Why Invest in Europe (FX Hedged)?

  • Leading indicators show tentative signs of stabilization (relative PMIs), and there is still substantial pent up demand (savings ratio of 13% and net investment is 1/3 its normal levels).
  • Bank balance sheets have stopped contracting and money supply is now accelerating.
  • The ECB has crossed the sovereign QE threshold with 60B Euro/Month in purchases through Sept 2016.
  • European equities are cheap on a P/B basis, Shiller P/E, and relative to bonds.

Please use the following link for the full investment update on European Equities: Europe Equity (FX Hedged)

Why Invest in the Japan (FX Hedged)?

  • The explicit policy of the Bank of Japan and Government of Japan is to weaken the Yen, create asset price inflation, and support economic growth.
  • Abenomics had a positive impact during 2014, and more accommodative initiatives are expected in 2015 (including a corporate tax cut).
  • Valuations are attractive while fundamentals are strong.

Please use the following link for the complete investment update on Japanese Equities: Japan Equity (FX Hedged)

Why Invest in U.S. Small Caps?

  • Falling energy sector profits and a rising dollar will be less of an earnings headwind for small-cap stocks given lower energy sector exposure and a greater proportion of sales derived domestically. (Small-caps derive 18–20% of earnings outside the US compared to 30–35% for large-caps.)
  • Historically, when small-cap earnings estimates are rising at a faster rate than earnings estimates for large-caps, small-caps have outperformed.
  • Following last year’s under-performance, small-cap valuations (relative to large-caps) are now attractive relative to the last five years.

Please use the following link for more investment insights on US Small Caps: US Small Cap Equity

Why Invest in the Technology Sector?

  • Select industries in the Technology sector are among the fastest growing segments of the market.
  • The US technology sector is attractively valued given its solid long-term earnings growth, improving cyclical outlook, accelerating cash distributions to shareholders, and exposure to secular growth drivers.
  • In the short term, rising demand for IT equipment should lift sales, while in the long term, cloud computing, e-Commerce, and Big Data, among other secular themes, should drive earnings growth.
  • Continued labor market gains and rising capacity utilization are symptoms of an improving cyclical outlook.

Please use the following link for more investment insights on US Technology: US Technology

Our Big Picture View Heading into H1 2015

The Accuvest Team invites you to download our Big Picture View for the 1st half of 2015. In the pages of our Outlook, we will provide some insight as to why the 2nd half of 2014 played out the way it did, what 2015 might bring, and most importantly, how our allocation and implementation strategies will benefit from what could be a powerful rotation in the financial markets. As always, the comments are not to recommend a certain strategy or product, rather to outline how our management process is applied in the current market environment.

Hopefully our thoughts and commentary are useful and insightful, and we encourage your comments and questions below.

From all of us at Accuvest, best wishes and happy new year as we begin 2015!

BPV H 1 2015

Germany Poised for Outperformance as Uncertainty Fades

The October 31st announcements from the Bank of Japan, and the resulting moves in the Yen and Japanese equities, reemphasize the impact that central banks and monetary policy can have on markets and portfolios. When central banks are involved in markets, headlines can often shift market outlooks and investor confidence. Unprecedented monetary policy has the ability to turn countries with weak fundamentals, poor momentum, and high risk into top performers, much like Italy and Spain in late 2012/early 2013. Recall the summer of 2012, when ECB president Mario Draghi pledged to do “whatever it takes” to save the Euro, causing the risks surrounding Italy and Spain to evaporate, and sparking a period of impressive outperformance for relatively unattractive high risk countries. For investors willing to take a more tactical approach to the markets, Germany appears well positioned to benefit from the unveiling of ECB monetary policy and the further stabilization of the Russia-Ukraine conflict.

Uncertainty surrounding the ECB’s Monetary Policy and Russian Sanctions remain in focus for global investors:

ECB Monetary Policy

  • ECB president, Mario Draghi, has pledged to expand the central bank’s balance sheet by as much as 1 trillion Euros, reversing a two year downtrend and targeting the peak balance sheet level last seen in 2012.
  • German opposition to the ECB buying sovereign bonds means the ECB will buy covered bonds and asset-backed securities (limited supply) to expand their balance sheet.
  • Covered Bonds and ABS appear to be the first target of the ECB, but if the ECB cannot find enough covered bonds and ABS to buy, they will have to consider corporate and government bonds as well.
  • The objective of ECB policy will be to create inflation, weaken the Euro, and entice investment/spending.

