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Baron Funds portfolio manager Michael Kass was a panelist at AdvisorIntelligence's latest 360 Views Webinar, on January 10, where he provided his 2018 market outlook and participated in a roundtable discussion and live Q&A session moderated by Litman Gregory's Chad Perbeck, CIMA®.
Here is a replay of the discussion:
Chad Perbeck: Hello everyone and thank you for joining us today. This is Chad Perbeck. I'm a senior research consultant at Litman Gregory. This webcast seeks to leverage our 360 views program, in which we aggregate valuable research content from Litman Gregory's research alliance members centered around a focused theme and then distribute it as a value add to subscribers of our research publishing service. Today's webinar - the format's going to be a virtual panel featuring Michael Kass of Baron Funds.
Now I would like to introduce our first panelist, Michael Kass joined Baron in 2007 as a portfolio manager and has 31 years of research experience. From 2003 to 2007, Michael was a managing principal of Artemis Advisors, which he formed to acquire the Artemis Funds, a long/short equity strategy he cofounded in 1998. From 1993 to 2003, Michael worked at ING Furman Selz as a director of proprietary trading and was named senior managing director and portfolio manager in 1996. From 1989 to 1993, he worked at Lazard Frere as an associate in investment banking, and from 1987 to 1989, Michael worked at Bear Stearns as a corporate finance analyst. Michael graduated summa cum laude from Tulane University with a B.A. in Economics in 1987.
Welcome Michael thanks for joining us. Please take it away.
Michael: Thanks. All right well thanks for inviting me to speak today.
I think we have a couple of slides that were just you know in the limited time I just wanted to try to focus on the key catalysts and drivers of market performance.
You know looking back the last year or two years in terms of where we've come from and use that as context to make some remarks about you know what maybe lies ahead both in 2018 and beyond. So if we can pull up the first slide.
I manage both the International Growth strategy, as well as the Emerging Markets dedicated strategy. So I'll really speak to all of the non-U.S. markets for the most part. So looking back I’d like to go back to maybe early 2016 which really was the inflection point coming out of what was a pretty protracted period of underperformance for international equity as well as an outright bear market for emerging market equity. That ended somewhere in the first I'd call and if I could pick a spot it would be March/April of 2016. And that was the point of which I would say we saw a return to policy resynchronization in terms of monetary policy in the U.S. The Fed indicating that they would be moderating for the time being there their hiking campaign and in bringing US policy more in line with what we were seeing which was kind of aggressive support in Japan and Europe.
And again right at that point in time there was an important G20 meeting in 2013 in Shanghai where really all global monetary policymakers shifted more aggressively toward a support mode. That was in the face of what was you know a lot of pressure on commodity prices, on economic growth, global trade, trade flows, capital flows.
You recall the U.S. high-yield market was beginning to seize up in January/February 2016. So to me the big important inflection point that we saw happened in March April causing triggering really a reversal of leadership and a bottom in the beginning of an outperforming phase for EM. We saw commodities turning at that moment into 2016, reverse of cyclicals. And so I would say 2016 was more of a reversion period for value and cyclical sectors, for those countries and currencies that were more that had more of a procyclical and more commodity bias. That is certainly as we manage a high-quality growth strategy, that's more of a headwind environment for our particular strategy in a from a relative performance perspective but 2016 was clearly a bottom a good year for international and EM equities. That was punctuated by the somewhat shock of the Trump victory in November as the market was not prepared for that outcome. That triggered an acceleration of a rotation to value/financials. Markets were quickly discounting a higher growth, higher interest rate, higher inflation bias, higher fiscal stimulus slight bias coming out of the U.S., which would obviously have impact globally. And so you saw a real rotation, dollar strength in particular.
You know I would say while it was a reasonably good year for international and EM in ’16 heading up to that moment from that moment to the end of the year there was a very significant sell off in high-quality growth stocks tech stocks, etc., in the fourth quarter of 16 that really set up what we saw last year because heading into last year the market had nearly fully discounted what I would call Trump's provocative campaign proposals during the campaign and they quickly discounted things like border import taxes or a trade war, you know, pulling out of the trade agreements, some form of a new you know aggressive position vis a vis Mexico or Taiwan. And that certainly had a real negative impact. On both international and particularly emerging markets.
I should also just call out at that time, late 2016 and early ’17, there was also India which was a large exposure for us but India you know Modi was implementing something called demonetization that also just had the impact of creating a near term liquidity vacuum in India.
