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Uncertainty Abounds - Perfect Storm for Value Investors

Wednesday, August 22, 2018
by Ric Palombi

Over the last six months, a growing number of issues have come together to create a perfect storm in the international markets – creating plenty of opportunities for value-minded investors.

1. Global Trade Wars – Uncertainty Abounds

Global trade wars have captured the headlines as US President Trump has been relentless in his pursuit of “Making America Great Again”. While Canada continues to renegotiate our portion of NAFTA, more of the world’s eyes are really on how China and Europe negotiate their agreements. The uncertainty of these future trade agreements are already reflected in many of the world’s stock markets.

Figure 1: YTD Performance of Global Stock Markets as of July 31, 2018 (C$)

Source: Bloomberg
 

The US is in the fortunate position of power as they continue to be the world’s largest economy. Currently, they are enjoying strong economic growth and historically low levels of unemployment. However, with mid-term elections fast approaching in the US, we believe President Trump will need to get a few key “wins” under his belt. A de-escalation of trade tensions with China and establishing a frame work for a trade deal would be such a win.

2. Turkey – Fear and Contagion

Turkey is in the midst of a crisis of their own - their current account deficit and geopolitical issues have caused the Turkish Lira to decline almost 40% against the USD this year, with the majority of the decline coming in the last two months. This in turn has led to fears of contagion spreading not only into other emerging markets but Europe as well. This has caused havoc in some equity markets, with the emerging markets down approximately 20% year-to-date (US$). What’s more interesting, however, is the fear of contagion has also spread into Europe via transmission through some major European banks and a weaker Euro.

Figure 2: Both Turkish Lira and Euro declining against the USD.

*Note: Based on the way the Turkish Lira is calculated, the scale is inverted which means when the number is higher, the Lara is depreciating.
Source: Bloomberg 

We believe Turkey’s issues are their own and manageable, and that the risk of a contagion is relatively low. 

3. Italy – Friction with Increased Government Spending

Europe is also contending with Italy where the focus of attention is the government’s upcoming September budget. The market fears increased fiscal spending and tax cuts, which may cause them to breach their 3% deficit target. If Italy breaches their target, this may cause friction with the EU and also may cause a downgrade of Italian government debt. This concern is reflected in the bond market, as you can see by the spread between the Italian and German 10 year notes. 

Figure 3: Fear is reflected in Italian and German 10-year Bond Spreads

Source: Bloomberg

Not helping matters was the devastating collapse of the bridge in Genoa, Italy.  This has caused the market to anticipate a significant need for Italy to invest in and upgrade numerous infrastructure projects, and the impact of this funding demand.

Our view is that a middle ground will be found with the EU and the increased uncertainty will cause the European Central Bank to refrain from following the monetary tightening the US Federal Reserve, for example, has embraced. The result, we believe, is interest rates will be lower for longer, a relatively weaker Euro and an extension of the business cycle.

Conclusion 

It is our view that while the risks outlined above are real, a significant portion of the uncertainty is more than priced into the many global stock markets. Our International Equity Pool has experienced bouts of uncertainty in the past. The last major pullback of the portfolio occurred when there were concerns over Greece, Chinese monetary policy, and the threat of Brexit on the horizon. Subsequently, it rallied over 63% before this recent pullback.

Figure 4: Our International Equity Pool has faced bouts of uncertainty in the past.

Source: Bloomberg

Our McLean & Partners research team focuses on the destination, not the bumps in the road. We remain steadfast in our investment approach despite market fears and uncertainty, and will continue to exploit inefficiencies in the market to uncover quality companies that are currently being mispriced. This disciplined approach is what ensures the portfolio is positioned for success in the future.

In conclusion, looking forward we see the political pressures mounting to act as the catalyst for more accommodative trade measures, and avert the negative impact of trade wars and extreme tariffs.  Secondly, we see the Turkish situation as one of isolation, and the longer-term fundamentals of the broader emerging markets compelling. Finally, the Eurozone should stand to benefit with an accommodating central bank helping to extend this global economic cycle.


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