The Russia-Ukraine Conflict

  • Economic sanctions between the EU and Russia have negatively impacted Europe’s business confidence and investor sentiment more than economic and corporate fundamentals.
  • The message being sent by the West is that Ukraine needs to find a way to co-exist and trade with its imposing neighbor, just as Finland did after World War II.
  • We anticipate that the current ceasefire will hold, but that Russia maintains de facto control, creating a “militarized demilitarized zone” akin to what evolved in Moldova in 1992 and Georgia in 2008.
  • European policymakers will start to dial back sanctions once they see signs of a credible truce.

These two sources of uncertainty have impacted European economies and equities in different magnitudes. As new risks are priced into markets, “country risk premiums” expand. In other words, if Germany’s equity market sells off, and all else is held constant, the return potential/risk premium of Germany expands as equity prices decrease. Importantly, “all else” is never “held constant” in reality. As German equities sell off and new risks are quantified, valuations, momentum, risks, and fundamentals change. Importantly, there are some cases where prices deteriorate more than fundamentals, risk, or valuations justify, creating an opportunity to invest in a market that has dislocated from its underlying intrinsic value. A dislocation from intrinsic value is the first parameter we look for in a tactical opportunity. The second parameter is a performance catalyst. Many market dislocations persist because of the absence of a catalyst. Similar to a value trap, absent any reason/driver for improved fundamentals or growth, valuations and prices are likely to stagnate or continue lower. With a meaningful catalyst on the horizon in Europe, the opportunity for risk premiums to narrow is becoming more real.

Regarding the investment thesis for Germany, the stabilization of the EU-Russia trade relations and the unveiling of ECB Quantitative Easing should significantly reduce the macro-uncertainty associated with Germany, allowing for meaningful appreciation and mean-reversion in equity prices and investor confidence. Of the EU’s four largest economies, Germany has been the weakest equity market since the beginning of the Russia-Ukraine conflict (chart below).

MSCI Country Equity Index Performance – Since Russia Invasion of Crimea

germanypoised1The Russia-Ukraine conflict has impacted economic sentiment in Germany more than most European countries. Russia invaded Crimea on February 27th of this year. Since that time German equities are down more than 9% in Euro terms and 16% in USD terms. In 2013, only 3.4% of German total exports went to Russia, while 5.1% of all imports came from Russia. It can be said that German business expectations and economic sentiment have been more negatively impacted than the long run economic fundamentals of the country. Since the implementation of sanctions on Russia, German business expectations and economic sentiment have rapidly deteriorated (chart below). Markets appear to be extrapolating the impact of Russian sanctions and Euro Area deflation into the future, driving down equity prices and creating an opportunity for investment in Germany.

German Expectations of Economic Growth (ZEW), Business Expectations (IFO), and Manufacturing PMI

germanypoised2Over the last six weeks, markets have seen CDS spreads widen for Italy, Spain and France, while CDS spreads have narrowed for Germany (suggesting less risk of government default). This data could imply that market participants are becoming less focused on Russia’s impact on German fundamentals (despite sanctions on Russia being increased on Sept 12th) and are becoming more focused on ECB monetary policy, bank stress tests, and the European Commission’s review of government budgets.

Sovereign 5 Year Credit Default Spreads (CDS) – Since 3rd Round of Russian Economic Sanctions

germanypoised3It is reasonable to expect that Italy, Spain and France will benefit from ECB action and a weaker Euro, but given Germany’s economic profile and focus on net exports, it is reasonable to expect that German companies have more to gain from a weaker currency (especially against the USD, RMB, and GBP). In 2013, 10.3%, 8.5% and 7.8% of total German exports went to the United States, China, and the United Kingdom, respectively. A weaker Euro makes German exports more competitively priced in each one of these markets, providing German companies with an opportunity to increase profitability or market share.

