Beyond Bulls & Bears Bulletin - INSIGHT FROM FRANKLIN TEMPLETON INVESTMENTS MANAGERS
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2013
30 October 2018
Beyond Bulls & Bears Bulletin
INSIGHT FROM FRANKLIN TEMPLETON INVESTMENTS MANAGERS
IN THIS ISSUE: The articles in this issue are as at 30 October 2018.
What’s Next for President-Elect Bolsonaro in Brazil?: Jair Bolsonaro emerged victorious in Brazil’s presidential election, an outcome that markets had largely priced
in, according to Frederico Sampaio, chief investment officer, Franklin Templeton Emerging Markets Equity Brazil. He says Bolsonaro now has his work cut out for him in
addressing an economic recession, closing a fiscal deficit and stamping out corruption.
A View from Mexico on a new North American Trade Pact: A new historic agreement to replace the North American Free Trade Agreement (NAFTA) was recently
struck between the United States, Mexico and Canada. Timothy Heyman, Ramsé Gutiérrez and Jorge Marmolejo of Franklin Local Asset Management Mexico answer
some questions about the implications of the new agreement for the country.
A View from Canada on the New USMCA: After more than a year of tense talks, Canada, Mexico and the United States have replaced NAFTA. Franklin Templeton
Multi-Asset Solutions’ Stephen Lingard gives his take on the new trilateral trade pact and explains why it could benefit select Canadian companies.
What’s Next for President-Elect Bolsonaro in Brazil?
Fred Sampaio, CFA
Chief Investment Officer
Franklin Templeton Emerging Markets Equity
Brazil
The Brazilian stock market’s rise after the first-round election That type of messaging is what the market wanted to hear, and
results—even in the middle of a profit-taking environment in the Brazil’s equity benchmark, the Ibovespa, began to rally when the
US markets—reflected investors’ optimism about a more polls started to indicate Bolsonaro was ahead.
market-friendly policy approach should Jair Bolsonaro be
elected as president. Looking forward, we think the local scenario should be extremely
positive for earnings growth and for the Brazilian equity market
Now confirmed as the winner, Bolsonaro faces the task of generally. The new composition of Brazil’s Congress—with
turning Brazil’s economy around and restoring confidence. conservative members gaining representation—should provide
Apparently, voters felt it was time for a dramatic change. him a reasonable base to secure approval of the measures he
pledged, including privatisations and reforms.
To voters, Bolsonaro’s rival, Fernando Haddad, ultimately
represented a continuation of prior policies that led to Now that the political uncertainty is settling, we think the risk of a
mismanagement of the economy, including a large fiscal deficit. U-turn in the actual conservative economic policy represented
While Haddad’s Workers Party was linked to corruption by the Workers Party, which had dominated Brazilian politics for
scandals, Bolsonaro grew in popularity in part as a result of his many years, will be removed. We think there should be a more
anticorruption rhetoric. positive climate where consumer and business confidence can
pick up again and lead to an acceleration in domestic economic
The Brazilian people have expressed their wishes for change activity.
and reform by choosing Bolsonaro, whose Social Liberal Party
was largely unknown before. The local market is trading at what we view as reasonable price-
earnings levels and should have more scope for improvement as
Bolsonaro gained some additional credence with his pick for the economic situation improves, though much of the positive
finance minister, renowned liberal economist Paulo Guedes, news has been priced in. After a recession which saw Brazil’s
who is a graduate of the University of Chicago. Guedes’ gross domestic product (GDP) growth decline more than 3% in
speeches have been in line with a more pro-business, market- 2015 as well as in 2016, we think there is a large margin of
friendly approach. He has spoken about the need to privatise, spare capacity to accelerate growth without inflationary
aggressively reduce the fiscal deficit and improve the efficiency pressures.
of the economy.What’s Next for President-Elect Bolsonaro in Brazil? – continued
When confidence is restored, we think there is a lot of room for Wider Global Implications
upward GDP growth. While the media has portrayed Bolsonaro as an extreme right-
wing candidate because of some of his social policies, the left-
A Big Challenge for Brazil: Pension Reform wing Workers Party, which dominated Brazilian politics, was
We see pension reform as the biggest challenge or economic more aligned with dictatorships in Latin America, a policy
worry for investors. Brazil has one of the most generous pension dubbed “South-South Cooperation.” That policy didn’t prove
systems in the world, particularly for public employees, who can fruitful for Brazil.
retire below the age of 60 and can collect nearly their end-of-
career full salary. Outgoing President Michel Temer tried to pass Bolsonaro has stated a desire to visit Israel and the United
reform, but didn’t have the ideal political conditions to do so. States as his first two trips outside the country. He wants to
increase trade, reduce import taxes and open up the economy.