The Indian economy and any real of the performance of Indian stocks were a very brief period of a few months that and again I thought those factors set up a very strong you know that brief period of underperformance set off a huge recovery and a mean reversion back to growth, high-quality growth emerging, the less commodity centric parts of the emerging markets and international markets. Because most of the first half of last year was really about the unwinding of the probability of Trump successfully implementing those proposals. It became very clear that his MO was to shock and awe with provocative opening negotiating positions and then continually walking back and up with some form of compromise that is somewhat business friendly, capital market friendly. Obviously you know healthcare bill not going through with them was then discounted amongst many other areas of his policy proposals that were then including tax reform that by the summer of late summer of last year the probability of those passing went down near zero and that was really the story I think in the first half in the US and globally are the big as it were the large catalysts particularly impacting international while that's playing out obviously we had you know a strong, cyclical, global recovery, acceleration in trade flows, all those things that were weighing on the sectors that I cover or the countries where we invest in the previous years were reversing to the positive.
So you had a big cyclical earnings momentum picking up, beginning to play out throughout 2017. I think a big factor in ’17 with the China Party Congress in November. But more important that was probably the success with which Chinese authorities were able to manage a rebalancing of their economy and a tightening of credit to the speculative financial pockets of their economy. They manage that pretty deftly and I think there were a lot of sceptics that had to begin to rethink their negative bias on China as you moved into the second half of last year. So all things related to China had a very significant appreciation in the second half of ’17. Another big catalyst was the U.S. tax reform which again is viewed as pro growth. Certainly here but also cyclically, globally. And I think it's you know while the earnings impact was here in the US, the stock market impact was global and that synchronized global acceleration continued through the end of the year and on some levels is also continuing into the early into January this year. I think the other points on international particularly developed international over both 2016 and 17 Support for international equities was really in both Japan and Europe. There at an earlier phase of the monetary cycle so there's much more significant monetary liquidity support in those markets.
Ongoing while the Fed is already had now begun to reverse out normalize policy is engaged in a series of rate hikes. We are not yet seeing that in Japan and Europe. Those markets. Japan certainly outperformed global markets or US over the last year or two. There's an acceleration of cyclical and credit act that credit growth in both Japan and Europe which is very healthy for equities. And last I would say there have been political risks in both of those pockets of Europe certainly and in Japan which were essentially put to rest or at least kind of favorably resolved over the last year in the second half of last year. I think all of that led to this. I'd say the third quarter at the end of the third quarter last year in our letter we kind of mentioned this upside overshoot alert that you know we saw how the environment was pretty. There was a rising likelihood of some upside overshoot coming based on all of these factors and I can probably say you know we're seeing that now we saw that developing through the fourth quarter and accelerated here into the very early part of this year. So the next slide is really talking about 2018 and ahead and what we had in our queue. I think there were a couple of important nuances that began to emerge late last year one that the market is kind of not necessarily today picking up discounting. But you know we're very forward looking at the way we think about the environment as the liquidity and risk environment. Just way we're forward looking in terms of identifying investment opportunities and then evaluating our investments in stocks.
But in terms of the broader macro liquidity risk environment you know I think that and entering into this year it's the time to begin to taper enthusiasm I think we reach somewhere in that upside overshoot alert. I don't know how far confidence can carry forward how far this rally right now we're looking at can go. I believe that as we move through this year it will be a year of fundamental strength that is pretty well recognized which will be you know increasing moderation and liquidity and monetary support environment most likely.
We're seeing the confidence you know I'd say the negative of the rising confidence measures we're seeing in recent months and even really the early days of this year. It is an increasing likelihood that the Fed particularly may need to tighten more than what is already been discounted. It will be the first time in seven years that that would happen. So while I believe you know we're likely to remain in a sweet spot for international and emerging market economic growth and earnings progression.
That is fairly well discounted today there is pretty high optimism rising optimism. You know I think the points that the counterpoints in addition to a rising risk of increased tightening is post the China Party Congress there was a series of shifts which I would just interpret as a tightening of regulatory guidance and a tightening up of certain financial tightening in certain pockets of their economy that I'd say particularly with regards to consumer credit where they seem to be pulling back the reins.
They were probably trying to err on the side of support in 2017 leading up to their appointment.