Furthermore, a weaker Euro, negative real interest rates, and expansion of the ECB balance sheet through quantitative easing could improve the economic prospects of the Eurozone as a whole and reduce the risks of deflation. To the extent that the ECB can stimulate inflation and investment, Germany will benefit from a stronger Europe. Importantly, the long fun fundamentals and underlying valuations in Germany balance the uncertainty surrounding the Russian and ECB catalysts. To the extent that our outlook on sanctions and ECB monetary policy is wrong, we suspect that Germany has the “fiscal space” to defend domestic growth and will continue to be a low risk, blue chip, value play for the Euro region and the global economic recovery.

Germany has attractive valuations and a low-risk profile (table 1 below). The problem with Germany, since the beginning of 2014, has been negative momentum and weakening fundamentals (table 2 below). Trailing 12 Month EPS growth and leading economic indicators are weak in Germany. However, Germany’s Long Term EPS Growth Rate is 13.15% compared to a 40 country average growth rate of only 7.09%. Looking forward, analyst’s consensus for earnings growth for the next 3 to 5 years is 11.1%, versus a 40 country average of 12.3%.

germanypoised4If the uncertainty surrounding the catalysts outlined above dissipates, there is an opportunity to capitalize on expanding valuations and improving confidence in Germany. The stabilization of the Russia-Ukraine conflict should improve economic sentiment and investor confidence in Germany. Additionally, low real interest rates and a weakening currency stand to strengthen European and German fundamentals and local currency price momentum.

The median estimate in forecasts compiled by Bloomberg is for the Euro to drop to $1.20 by Q4 2015. To best capture the potential benefits of these two catalysts investors should consider using a currency hedged ETF. These investment products provide exposure to the underlying equity markets of a country (Germany), while at the same time neutralizing the effects of any local currency (Euro) strength or weakness against the US Dollar. The two available currency hedged ETFs for Germany are HEWG and DBGR, and both effectively neutralize the impact of a weaker Euro on investment returns. HEWG and DBGR have the same underlying holdings (company and sector allocations are approximately equal to the MSCI German Index). As a result, the historical performance these currency hedged ETFs is nearly identical, DBGR may have a slight edge over HEWG only because it has a lower expense ratio.

Japan: Quality Q.E.

For some time, one of our stronger themes has been to buy Japanese stocks with the yen hedged. An update on this topic seems warranted at this time. Measured to mid-October of this year, a fairly large range of returns can be calculated between the Nikkei and the ACWI. Depending on the date used to calculate returns, outperformance by the Nikkei can be seen as high as 8% and a similar number can be seen if looking for underperformance by just changing the start date.  A currency-hedged ETF such as DXJ or DBJP has increased the upside and decreased the downside when looking at similar measurement periods. As always, different stories can be written depending on when return calculations start. What really matters is the outlook going forward. We believe that improving earnings, valuations, monetary policy, and reforms all point to a strong relative value story tipping in favor of Japan.

Japan has seen one of the strongest EPS trends of any country in the ACWI. While they have slowed recently, the longer-term growth rate remains around 10%. Valuations are attractive on an absolute and relative basis. Out of a universe of 40 countries, Japan has the 7th lowest price to book ratio (1.35x) and the 9th lowest price to cash earnings ratio (7.88x). Relative to history, Japan has the #1 ranked value profile. Japan’s current P/E ratio is 6.18x lower than its 5 year average P/E ratio. Lastly, Japan’s forward P/E multiple is trading at a 10.6% discount to the MSCI World, the largest discount in 20 years.japan pic 1Monetary policy has become one of the most important drivers of stock market outlook. While the market has not necessarily rewarded countries with cheap valuations or countries with relatively strong fundamentals, it has rewarded countries where the central bank is loose. The playbook since the crisis has been to buy stocks on pullbacks in the market where monetary policy is most accommodating. That has meant the US for some time has been the stock market to buy on pullbacks. With the Fed at a key juncture in its policy, meaning moving to neutral, the Bank of Japan is the central bank that wears the mantle of most accommodating.

japan pic 2Recent economic data has come in weaker than expected in Japan, but this will lead to further easing of monetary policy within weeks perhaps. This is the stated policy of the Abe regime which is actively devaluing the yen in pursuit of inflation. The BoJ is entrenched in policies that will depreciate the currency in order to gain a competitive edge internationally. This makes companies more profitable; that seems to be a clear outcome. Whether the BoJ can engineer an economy that grows consistently at an acceptable rate and breaks a multi-decade deflationary cycle is a question with a less-clear answer.  As equity investors, owning export-oriented companies and hedging that exposure out of JPY into USD is an attractive play. The average forecast of 80 financial institutions is for JPY to move to 115 over the next year. Against EUR, the yen is expected to weaken as well. For the Japanese economy to recover, a depreciation of the yen is a necessary condition. While the Fed approaches the end of QE, the BoJ will be expanding its balance sheet, gaining a relative monetary policy advantage.