Wages and pensions account for a large part of government He wants to open up trade with the United States and with
spending, and pensions are adjusted by the minimum wage, Europe, which is a contrast to prior administrations that lost out
leading to an increasing spending as a percentage of the in terms of global trade as a result.
country’s GDP. So, the reality is that the retirement age probably
has to be increased and the generous public employees’ I’m optimistic about Brazil’s prospects considering the state of
conditions should be revised. the economy and the market, but we shall have to wait and see
whether Bolsonaro’s campaign promises actually become policy.
The market expects pension reform to pass under the next He has not historically voted for conservative economic
president. Bolsonaro has talked about this, but as they say, the measures during his terms as congressman and hasn’t been
devil is in the details, and for now, we don’t have many. The tested yet, so there is still some uncertainty. But in our view,
good news is that the elections saw a larger contingency of his Brazil has a lot of upside potential.
supporters represented both in governorships and in Congress,
so he should have the ability to gain support to make changes. We will probably see a bit of a honeymoon phase until the end of
Brazil’s parliament will now be more conservative than the prior the year as Bolsonaro lays out his plans and makes
one, which should help reforms pass, including more appointments. Next year, it’s all about implementation, and we’ll
privatisations. Maybe not the state-owned oil company, be watching.
Petrobras, but other smaller companies will likely be targets.
And as noted, Guedes has championed fighting the deficit,
improving the efficiency of the state-owned companies and
lowering corporate taxes.
A View from Mexico on a new North American Trade Pact
Timothy Heyman, CBE Ramsé Gutiérrez, CFA Jorge Marmolejo, CFA
Chief Investment Officer Vice President, Portfolio Manager
LAM Mexico Portfolio Manager LAM Mexico, Fixed Income
Franklin Local Asset LAM Mexico, Fixed Income Franklin Local Asset
Management Franklin Local Asset Management
Management
Q: How much of a surprise was the news of the US-Mexico- must be approved by the legislature in each country. It seems
Canada deal? likely that the Mexican and Canadian legislatures will approve
the deal. However, there is a residual risk that, if the Democrats
A: It was hoped that a new deal would eventually emerge as the were to win a majority in either the House of Representatives or
North America economic zone is too important in terms of the Senate (or both) in the November US midterm elections, they
global economy (representing 28% of global GDP1) and also could oppose the deal, with the possibility that the desire for
geopolitically for the United States. However, it was a surprise political vengeance against Trump outweighs the obvious
that the revised 30 September deadline to renegotiate NAFTA economic advantages of the arrangement, especially as the US
was met in the 48 hours of the weekend 29–30 September. seems to have scored some points in the renegotiation.
Canadian Prime Minister Justin Trudeau had stated that Canada
“would take as long as necessary in a bid to negotiate a new Q: What, in your view, are the potential investment implications
NAFTA deal,” which, together with his known mutual antipathy for Mexico of the new deal?
with Trump manifested in the G20 meeting in Canada, lowered
the probability of it happening by then. A: Since Trump was elected in November 2016, Mexican
investments have been more volatile due to the possible end of
Meanwhile, it should be understood that the deal has only been NAFTA, which he had threatened during the campaign. NAFTA
approved by the executive branches of each government and transformed the Mexican economy, resulting in an increase in
Beyond Bulls & Bears Bulletin 2A View from Mexico on a new North American Trade Pact – continued
annual average foreign investment in Mexico from US$4 billion the end of the global economic cycle, with the emerging-market
per year up to 1993 to US$20 billion in subsequent years since selloff reflecting a normal part of the cyclical sequence. The
NAFTA’s implementation on 1 January 1994.2 canary in the mine, if you wish.
