A top investment expert at a $487 billion fund on her outlook for 2017, Europe and Trump
The multi-asset team builds portfolios that invest across asset classes in a dynamic way. The team make adjustments based on where they see value and the economic environment, rather than long term assumptions.
We recently asked her about her outlook for 2017, elections in Europe and the state of the US market.
This interview has been edited for clarity and length.
Tina Wadhwa: In your outlook note for 2017, you said that you support a shift into value stocks out of quality and an upgrade to Japanese equities, emerging market assets and commodities. Can you go through your rationale for this view?
Johanna Kyrklund: If we think about the world, in recent years, the main performers were the beneficiaries of quantitative easing around the world, and anything correlated with that rally in interest rates. And really a year ago we started to reach a point of what we call quantitative fatigue. We thought the efficacy of quantitative easing was going to be a bit undermined.
At that point we noticed that the more cyclical areas of the market which had been left behind by quantitative easing were looking relatively cheap. So we'd been out of value for years, we'd been out of emerging equities for years, but really by this time last year we felt that their relative valuation had become provocative. And that's what prompted us to start shifting the portfolio, even though at that point in time, there didn't seem to be a cyclical catalyst for doing so, in the sense that the economic environment was very stable, but wasn't particularly improving.
Clearly over the year we've seen some of these areas rally, but now they're being supported in addition by an improvement in leading indicators, which began, in our view, last summer. So that's really been the rationale - initially a relative valuation argument and then over the last few months recognition that leading indicators of economic activity were improving.
Wadhwa: You also said that Schroders is avoiding European assets for now. Can you explain more on your thought process behind this? How long will this last, and what would change your policy?
Kyrklund: I should make a distinction there. We have bought European equities, but what we're avoiding is European government bonds and the Euro. European equities have generally lagged the recovery that we have seen in US equities in recent years, so they're offering relative value. We think the strength of the dollar and the weakness in the Euro supports European earnings, and we're seeing a bit of improvement in activity. So we have added to European equities.
Reuters/Charles PlatiauMarine Le Pen, French far-right National Front (FN) party president, member of European Parliament and candidate in the French 2017 presidential elections, speaks during a New Year wishes ceremony to the media in Paris, France, January 4, 2017.What has led us to then avoid European government bonds of any kind and the Euro is two factors. One factor is that inflation is gradually picking up, so there is a world, this year or maybe the middle of this year, where the ECB might talk about a slightly less dovish policy. Which given where European yields are priced, could be quite a challenge for European bonds. Another issue is that the sovereign debt crisis in Europe, in our view, is dormant rather than extinct. So there's still challenges, particularly in Italy. And so again we don't think risk is rewarded in peripheral bonds. And the final element is that we do have a number of key elections this year and although the central scenario is that the establishment parties will come through it okay, we do think the center of gravity is shifting in Europe. The European project is increasingly questioned. If you take the example of the UK, we didn't need the UK Independence Party to win the election for us to end up with a referendum and leaving Europe. So extreme parties can impact policies even without winning elections, particularly when you are dealing with coalition politics which is often the case on the continent.
Wadhwa: Which election would you say you're the most worried about or watching the most closely?
Kyrklund: To be honest, I think all of them present their challenges. The main ones would be the French elections and then the German elections later this year. Central scenario is that the establishment candidates win, but I think that some of these more populist movements are really gaining popularity. What tends to happen is that when you start getting more extreme parties doing well, some of their policies then get adopted by the more mainstream parties in an effort to support their popularity. So that's why we're worried.
We like European equities. Ultimately we focus on valuation in the economic environment, but we're cognizant that there's potential risks in Europe associated with the pickup in inflation, which would impact ECB policy, a dormant sovereign debt crisis, and obviously a series of political elections this year.
Wadhwa: That being said, do you become a buyer of the Euro at Dollar Parity?
Kyrklund: Possibly. It would depend on what's been going on politically. One thing we must say about the Euro is that the European region is in a current account surplus. So environments where the Euro could do much better would be first of all in a risk-off environment where if Fed rate hikes get postponed, you would see the Euro recovering. If growth actually weakens and disappoints in the US, that would be a reason to buy the Euro. As I said, it's a current account surplus region, so if it gets cheap enough against the dollar, there is support for it. I'm not a perennial bear on the Euro. In fact, quite often I quite like buying it. Just for now, given the position we have in European equities, we think it's prudent to avoid the currency.