On the reform side of the ledger, expectations for more aggressive action should be expected on several fronts; tax, labor, social spending, electoral system, agriculture, immigration, and education. What should also be of interest to equity investors is the announcement that the Government Pension Investment Fund is planning to increase its allocation of domestic equities to 25%. The current allocation is 12%. The increase could drive purchases of up to ¥8T of Japanese equities. Other mutual funds that follow the GPIF weights could create buying demand double that amount. It is also probable that Abe delays the raising of the consumption tax that affected the market negatively in the spring.

Based on fundamentals and valuations, our call is to have an overweight to Japanese stocks in core strategies. A weaker yen is part of that outlook as we believe many of the companies in the index will do well given a more competitive stance with a weaker currency. Typically we would add to the analysis that a potential currency appreciation creates additional return possibilities. In the case of Japan, we do not expect currency appreciation to play out, hence our desire to hedge the yen when it comes to owning Japanese stocks. While there are other ways to do this, an ETF is our preferred vehicle. The ease of purchase, the very low cost relative to replicating the strategy independently, intra-day liquidity, and instant diversification all play into the selection. DBJP and DXJ both fit the bill.  We have rotated between the two based on our view of relative value at the sector levels where there are key differences between these two ETFs.

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Disclosures: This article was compiled by Brad Jensen, a Portfolio Manager at Accuvest Global Advisors. This article is strictly informational and should be used for research use only. It should not be construed as advertising material. The opinions expressed are not intended to provide investing or other advice or guidance with respect to the matters addressed in this brochure. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions to comply with matters addressed in this brochure. Charts and information are sourced from Bloomberg, unless otherwise noted. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. You should seek advice from your financial adviser before making investment decisions. Investment risks are borne solely by the investor and not by AGA. AGA is an independent investment advisor registered with the SEC. All disclosures, marketing brochures, and supplemental firm sheets are available upon request.

US Dollar Strength and what it means for Global Portfolios

Recent US Dollar Strength

The last six months have seen impressive gains for the US Dollar versus the Yen, Euro, Emerging Market currencies, and commodities. USD strength is likely to persist; however, we expect that it will proceed at a more moderate pace. From the end of June through the end of September, the US Dollar strengthened 6.64% and 7.95% against the Yen and Euro, respectively. Furthermore, the greenback strengthened 10.77% against a basket of commodities. These are strong moves exhibiting increasing momentum. If these trends are reinforced it will introduce a new dynamic to global financial markets. Potential developments include: import inflation in Japan and Europe, a stronger US consumer, lower US commodity and input costs, and lower US interest rates for longer. US large cap multinationals would face headwinds relative to domestically oriented US small caps, while foreign companies exposed to the US consumer could see gains in market share and profitability.

usdollar1

Chart 1: Accelerating USD Strength

Interest Rate Differentials

The recent USD strength has been driven by relative monetary policy and global interest rate differentials. Liquidity seeks out yield, and flows to where it can earn the highest risk adjusted returns. The economic upturn in the US in the context of non-US economic disappointment has widened front-end rate spreads between the USD and every major currency except GBP and AUD. The interest rate differential between 10 Year UST Yields and 10 Year German Bund Yields is at the highest levels since 1999. The differential equaled 1.5534% as of the end of September, and is at a 99.67 percentile level versus the last 30 years (seen below in the spread summary and distribution chart).

Chart 2: US-Germany Interest Rate Gap at Historic Level

Chart 2: US-Germany Interest Rate Gap at Historic Level

This historically wide interest rate differential (higher rates in the US) is drawing international capital into US Dollars. These flows should increase demand for US financial assets ranging from Treasuries to Real Estate to Equities. The USD Index (a trade weighted basket of currencies) was up 3.85% in September. As seen below, the US Dollar strengthened vs. all expanded major currencies but the Chinese Renminbi during the month of September.