The Mexican peso has been the most affected asset, reaching Coming back to Mexico, during the transition period, while most
an intraday low of 22 MXN/USD after Trump’s victory. Since members of the incoming government have expressed
hitting that low level, the peso has strengthened, reaching a high
themselves generally in favour of USMCA, there have been
of 18.5/USD just after the deal was announced. This has made it
one of the best-performing currencies against the US dollar in mixed signals in various aspects:
2018, as it began the year at a level of 19.66/USD.3 • The leadership style of the next president, Andres Manuel
López Obrador (AMLO), showing much more concern for,
The asset class most directly related to NAFTA is Mexican real and knowledge of, politics than economics. In his only
estate investment trusts (REITs; Fibras in Spanish) because prior experience of government, as mayor of Mexico City,
many important REITs hold industrial property with tenants he was generally pragmatic. However, many in Mexico
closely linked to the supply and logistics chain between Mexico,
argue that the presidency of a country is very different
the United States and Canada, related most notably to the auto
industry. It is significant that so far this year, Fibras have and that with his talk of a “Fourth Transformation,” AMLO
outperformed stocks. has set his goals far higher.
• The lack of homogeneity in his already announced
Assuming the deal is ratified, probably at some date during government team, composed of a mixture of technocrats
2019, we think the investment implications for Mexico are with party zealots.
generally positive, as it implies a continuation of the stable
• Macroeconomy. It does not seem that the programmes
conditions of economic integration that have underpinned
Mexico’s economic, industrial and commercial progress over the and policies announced so far can be fully financed
last 24 years. In addition, after 24 years, NAFTA has been without producing enormous disequilibria.
modernized and adjusted to changing circumstances, with new • Microeconomy. There appear to be moves to reverse
sections that were not included in the original treaty spanning: structural reforms made under this administration which
energy, e-commerce, corruption, environment and labour, could undermine confidence in the business sector.
although some critics complain that the modernization did not go
far enough.
US Federal Funds Target Rate vs. Mexico
For specific investments, in our view, this would mean a Overnight Target Rate
stronger peso, which has been chronically weak since the 1 October 2015–28 September 2018
Trump election. While the full details of the agreement have not
yet become available, we would assume that Mexico’s industrial,
financial and commercial sectors should be beneficiaries, with
(%) (%)
REITs, for the reasons mentioned above, standing out.
10 6
The political aspects should also not be ignored. With its first 9
openly socialist government since World War II, which also has 8
majorities in Mexico’s House and Senate and at the state level, 7 5
the legal, economic, and financial framework provided by 6
USMCA could provide an institutional counterweight to the new
5 4
government, offering more confidence to investors.
4
3
Q: From what you’ve read so far, are there any aspects the 3
media may have missed about this deal that you think investors 2
should be aware of? 1
0 2
A: What has been missed by the foreign media, as far as we Oct 2015 Apr 2016 Oct 2016 Apr 2017 Oct 2017 Apr 2018 Sep 2018
can tell, is that, now that the risk of NAFTA has been (most
probably) eliminated, focus has now switched to what are US Mexico Spread
considered by many Mexicans to be the potential risks of the Source: FactSet. Data as of 28 September 2018. The chart is for illustrative purposes
incoming administration. only and does not reflect the performance of any Franklin Templeton Fund.
Q: Have the risks to the economic (or political) outlook tilted Q: The US Federal Reserve (Fed) raised interest rates for
more positively after this news?
the third time this year in September, and one more rate hike
is anticipated this year. In your view, can Mexico and
A: In general, yes, for all the reasons mentioned above: stability
and continuity. It is possible that the three USMCA countries will emerging markets in general weather rising US interest
adjust over time to the new rules, and that the damaging steel rates?
and aluminium tariffs will be reduced over the short term.
A: In recent years, interest rates in Mexico have risen faster
However, it is significant that, 10 days after the deal was than in the United States due in part to NAFTA uncertainty,
announced, the peso and the stock market had actually
especially to retain foreign financial investment in Mexican
weakened. Some of this weakness may be due to global factors
as well, especially if we take into account that we seem to be at government debt, where it reached a maximum level of 38%
of the total. It has more recently fallen to 31%.
Beyond Bulls & Bears Bulletin 3A View from Mexico on a new North American Trade Pact – continued
Mexico’s benchmark short-term rate increased from 3% to Mexico Official Overnight Closing
7.75%, while the Fed’s benchmark rate increased from 0.25 to Government Rate
2.25%. It is possible that with NAFTA uncertainty reduced, 31 January 2006–30 September 2018
Mexico’s central bank may not see the need to raise rates, even
if the Fed keeps tightening. However, if another emerging (%) (%)
market has a crisis, Mexico may be affected by short-term
10
contagion. More importantly, much depends on the resolution of 3.5
the conflict between the technocrats and extremists in the new
8 3.0
government, and the resulting competence and coherence of its 2.5
economic policies.