You know once every five year party Congress where they lay out objectives and reset the kind of things, the leadership and the policy they communicated that and now we're seeing some pulling back and normalization of what was very significant support. So those factors caused me to think that once we see that overshoot kind of conclude we're likely to see some rising volatility in the year ahead. More of a broad trading range environment probably a broader range top to bottom than we saw in a normal year. I wouldn't. Last year I wouldn't call it a normal year. The up 30 percent or so in an international 40 percent in EM that we were able to return was really not normal. I think that the trading range and in volatility is going to go back to are going to be a little bit wider than what we will be seeing a little more volatility a consolidation of perhaps at some point this year a more meaningful correction. Longer term however you know I think very much the international and EM outperformance that we're seeing you know maybe well maybe in the early innings I say that because we believe we see widespread favorable shifts in the political orientation in many of my markets relative to what we see in the U.S. with attractive reform agendas in all these countries Japan, India, China, Brazil, Argentina, Chile, France, South Africa. We think there's room for the Europeans discounts to narrow to the extent that some of the political risks continue to be you know kind of addressed and resolved.
There was always some risk that there's an election coming up in Italy you know we're going to be carefully watching that in March. We think that hard Brexit is now becoming much less likely if that's the case the U.K. The pound and the UK equity market. Probably had lagged the rest of the world and will probably have a large part of an international index well into the double digit percent of the index maybe 15 percent and that that can be a source of performance. We think that a lot of the good news in the U.S. while it’s good. It's fairly well discounted. The impact of tax reform is on its way to being discounted we think that the US is more advanced in its economic and monetary cycle. And you know corporations are already coming off the peak of operating margins. So you know we for all these reasons. The risk of the populist shift continuing to take hold in this country to us represent some risk due to excess earnings, excess margins today, or about above normalized margins in the U.S. So there's some risk to corporate margins and some risk to the owners of capital in the US based on this current trend towards the populist direction essentially. I guess what I'm saying is there may be some mean reversion back toward labor towards the middle and lower classes on the income side where that that would be at the expense of corporate profits.
And then last I think one of the big factors in that is that we're looking at is the potential impact that China has nowm for manym many years they focused on gaining global share in low value, high labor intensive high capital intensive industries and they kind of became dominant in a number of those industries worldwide.
Where they kind of are the marginal driver of growth and pricing. They are now turning their emphasis on high value added intellectual capital they industry, areas like technology healthcare bio sciences. You know we think that could have very significant implications over the next five to 10 years in terms of profit share where the developed world companies have targeted China as a big driver of growth in earnings. And that's just going to get on the margin a little more difficult, doesn't mean it won't be attractive for those stories, those companies that are you looking at EM as an opportunity but the next 10 years is probably going to be a slower rate of earnings growth as they have to suffer some loss of market share and pricing power. That will be to the benefit of companies that are operating on the ground in both China and other emerging markets. We see this as this is a phenomenon is going to spread to India and other places, some of the large EM jurisdictions and that's an opportunity for local companies as well as international companies. I would just say that the U.S. has less of a presence on the ground than corporates related to you know other countries such as Japan, some European, France, I mean it's some very active participation and in the EM the large the U.S. economy is a little more insulated kind of on their own.
So for all those reasons we see the next 5 10 years potentially being different and where international and EM can perform there will still be a correlation with things like global liquidity, global growth, the dollar, commodities, etc. But there's probably room for stronger than what has been the historical performance in a downturn in a rising dollar environment and a weaker economic environment and certainly opportunity for we think you know ongoing significant outperformance in the upturn.
And we think we may be heading into a pause which will then hopefully give way to the next leg of an upturn perhaps in 19 or 20. So I'll cut it off there are probably longer than I was supposed to. Sorry about that.
Now I look forward to your question.
Chad Perbeck: Thank you very much.
I think you did a excellent job of painting a good picture of where we've been in ’16 and ’17 and developed international and foreign markets and setting up a great outlook of where we think we're going and you know just speaking as an individual shareholder in the emerging fund as opposed from the Litman Gregory side of the house. I was a little disappointed that I shouldn't expect 40 per cent again this year but I appreciate you tempering my expectations
Will you just please share your view on currencies and really the U.S. dollar outlook specifically, how that's going to impact your investment thesis in 2018 and beyond?
And really a lot of people have been asking you know is it necessary for a decline in U.S. dollar, for dollar based investors to get outperformance in developed international and emerging market stocks?
Michael: Okay that last question I would say no there's plenty of periods.
You know through recent and longer term history where you know you can have you can have commodity prices rising with that with a firm dollar you can have internationally and EM equities outperforming and a stronger dollar environment that's often a function as I think as Tushar was just talking about how you know if the economic momentum remains you know pretty solid that that is the larger you know you got lower valuations and stronger and stronger earnings growth in those parts of the world. And so you can have a a correlation. You can have a relationship that's sort of untraditional in terms of the performance of those asset classes versus say a dollar. That's not to say that we have a view particularly right now you know where the dollar is headed I'm seeing you know, there's a lot of controversy around that. So I mean the first thing I'd like to say is international/EM equities could outperform in a firm or even strong dollar environment. But then the question is you know certainly it's a tailwind if you have a weaker dollar environment which is an environment we started seeing in the last in recent weeks as essentially as you're seeing energy/commodity prices get a resurgence of the acceleration here in the last few weeks month.