Chart 3: September FX Returns: Expanded Majors

Chart 3: September FX Returns: Expanded Majors

USD Trend to be reinforced by ECB and BOJ

In a capitalistic free market, this US Dollar strength and capital inflows into the United States would act to re-balance global markets. Interest rates would have bias to move lower in the US and higher internationally. US equities would tend to become overvalued while international equities could see price multiples contract. However, in the current context of systematic intervention and unprecedented central bank monetary policy these equilibriums are likely going to take longer to find.

The ECB has pledged, and appears poised, to expand their balance sheet by 1 Trillion Euros to combat very low inflation and weak economic growth. European economic weakness spurs and requires further reflation. The ECB is set to announce further details of its covered bond and ABS purchase programs on October 2nd and the second TLTRO operation takes place on Dec. 11th.

Likewise, Japan faces growth and inflation challenges and has responded in similar fashion. The Bank of Japan has been monetizing their sovereign debt with QQE (quantitative and qualitative easing) for the last 24 months. The Bank of Japan has purchased 70% of newly issued JGBs (Japanese Government Bonds) in total and over 100% on a net basis under its unprecedented monetary easing program.

What does this mean for global portfolios?

The relative monetary policy described above points to further strength for the US Dollar, and US Dollar strength can have a major impact on international equity returns for a US based investor. The two charts below show the performance of the United States, European Monetary Union, and Japanese equity markets. The first charts below shows the simple price appreciation of these markets in local currency terms. The second chart shows the performance of these equity markets in US Dollar terms. A US based investor would have experienced net returns in line with the performance seen in the second chart over the last six months. This is because a US based investor takes on the currency risk of international investments, whether using ETFs or individual ADR stocks.

Chart 4: Month Equity Market Performance in Local Currency

Chart 4: Month Equity Market Performance in Local Currency

Chart 5: 6 Month Equity Market Performance in US Dollars

Chart 5: 6 Month Equity Market Performance in US Dollars

In local currency terms, Japan was one of the best performing markets in September, and has nicely outperformed the US market over the last 6 months. The Japanese equity market from a Japanese investor’s perspective is doing quite well. Yen depreciation has resulted in positive Japanese earnings revisions. Japan strategists at JP Morgan estimate that each unit of yen depreciation vs. the dollar increases EPS by about one percentage point. With Yen weakening from 101 in mid-July to 109.50 at the end of September, the prospects of better than expected earnings in Japan are real.

Nonetheless, after allowing for the impact of a strengthening dollar, the performance of these international markets (for a US investor) is substantially lower. Furthermore, the volatility of these investments has increased as a result of uncertainty surrounding FX rates, relative monetary policy, and unbalanced economic growth.

Strong US Dollar = Low Rates for “Considerable Time”

Growth should continue to be weak globally, and deleveraging is still needed. The private sector appears to made substantial progress, but governments are still faced with eventual spending cuts and tax hikes. This suggests that incomes and wage gains will remain under pressure; making runaway inflation unlikely in Europe and Japan, but also in the United States. The continued USD strength proposed above suggests that prices, commodities, and input costs are likely to remain contained. All of this points to lower interest rates for longer. While it seems a majority of market strategists expect higher rates, US rate forwards through 2017 remain solidly below consensus and Fed forecasts for short USD rates.

The Fed has defended against decreasing inflation expectations in the past. Entering markets or providing guidance that has reinitiated USD weakness. The question is whether or not current US growth is strong enough to create inflation in the face of a strengthening US Dollar (i.e. demand pull inflation). In other words, is demand for commodities, like oil and base metals, strong enough to drive prices higher (inflation) despite strength in the USD? Or does the Fed need to step back in and once again backstop the economy, provide liquidity, and protect against U.S. deflationary pressures coming from Europe and Japan?As of the end of September, the US Dollar has strengthened to 4 year highs, inflation expectations, as defined by the Fed’s Five-year Forward Breakeven Inflation Rate, have moved to 3 year lows. In other words, inflationary pressures are as low as they have been since 2011 (Blue line in the chart below).