Kyrklund: We sold out of a lot of our government bond exposure in the summer, and we're still standing back from bonds a bit. I think there's still room for yields to rise to 3%, but ultimately as we go through 3%, we'll probably start reconsidering exposure to government bonds. And the reason is because we are quite procyclicly positioned in equities and in commodities, and in the context of the overall portfolio, government bonds above 3% offer an interesting hedge. So I wouldn't buy government bonds as an investment on a stand alone basis, but as a useful counterweight in a portfolio that's very cyclically positioned I do think there is potential value in bonds above 3%.
Wadhwa: Over 2016 the dollar index strengthened significantly. What's your view on dollar strength going into 2017? Trump's stated policy has always been around that of "King Dollar" - and the Fed hike scenario would seem to support this. But given the new trade deals Trump is seeking to negotiate, wouldn't he be helped in this endeavor by a weaker dollar?
Kyrklund: For now it seems like the path of least resistance is for a stronger dollar just because of the divergence in rate policy. In particular, we like being long dollar against Asian currencies because there is a risk of a more aggressive Chinese devaluation out there, so we continue to like the dollar versus Asian currencies in particular. I think against other markets, the dollar is starting to look quite expensive. For example, we do like some emerging market currencies like the Russian Ruble, so I would say the outlook for the dollar at these levels is mixed. It depends what cross you're looking at. While in Q4 we were just long dollars against everything. I think we have a more nuanced view of the dollar at this point.
REUTERS/Jason LeeChinese President Xi Jinping delivers a speech at a ceremony to present commemorative medals of the 70th anniversary of the Victory of Chinese People's War of Resistance Against Japanese Aggression, to World War Two veterans at the Great Hall of the People in Beijing, China, September 2, 2015.Wadhwa: Turning to China, what do you think are the main challenges facing the nation's currency?
Kyrklund: China's on quite solid footing at the moment. The main challenge its facing is that the yuan has been depreciating quite aggressively on its doorstep which puts pressure on China, and obviously China stems capital outflows to try to slow the depreciation of the Chinese yuan. So I think China's fine, as long as the dollar doesn't strengthen too aggressively from here.
Wadhwa: You wrote of an upgrade to emerging market assets but also of Trump's protectionist stance impacting EM exposure. What's your view on that? Do you think a hawkish fed and a strengthening dollar is going to hurt EM in 2017?
Kyrklund: We still have emerging equities, but we have reduced allocations so that's the one shift we have made post the election. And actually it's not just about Trump. What's concerning is that trade growth still isn't picking up, so that's what we're really focused on. We like emerging market currencies though and we like local currency emerging market debt. We're just a little bit more cautious on emerging market equities, because as I said the trade growth isn't really picking up.
Wadhwa: Equities have rallied hard since Trump's win. How much further do you see this rally going? Can current price-to-earnings multiples be justified with three hikes expected for 2017?
Kyrklund: For now we remain positive. It's not really about Trump. It's the fact that we have seen a turn in economic activity, and optimism surrounding Trump can amplify that trend. But for now the theme that we're watching is cyclical indicators. While they're still going up, we'll stay long.
It's hard to predict what Trump will say next, so we're focusing on the underlying indicators. And even if Trump intends to implement fiscal policy, realistically we won't see the impact until later this year. The way I'd summarize it is with indicators of economic activity picking up anyways, we can afford to give Trump the benefit of doubt. We'll be looking at manufacturing surveys, producer price indices, earnings revisions, industrial confidence - all of these things have been improving.
Wadhwa: How do you see the price of oil evolving over 2017?
Kyrklund: We're generally expecting very stable energy prices, we're not making big assumptions. But commodities is another area we have generally been avoiding in recent areas, consistent with our idea of avoiding anything that was cyclical. And again consistent with the rotation into cyclical areas, we did add back to commodities last year and we've added further. And that's really because we see some stability in the economy. Commodity prices are still quite cheap, and crucially we're getting a positive oil yield now from a number of commodities, which was a huge headwind for commodity prices for quite a long time. So generally we're mostly positive on commodities, and we think they serve an important role in a portfolio. And this has not been the case in the last few years.