And I think you know perhaps it is my view and I think some one it both the other panelists kind of I think alluded to this.
I think we're likely to reach a point in the near future where the markets are trying to show the Fed that they're behind the curve on some level and that they're going to have to up their game. They're going to have to increase expectations perhaps of you know perhaps an incremental tightening this year etc. And I think the weaker dollar is partially a mechanism that the market is calling out to try to force that to happen.
And you know that is kind of that that doesn't and that certainly can be happening independent of what's going on economically and from the earnings outlook in the non U.S. markets that can be operating totally independent of that which I think is what's happening now.
I think if you get to a point where the Fed essentially you know foreshadows that they believe they're behind the curve and that there is a fairly significant amount of incremental tightening is going to have to happen. I think when that happens when the market digests that then we're at risk of a more traditional correlation where you have an international that could begin to look a lot more. It looks like they're heading into a correction consolidate consolidation perhaps correction could underperform the U.S. during that period of time. But I think it would be by less than is historically you know less than would be expected and less than we've seen historically for all those reasons that I think we are likely have entered a longer term more protracted period of non U.S. performance outperforming US. But it just means that it'll do it'll underperform by less in the more difficult environment and to outperform by more than expected in the positive environment. But at some point this year I think we will head into that consolidation.
Chad Perbeck: Okay great. Thank you for those comments, Michael.
This is a question that we've been getting a lot and it's on a lot of people's minds and if not specifically for 2018 maybe looking ahead.
You know we've been nine years now into this bull market we're at all this fiscal stimulus is being implemented as well. Many people on the panel and other people have been representing that the Fed is going to hike maybe four times this year. Will all of this lead to us starting to see inflationary pressures in 2018 or do you think that's further out?
Michael: Well I guess I get the distinction of going first again, which means I get no time to think about this but it's not that we haven't thought about it internally.
So I guess what I would just say is or for now there's the global balance and you know certainly U.S. centric impact or view of that for me. You know I would say I see the emerging market universe is 18 months coming out of the bear market. We're 18 months into the next bull market not this. And I would say places like Japan are a couple of years coming out of a 20 year secular bear market just at the early stage of a very massive you know reforms in terms of you know returns on capital an entirely different psyche you know led by the government pensions have in Japan shifting 20 percent of their assets in the direction of equities away from fixed income.
So an entirely new dawn in terms of thinking about the potential for returns on capital and equity and returns on equity investments in a jurisdiction like Japan. So you know a number you know you've got to have a lot of changes happening, politics, things happening in France versus Germany in different years. Within my universe it’s so broad, Argentina you know a year a year into a just, really all of Latin America, about a year into a major 180 degree turn in political direction orientation policy.
So from my perspective you know while I'm certainly cognizant of that the U.S. monetary and the US cyclical pressures and perhaps the adjustment that's going to be required on monetary support, liquidity support, is going to have an impact but I don't believe right now it's going to disrupt the longer term opportunity that I'm looking at in most of my markets. It could have you know some turbulence over the next you know some point in the next year or two. As I think we've all kind of alluded to it so you know and for me as we move through that again you know probably somewhere in between the other two panelists are probably like a year.
I'd like to try to anticipate that the environment I see because the market often is discounting nine months to a year or so in advance. So if you understand what the market's telling you today about where you're headed I think it's going to just depend on how aggressive you know how aggressive will the Fed and other global monetary authorities have to be if we enter that scenario. If they over overtighten gradually into what will become a global slowdown. Then it will be more painful. If they understand that you know they have triggered a cooling off period and they allow things to settle out and don't go slow and don't get too aggressive. Then I feel pretty good about the outlook for the areas I invest in.
I thought I would communicate it from my perspective.
Chad Perbeck: Thank you Michael. And sorry for putting you on the spot there first. With that I'd really like to thank everyone for joining us today in the audience and a real special thanks to Michael for being with us and sharing their wealth of experience and perspectives if you'd like to stay current on Litman Gregory's views and strategy as well as those of our research alliance members please visit our website www.advisorintelligence.com or you can contact us via phone or e-mail. They're up there on the slide. And with that like to say thank you again. Have a great day everyone.
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