Chart 6: Inflation Expectations vs. US Dollars Index since 1999

Chart 6: Inflation Expectations vs. US Dollars Index since 1999

Global Accommodative Monetary Policy is Bullish for Risk Assets

Central banks are keeping the reflation story alive in developed countries, providing support to economies and abundant liquidity to markets. Our analysis suggests that the Fed will remain accommodative, but less so than either the ECB or BOJ. This relative under-accommodation points towards further US Dollar strength, persistent global liquidity, and anchored benchmark interest rates. Furthermore, longer term inflation risk would be to the upside because the Fed and Janet Yellen will likely wait to see the “white of the eyes” of inflation before blinking and raising rates. This indicates negative real interest rates for a “considerable time” and implies that risk assets will outperform risk-free assets, equities are relatively more attractive than fixed income, and the crowded chase for yield with continue. In this environment, we recommend currency hedged international exposures. ETFs that hedge out the impact of currency returns, like DXJ and DBJP for Japan, HEZU and DBEU for the Europe, and HEWG and DBGR for Germany, have seen meaningful AUM growth and become popular investment vehicles for a good reason.

Diversify with Equities, not Currencies

International equity allocations continue to play an important role in global portfolios, but we advise taking more calculated currency risk in today’s market environment. As seen below, the current Price to EBITDA discount (-3.35x) between the US and the European Monetary Union is larger than 94% of the observations seen since 1995. Japan’s Price to EBITDA discount (-2.98x) is similarly attractive, currently larger than 86% of the observations seen since 1995. Of course, cheap can always get cheaper and U.S. equities should certainly remain a core allocation, but for longer-term investors the upside to developed international exposure is significant, especially after protecting against currency weakness. The ECB’s coming reflation boost should unlock value in Eurozone equities, and we expect that Japanese risk assets will benefit from further monetary easing from the BOJ.

Chart 7: MSCI USv.s MSCI European Monetary Union: Price to EBIDA Ratios since 1995

Chart 7: MSCI USv.s MSCI European Monetary Union: Price to EBIDA Ratios since 1995

Lastly, to hedge/protect this broader US Dollar strength thesis, we recommend energy and the OIL ETF. This commodity should respond nicely to any re-initiation of quantitative easing, U.S. inflation, or economic surge. Furthermore, the OIL ETF taps into an attractive roll yield provided by the steep backwardation currently seen in crude oil futures.

Disclosures

This article was compiled by James Calhoun, a Portfolio Manager at Accuvest Global Advisors. This article is strictly informational and should be used for research use only. It should not be construed as advertising material. The opinions expressed are not intended to provide investing or other advice or guidance with respect to the matters addressed in this brochure. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions to comply with matters addressed in this brochure. Charts and information are sourced from Bloomberg, unless otherwise noted. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. You should seek advice from your financial adviser before making investment decisions. Investment risks are borne solely by the investor and not by AGA. AGA is an independent investment advisor registered with the SEC. All disclosures, marketing brochures, and supplemental firm sheets are available upon request.

Mexico Energy Reform: What Investors Should Know Now

In May, we posted “Mexico: A Country in Transition”. That piece received favorable feedback related specifically to its overview of energy reform taking place in Mexico. At that time, we mentioned that the reform is a journey and not a destination, stating that occasional updates would be necessary to stay plugged into the reform process. Recent events create the need for such an update.

What You Should Know

This month, legislation to implement energy reforms was approved with the spotlight now on implementation. The information that will begin to flow will cover corporate investment and business opportunities and will dwell less on the legislative process. Regardless of how these opportunities present themselves and whether investors are able to take advantage in direct ways, the country of Mexico has pushed the ‘go’ button on activity that will create long-term, growth-enhancing capabilities. Investment vehicles that could play the benefits of the structure reforms are limited presently, certainly for average investors. However, the Mexican equity market as a whole should benefit, the Peso should see relative strengthening, the trajectory in economic growth will tilt further upward, and societal benefits will also be seen in a country that has already begun to grow its middle-class. Further sovereign credit rating upgrades are likely to be seen, lowering risk premiums and spreads for Mexican bonds. Some have likened Mexico’s energy reform to Germany’s reunification in terms of economic impact, timing, human capital, and infrastructure. Investors should consider the shot-gun approach to investing in Mexico currently, building exposure broadly across Mexican asset classes while looking for positive knock-on benefits from the ongoing energy reform.

