CIO Insights: November 2017

Freddy Lim
Freddy Lim

Co-founder and CIO

08 December 2017

This month’s CIO Insights is a bit different than our previous ones. We still have the regular market updates that you can always expect, but we are also discussing the application of one of our investment framework’s features, re-optimisation, and why some customers’ portfolios will be re-optimised in the coming days.

What You Need to Know About November in 30 Seconds:

  • In the US: In November, the technology sector didn’t perform as well as it usually does, largely due to the proposal of the “alternative minimum tax” (AMT) that could hurt sectors that have high investments in intellectual property, research, and development tax credits.
  • In China: Chinese regulators have proposed sweeping guidelines to curb risks for financial products. The extent of regulator’s resolve surprised the markets, leading to liquidity concerns in the Chinese financial market throughout November. Consequently, the Shanghai Shenzhen CSI 300 stock index declined 6.07% between 23rd and 30th November, erasing most of the gains in earlier part of the month.
  • Defensive sectors in equities, such as consumer staples, are starting to perform. For the first time in 2017, consumers staples is the top performer in November, and the usual laggards, such as REITs, have also performed reasonably well.

ERAA® Updates at StashAway

  • The latest economic data confirm that we are still in a “Positive Growth with Low Inflation” economic regime (Regime B), and StashAway’s ERAA® continues to optimise portfolios for a positive macro environment.
  • One of the main considerations of StashAway’s investment framework is valuation adjustment. Our system’s regular valuation assessment have identified a significant undervaluation in gold and consumer staples. As a result, our system will be re-building asset allocations that incorporate these findings, further enhancing the performance of growth-oriented portfolios. We call this intelligent reallocation, “re-optimisation,” and it is a key feature of our investment framework.

Growth assets’ performance tamed in November

For the first time in 2017, defensive sectors in equities have started to shine in November, taking two of the top five performance spots. In particular, consumer staples gained 5.8% and outperformed growth-oriented consumer discretionary for the top-performing position. Additionally, US REITs, which has been the laggard in the equity space this year, has gained 3%, meaning it’s now performing as well as small-cap growth-oriented stocks.

In general, growth-oriented assets, with the exception of consumer discretionary, were relatively subdued in November; the usual outperformers, such as US technology, Asia ex-Japan, and Japanese equities, gained only 1.5%, 0.5% and 2.2%, respectively. Comparing these gains to consumer staples’ 5.8% makes the clear case that defensive sectors are performing.

The reason why technology had a relatively tame November was that last-minute bad news regarding the “alternative minimum tax” (AMT) proposal in the US. If you missed the news about the AMT proposal, here’s what you need to know: currently, under existing tax law, corporations must calculate tax liability on either regular corporate income tax or the 20% AMT, whichever amount is greater. Essentially, the corporate AMT currently acts as an insurance policy to prevent companies from using various tax breaks to pay too little in taxes. Under the new tax bill proposal, both the Senate and House are in agreement to cut the regular corporate income tax rate from 35% to 20%. What’s still up for discussion is when this tax change would go into place. If the new corporate income tax rate were to become the same as AMT, any deductible benefits relating to intellectual property, research and development tax credits, and other capital expenditures would be negated because corporations are obligated to pay whichever tax threshold is greater. This is bad news for companies, particularly the technology sector, with significant spending in intellectual property and research and development.

Figure 1 – November Scorecard for Asset Class Performance

Asset Class Performance in November 2017

Source: StashAway, Bloomberg

Meanwhile, in China...

China has continued to be a drag on the Asia-Pacific region. Chinese regulators have proposed sweeping guidelines to curb risks for financial products. According to a Bloomberg article, the new rules will be applied to the 29 trillion yuan ($4.4 trillion USD) of wealth-management products issued by banks, 17.5 trillion yuan of trust products, as well as asset-management plans sold by insurers, fund managers, and brokerages. Institutions will be required to set aside risk provisions equivalent to 10 percent of the management fees.

The extent of regulator’s resolve has surprised the markets, leading to liquidity concerns in the Chinese financial markets throughout November. The Chinese stock market reacted with a delay, and between 23rd and 30th November, the Shanghai Shenzhen CSI 300 composite index had declined 6.07%. This effectively erased most of the earlier gains in November. As China has a large market share of nearly 30% in the Asia ex-Japan, equities in the region were similarly affected.

However, as long-term investors, we need to look beyond the immediate term and take a step back to look at the big picture. The commitment made by Chinese regulators to manage systemic risk is a very encouraging policy development. We recommend investors to focus on the steady fundamentals in China (and the rest of Asia-Pacific region), and not to overreact to short-term events.

Re-Optimising Portfolios to Harness Valuation Gaps

A key feature of ERAA®, our investment framework, is that it reallocates assets in portfolios when economic environment changes in a substantial manner (eg. moving from growth to recession) OR when there are substantial deviations of asset prices from their economic fair value. This process of determining new asset allocation targets to a portfolio is what we call “re-optimisation.” It is conducted systematically, and keeps each individual customer’s risk profile constant. Re-optimisation is not to be confused with rebalancing, which is a process of returning asset allocations back to target and tends to be necessitated by significant outperformance of a certain assets relative to the rest of the portfolio.

The latest economic data confirm that we are still in a “Positive Growth with Low Inflation” economic regime (Regime B), and StashAway’s ERAA® continues to optimise portfolios for a positive macro environment.

Recently, our systems flagged significant undervaluation in both gold and consumer staples. This triggered the re-optimisation of growth-seeking portfolios where the algorithm would increase allocations to gold and consumer staples. This will be done by some selling in other assets in the portfolio that are relatively expensive and also keeping portfolio’s risk level constant. Conservative portfolios on the platform are not affected.

Figure 2 – 7yr Valuation of Gold vs Growth, Inflation and Interest Rates

7yr Valuation of Gold vs Growth, Inflation and Interest Rates

Source: StashAway

So how did the system determine that gold was undervalued? Let’s look at the valuation adjustment for gold in Figure 2 (the situation is very similar for consumer staples). The system looks at how an asset’s mean return is performing versus economic factors over a given time horizon.

We are most interested in the difference between actual and model so that we can assess the valuation gap for gold versus economic fundamentals. This valuation gap is depicted as the blue line that can be found at the bottom-left axis of Figure 2. We are able to determine that gold is undervalued by looking at the distance from the mean, which is the valuation gap. More importantly, the valuation gap must have desirable behavior such as mean reversion for the model to work well.

Gold is a great indicator of sentiments. When gold is undervalued, it means that markets are complacent and very eager to chase growth at any price. So even if economic fundamentals are strong in 2018, the markets are paying too much for growth. In ERAA®’s latest estimation, gold is undervalued by approximately two standard deviations below historical mean. This undervaluation level is even more depressed than past lows seen only in October 2005, October 2008, January 2010, and December 2015 (see the blue line in Figure 2). Gold is effectively valued at the bottom 4-5 percentile of its historical prices since 1996. This uncommon yet major drop in valuation translates into a potential upside of 9.8% for gold price over the next one year, but regardless of what actual upside is, there will be an upside.

Figure 3 – Gold (and consumer staples) offers insurance against unexpected changes in the economic environment

Gold (and consumer staples) offers insurance against unexpected changes in the economic environment

Source: StashAway, Bloomberg

Investing in any asset when it is undervalued can lead to strong upsides. The added advantage with gold and consumer staples is that they also offer insurance against unexpected changes in the economy. As shown in Figure 3, gold (and consumer staples) can outperform and offset stock losses in a “recession with low inflation” and in “recession with high inflation” environments.

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