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Five trading ideas for 2017

19th December 2016

Aviva Investors’ Multi-Strategy team offers insight into five trade ideas for 2017. Ian Pizer, Head of Investment Strategy and Co-Fund Manager, AIMS Target Return and Target Income Funds discusses the rationale for each of the five below.

  1. Long emerging market small-cap equities

“For much of the last decade emerging economies have driven world economic expansion. Despite the threat of rising protectionism following Donald Trump’s US election victory, we believe this trend will persist.

“Growth in emerging markets will continue to be underpinned by rising household incomes, growing middle classes, rapidly expanding workforces, rising productivity and stable inflation. History suggests that once basic needs have been met, demand will shift towards growth in consumer products and services, housing, infrastructure and healthcare. Investing in the shares of smaller companies offers the cleanest way to access this growth. Smaller companies are more exposed to their domestic economies than their large-cap peers, and especially to sectors that are likely to benefit from rapid income growth such as retail, healthcare and industrials.

“In developed markets, small-caps shares are often perceived as risky, as they are commonly less liquid and focus on a single business line, however over time investors are usually compensated for this additional risk by receiving higher returns. For emerging markets however, small-caps have historically been less volatile and consequently offered better risk-adjusted returns than large-cap equities. That is mainly because a big proportion of EM small-cap shares tend to be owned by domestic investors and as a result their price is usually less heavily influenced by external capital flows. In the current environment, that should make them much less vulnerable to higher US interest rates.

“The main risk to this trade would appear to come from a rapidly appreciating US dollar. That could force the central banks of emerging nations to raise interest rates, in turn choking off domestic economic growth.”

  1. South Korean yield curve steepener

“The South Korean yield curve is one of the flattest in the world, with ten-year debt yielding just 47 basis points more than two-year notes. The shape of the curve rates at the short end are low due to the weak near-term economic outlook for South Korea, while longer-term prospects are clouded by a significant overhang of private-sector debt, unfavourable demographics and the very low level of global ‘term premia’.

“Against this backdrop, this provides a potential opportunity to profit from the curve steepening by going ‘long’ of two-year, and ‘short’ of ten-year, interest-rate swaps. The Bank of Korea has cut interest rates to a historic low of 1.25 per cent, and we think there is the potential for at least one more cut. That should help to pin down the front end of the yield curve. At the same time, the long end of the curve looks vulnerable to a global bond sell-off. Indeed, the recent US-led sell-off has seen the Korean curve steepen in response.

“If global monetary policy remains loose, we could see this strategy deliver a small positive return of the next few years given the prospect of at least one more cut in interest rates. The primary rationale for the trade is that it should produce a more significant return as a more reflationary environment develops. The strategy should also work – albeit probably less well – if we see deflation materialise and the Bank of Korea cutting rates more aggressively.

“The main risk would appear to come from a reversal of the recent rise in global yields on weaker global growth prospects. That said, we would not expect the curve to become inverted, meaning any potential losses should be limited.”

  1. Long US dollar versus Japanese yen

“The Japanese economy remains on life support despite the best efforts of policymakers to resuscitate it. By contrast, the US economy is ending the year in reasonable shape. Furthermore, US growth looks set to receive a sizeable boost next year in the shape of looser fiscal policy, meaning that US interest rates are likely to rise further.

“Although the dollar has rebounded sharply in the past two months, against the Japanese yen it remains around six per cent below where it began 2016. With the market arguably still long of the yen following heavy ‘safe-haven’ buying earlier this year, we believe the yen has scope to weaken considerably.

“Our central expectation is that it will climb another 10 per cent to its previous high of 125 yen, set in the middle of 2015. But it could feasibly reach 140 yen if we were to see the Bank of Japan engage in particularly aggressive monetary easing.

“The Bank of Japan’s actions are giving the government an opportunity to finance unlimited borrowing at a very low rate of interest for the foreseeable future. Given the strength of Prime Minister Shinzo Abe’s mandate, and that ‘Abenomics’ has not really succeeded to date, there is a likelihood we will see much more fiscal stimulus in Japan. This would likely put further pressure on the yen. At the same time, we believe the US Federal Reserve is likely to hike interest rates faster than the market anticipates, further boosting the dollar.

“The main risk to this trade would appear to come from a renewed bout of risk aversion as was seen around the turn of last year, which led to a sharp appreciation in the yen.”

  1. Long US High Yield Bonds

“The US high-yield corporate bond market, even after an impressive rally in 2016, offers one of the few opportunities for an attractive return in today’s environment of low interest rates, with a ‘yield to worst’ of 6.4 per cent. It should do especially well if Trump’s pro-growth rhetoric were to translate into stronger US economic growth in 2017.

“Fiscal stimulus, lower taxes and reduced regulations are potential tailwinds for the US economy. High-yield debt has equity-like characteristics, which means it tends to benefit from a ‘risk-on’ environment but with lower volatility.  Trump’s victory has stoked expectations of higher inflation and interest rates. But while high-yield bonds are not immune to rising rates, the sector’s relatively low duration make it less sensitive to this threat. In the early stages of rate-hike cycles, credit-spread compression has historically helped to cushion the blow of higher rates.

“Credit spreads have fallen by more than 400 basis points from the February peak. Yet they remain more than 100 basis points wider than in June 2014, the peak of this credit cycle. With a coupon yield over 6.5 per cent, we would expect US high yield to continue to be in demand from investors hungry for both yield and income.

“Although default risk is historically the largest hazard of investing in high yield bonds, we expect defaults to decline in 2017. That is largely because of the stabilisation in commodity prices, with the price of crude oil having nearly doubled from February’s low. The main risk to the trade is that US economic growth begins to slow, perhaps because the US central bank raises interest rates faster than we anticipate in order to combat a sharp pick-up in inflation.”

  1. Long US Inflation protection

“We have for some time argued that financial markets were too concerned about the threat of deflation and that inflation would eventually begin to take root. At the start of 2016, with the market preoccupied with the threat of deflation, the Treasury bond market was pricing in average annual inflation of no more than around 1.5 per cent over the next ten years. The figure now stands at closer to two per cent, but we still believe there is room for growth given the recovery we have seen in oil prices.

“The prospect of rising US inflation explains the rationale for one of our favoured trades at present which is to be long of US Treasury inflation-protected securities and short of conventional Treasuries via the ten-year future. Structuring the trade in this way means we can effectively take a view on the amount of inflation being priced into the US Treasury bond market. While this has been a profitable strategy within our AIMS portfolios for some time, we believe it has further potential.”

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