What You Should Watch

However, to stay in front of the curve and to build knowledge and awareness of how the game is evolving, the playbook, and an understanding of the roster of players, a brief overview follows.

The Players:

  • Secretaría de Energía de México. SENER will have the responsibility to select fields and define contracts in the bidding process.   The Secretariat’s website has video and other material covering recent and future efforts in the reform process.
  • Secretaría de Hacienda y Crédito Público de México. The Finance Ministry will determine the fiscal regime related to any bidding process.
  • Comisión Nacional de Hidrocarburos. CNH is a technical body dealing with the implementation of Mexico’s hydrocarbon policy. It will supervise and regulate exploration and production which will include opening the bidding process and awarding contract.
  • Pemex. The state owned petro company established in 1938 whose mission and business model will change significantly going forward.
  • CFE. The state owned electric utility whose dominance is second only to Pemex.

Recent Regulatory Changes

  • CFE and Pemex are now “State Productive Companies” with budgetary autonomy as well as economic, administrative, and technological independence. Both are free to partner with private entities through a process managed by SENER.
  • CFE can engage in contracts with private companies for the operation of the distribution and transmission network. Private companies will be able to generate electricity for self-consumption.
  • SHCP will slowly migrate from collecting taxes on CFE and Pemex to dividends starting in 2014.
  • Expropriation of private land will cease. Land owners will get rent or 3% of project earnings.
  • The Mexican government will assume a percentage of the Pemex and CFE’s pension liabilities.
  • CNH will regulate and grant contracts through auctions in which private and state companies can participate.
  • SENER will determine the technical conditions of the contracts to be awarded.
  • CNH will receive all geological and technical information held currently by Pemex.
  • Private companies can distribute gasoline with impendent franchises in 2016 and import gasoline from 2017.

Opportunities for Foreign Investors

  • Investors can participate in gasoline commercialization and petroleum gas distribution
  • Investors can own up to 49% of companies dedicated to offshore activities in exploration.
  • Pipeline construction is possible for foreign investors.

Future Steps:

  • Round 0. This is what has been happening over the course of 2014 and was essentially wrapped up this month. Pemex was required to present to SENER the economics and technical aspects of the projects they wanted to keep. Pemex also provided a list of likely private company partnerships. Pemex requested 100% of proved reserves, 83% of proved and probable, and 70% of proved, probable and possible, as well as 31% of prospective resources. SENER effectively ended Round 0 by issuing a resolution in which Pemex was declared to keep certain projects where they are considered a competitive operator and a list of projects where a private partner could improve production or efficiency. Of those projects requested, Pemex has been granted all of the reserves requested which is about 20.6 billion proven barrels of oil equivalent (boe) and 22.1 billion boe of possible reserves. In the Round 0 disclosure only a small fraction of the prospective resources were awarded to Pemex. Hardly any of those already small prospective resources correspond to deep sea and shale gas fields. The lower initial allocation should be seen as a desire for SENER to be flexible and allocate broadly to private enterprise.
  • Round 0.5. This round should take place over the remainder of 2014 and into the Q1’15. It is in this round where farm-outs and JVs will be announced. SENER will auction projects in which Pemex has solicited or been assigned a private partner. This round is unlikely to involve any meaningful transfer of assets as Pemex was granted most of the reserves requested already in Round 0. Projects that will be farmed out will be the deep sea, heavy crude oil in shallow waters and mature fields. There are approximately 10 sites fitting these descriptions that have been identified.
  • Round 1.0. This round is likely to play out in H2’15 and will focus most attention on the auction process. SENER, CNH and the Treasury will auction oil and gas projects in which Pemex and private companies can compete head-to-head. The bidding process currently includes 109 blocks in exploration and 60 blocks in production, leading to 28k sqm. Blocks include fields in deep water, extra heavy crude oil and shale resources. Nearly $13B p.a. in additional spending is expected to be invested in the sector over the next six years. Pemex has been spending about $23B p.a. in capex in recent years.