6 2.0
1.5
4
1.0
0.5
2
0.0
0 -0.5
2006 2008 2010 2012 2014 2016 2018
Overnight 10-Year Yield Term Premium
Source: Bloomberg. Data as of 30 September 2018. The chart is for illustrative
purposes only and does not reflect the performance of any Franklin Templeton fund.
A View from Canada on the New USMCA
Stephen R. Lingard, MBA, CFA
Senior Vice President, Portfolio Manager
Franklin Templeton Multi-Asset Solutions HOW USMCA DIFFERS FROM NAFTA
• Tighter country of origin rules—especially tough on
the auto industry.
• Minimum level of input from factories paying
workers US$16+ an hour.
• Deal will be reviewed in six years and will take
effect for 16 years.
• Improved access to the Canadian dairy industry,
but on terms similar to those of the Trans-Pacific
Partnership and Comprehensive Economic and
Trade Agreement.
On 30 September 2018, Canada and Mexico reached a last-
• Overall, balanced, with restrictions on trade and
minute deal with the United States to replace the 1994 North investment in some areas (autos) but relaxation in
American Free Trade Agreement. others such as agriculture and technology.
We think the new United States-Mexico-Canada Agreement Sources: Office of the United States Trade Representative, Export Development
Canada.
averts the worst fears of a breakdown in trade relations between
the three countries and potential disruption to regional supply
chains. As we mentioned earlier this year, the protracted In our view, the new North American trade deal is neither
renegotiation process posed threats to the North American auto especially good nor bad for Canada and Mexico. But the fact
market in particular. that it clears away some of the uncertainties is positive, in our
eyes. This new deal may support capital expenditure and
At right are listed some of the main differences we see between remove a headwind from future growth.
NAFTA and USMCA:
However, the path to this agreement included threats, tariffs and
sanctions, which are not generally part of the normal course of
negotiations.
Where was the collaboration within established institutions? The
lasting damage to trust and mutual respect has created a
challenging environment. We think this will heighten concern in
Beyond Bulls & Bears Bulletin 4A View from Canada on the New USMCA – continued
Canada and Mexico about being so dependent on one trading Investment Implications
partner. And it may push those countries to start looking at
We think the conclusion of trade negotiations is a positive for
trading opportunities further afield.
Canada as it removes a cloud hanging over the economy and
adds to other shorter-term tailwinds supporting cyclical activity.
Who won in the stand-off? Canada initially stepped back from
However, some deceleration in the pace of Canada’s GDP
the negotiations. After the United States agreed to a deal with
growth is still anticipated in 2019.
Mexico, Canada came back to the table. But would a US-Mexico
bilateral deal have ever passed in the US Congress? The depth
For global portfolios, we maintain a slightly cautious stance
of the integration of the United States and Canada supply chains
towards Canadian bonds.
seems to have been enough to persuade the United States to
make critical concessions at the last minute.
The uncertainty around trade had previously been cited by the
Bank of Canada. With that uncertainty removed, we expect that
Or was it just that the United States decided to narrow the trade
it will continue to raise interest rates.
war, and fight on one front (at a time)? Initiating talks with other
long-term allies such as Japan and the European Union
We see select opportunities in Canadian stocks, with financials
suggests that the United States is summoning all its energy for
likely benefitting from a rising interest-rate environment and the
the bigger fight, with China. As the chart below shows, these
energy sector benefitting from higher crude oil prices.
countries and the European Union have been the top US trading
partners over the past 10 years.
The Canadian dollar might benefit from these trends as well.
Top US Trading Partners
Total Sum of Import and Export Goods
2008–2017
4500
4000
3500
3000
Export (Billions $)
Canada European Union
2500
2000 Mexico
1500
1000 China
United Kingdom
Japan
500 Taiwan Korea, South
Brazil
India
0
0 500 1000 1500 2000 2500 3000 3500 4000 4500
Import (Billions $)
Source: United States Census Bureau. Data as at 18 June 2018. Sizes of the series indicates the US total trade with the country from January 2008 until December 2017.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up,
and investors may not get back the full amount invested. Investments in foreign securities involve special risks including
currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets
are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size,
lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these
frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for
extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in
frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular
industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as
prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.
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1. Source: World Bank, as at 2017.
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