK: QE Failure & Long-Term Headwinds
The key risk is if quantitative easing in Europe and Japan proves impotent, and the U.S. consumer fails to ride to the rescue. The word “deflation” has all but disappeared from the vocabulary of investors. Unfortunately, the risk of deflation – albeit low – has not disappeared.
Long-term headwinds to growth remain. First, demographic: population growth continues to slow in developed markets and the percent of the population able to work is declining. This means the population of workers that drive economic growth is shrinking.
The second headwind is slowing productivity growth, at least in the U.S. No one really knows what drives productivity growth, but historically, technological advancements may have played a role. The last big burst of innovation was the broad adoption of the Internet. Productivity growth has now slowed, and there is no obvious great leap forward in technology on the horizon.
RARE Infrastructure KEY RISK: Unintended Exposures
As newer entrants have looked for points of difference, definitions of “infrastructure” have evolved, as have regional, sector and stock weighting methodologies. Investors need to be cautious to ensure that they understand the types of risks they are taking on in this sector.
Understanding the different ways infrastructure assets can be defined, and how regulatory or concession and contractual frameworks operate to determine revenues, can help. Risks synonymous with infrastructure assets include regulatory risk, asset operating risk and some economic risk, such as organic passenger growth.
Listed investments that resemble infrastructure, but carry substantially different risk profiles that infrastructure investors are not typically seeking – including large refinancing, management turnaround or large commodities risk – may be less appropriate for new infrastructure investors.
Royce & Associates KEY RISK: Small Cap Valuation Reset
Equity returns for major market indexes, including the Russell 2000, have been significantly above their historic averages for most of the last five years. Basic reversion to the mean would strongly suggest that overall returns for stocks will be lower going forward.
Russell 2000 companies with negative EBIT (earnings before interest & taxes) have had mostly positive absolute returns for the last three years, which is atypical and unsustainable. Throughout the history of the stock market, profitable companies have had an edge. This fundamental rule of capitalism is unlikely to be repealed.
As overall equity valuations begin to normalize and unprofitable companies receive the returns they clearly deserve, small cap markets could overshoot, punishing the worthy and unworthy alike. In this type of environment, active management can help discover companies that are unreasonably underpriced.
Western Asset Management KEY RISK: Weakening Global Growth
Policy accommodation from central banks around the world will continue to underpin growth, given global inflationary pressures that remain very subdued and show little sign of increasing. Even as the Fed increases interest rates, the pace of rate increases will be very slow and gradual.
Low and declining global inflation, and accumulating EM weakness, suggest watching downside risks and utilizing appropriate macro strategies. The contrast between decent U.S. growth and a still-fragile global recovery means risk markets will be susceptible to periodic pullbacks, even as the pricing for risk markets is attractive. We expect European growth will continue to stabilize.
We believe China will manage to avoid a hard landing, as policymakers there have again demonstrated their willingness to ease policy to support growth as well as to liberalize financial markets.
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Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.
G3 refers to the world’s top three developed economies: US, Europe and Japan.
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
Price-to-earnings (P/E) ratio is a stock’s (or index’s) price divided by its earnings per share (or index earnings).
Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
Russell 2000 Index is an unmanaged stock index representative of U.S. small and/or midsize companies.
S&P 500 Index is an unmanaged index of 500 stocks, generally representative of larger U.S. companies
Tokyo Stock Exchange Index (TOPIX) is a market cap - weighted index of over 1,100 stocks traded in Japan.
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