What You Should Remember

In the country of Mexico, Energy Reform will create a significant number of new jobs, lower the cost of energy, increase the manufacturing competitive advantage, ignite a strong infrastructure build-out country wide, bring significant foreign investment, all adding up to increased economic growth to as much as two percentage points higher. It is not just in the energy sector where benefits will be seen, but across the entire economy with important benefits to society as a whole.

Investors will find it difficult to uncover any pure-play investment vehicles focused on energy reform. However, all asset classes should be considered for increased exposure. The Mexican stock market is not cheap currently, but it has always traded at a premium to EM and should not discourage long-term investors from building positions. Mexican sovereign debt should see relative price improvement through spread compression given potential rating-agency upgrades. This would include the quasi-sovereign entities, CFE and Pemex. Pemex is currently rated A3 by Moody’s and BBB+ by both S&P and Fitch. All three services have the credit as “Stable”. Pemex disclosures all abide by US SEC standards and most of the USD-denominated bonds are eligible for major investment grade indexes. A broader base of investors will be holding the bonds going forward. Corporate credits in Mexico also can see spreads narrow. Much of the fixed-income sector of the market has not seen the improvement yet that can be expected. Exposure to MXN is also a likely beneficiary of energy reform and should be sought through local fixed-income instruments.

 

Sources: SENER, Credit Suisse, UBS, Morgan Stanley

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Disclosures: This article was written by Brad Jensen, a portfolio manager at Accuvest Global Advisors. The opinions expressed in this report are those of the author. The materials and commentary are strictly informational and should be used for research use only. This brochure should not be construed as advertising material. The opinions expressed are not intended to provide investing or other advice or guidance with respect to the matters addressed in this brochure. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions to comply with matters addressed in this brochure. Past performance is not indicative of future results. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. Investment risks are born solely by the investor and not by AGA. AGA is an independent investment advisor registered with the SEC. All disclosures, marketing brochures, and supplemental firm sheets are available upon request Charts and information used in this report are sourced from Accuvest Global Advisors, unless otherwise noted above.

Country Selection 101 – Exploring the range of country returns

In Dave Garff’s 2011 whitepaper, Do Countries Matter?, one of the most compelling charts was looking at the Monthly High-Low Range of country returns. The chart looked at 39 countries in both emerging and developed markets going back to 1991, and charted the monthly range of returns between the best performing market and worst performing market. Since 1991 it has been a compelling opportunity for investors to consider that by purely focusing on country selection within their global equity allocation, the long-term average monthly return range was over 33% per month.

countryselection1

However, since 2010 global investing has been marked by a period of significant outperformance of the United States relative to the rest of the world. As of July 31, 2014, the United States had outperformed the average country in the 39 country universe by a cumulative 56.02% in USD or an average annualized performance of 10.49% per year.

countryselection2What is striking to me is looking at how significantly the range of returns dropped from the last decade. During the preceding 10 years, the United States underperformed the average country by a cumulative 299.95% or average annualized performance of 14.22%. Since that time, the average monthly range dropped by nearly 6% per month and the max monthly range dropped by nearly 30%.

countryselection3While it is possible to look at the recent trend and suggest the country selection opportunities are narrowing, I would suggest that the recent drop in country selection opportunities has more to do with United States dominance of global equity markets, and less to do with a systematic change to the marketplace. As international markets turn and more specifically emerging markets recover, my expectation is that country selection opportunities will increase and give investors increased alpha generating opportunities for their investment portfolios. Using the abundant list of single-country ETFs should make expressing those opportunities even easier.

 

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Disclosures: This article was written by David Allen, a Portfolio Manager at Accuvest Global Advisors. This article is strictly informational and should be used for research use only. It should not be construed as advertising material. The opinions expressed are not intended to provide investing or other advice or guidance with respect to the matters addressed in this brochure. All relevant facts, including individual circumstances, need to be considered by the reader to arrive at investment conclusions to comply with matters addressed in this brochure. Charts and information are sourced from Accuvest, unless otherwise noted. Remember that investing involves risks, as the value of your investment will fluctuate over time and you may gain or lose money. You should seek advice from your financial adviser before making investment decisions. Investment risks are borne solely by the investor and not by AGA. AGA is an independent investment advisor registered with the SEC. All disclosures, marketing brochures, and supplemental firm sheets are available upon request.