UBS strategist Emanuel says Trump to spark a revival in active investing next year

Published Tue, Dec 6 20162:00 PM ESTUpdated Tue, Dec 6 20162:12 PM EST

The pro-growth agenda of President-elect Donald Trump will spark a revival in active investing, according to UBS equity and derivatives strategist Julian Emanuel, who shared his 2017 investment playbook with CNBC PRO. "The change in [market] psychology is very profound ... to us, it's essentially getting away from eight years of worrying about zero interest rates as the guiding principle for alpha generation, for searching for yield and for stock selection, which actually has also led to more passive investment," Emanuel said in the exclusive interview. In 2017 and beyond, however, a resetting of interest rates along with pro-growth economic policies proposed by Trump should result in investment opportunities for stock pickers. "The active managers that we speak with who've had their head down for the last several years are for the first time showing smiles on their faces. The game in our view has changed for the medium term," Emanuel said. In this in-depth conversation with CNBC's Mike Santoli , Emanuel, who has more than two decades of investment experience, also discusses: How to profit from changes in the investment landscape. The likely winners and losers from the rise in interest rates. The best sectors to own in 2017. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) Julian Emanuel is U.S. equity and derivatives strategist at UBS, responsible for S & P 500 index earnings forecasts and target prices. Julian has worked in the brokerage and asset management industries for more than 25 years. Prior to joining UBS in 2010, Julian worked at Tullett Prebon, where he specialized in equity and macro derivatives as a sales trader. Prior to that, Julian was a portfolio manager and chief risk officer at Tiedemann Investment Group in New York. He also began his career in the late '80s on the floor of the American Stock Exchange trading options. Julian holds an undergraduate degree from Emory University and an MBA in finance from NYU's Stern School of Business. And he joins us here at the NASDAQ to talk about his 2017 outlook and-- investment approach in general. So thanks a lot, Julian. JULIAN EMANUEL: Pleasure to be here. MICHAEL SANTOLI: You know, we now come into the end of this year, you know, what is it, almost eight years into a bull market in stocks. We have gotten used to the idea, at least until recently, of interest rates lower for longer. And it was a lot about watching the Fed. And then we get this sort of a change in the narrative following the election. So I don't know if it's the economic inputs and fundamentals have changed that much or if it's investors' psychology that's really taken a shift. But where does that bring us in terms of the 2017 outlook in your view? JULIAN EMANUEL: So the change in psychology is very profound, no question about it. To us, it's essentially getting away from eight years of worrying about zero interest rates as the guiding principle for alpha generation, for searching for yield, and for stock selection, which actually has also led to more passive investment, as well. To what is actually, when you look at past bull markets, much more typical. A more pro-growth type of environment, where the Fed, we can confidently feel, is going to hike in December and then hike a couple of times next year and into '18, as well. But essentially what that does is advance the narrative of the typical lifespan of the bull market. Because, at this time, when the Fed is going, we do expect to see the kind of growth that's been largely missing for a couple years. And clearly there's a lot of unknowns with respect to the Trump agenda. But if anything, the tail risks for growth and for earnings are now moving towards the upside. MICHAEL SANTOLI: It's interesting that we talk about it having been this slow growth environment, kind of a muddle through type macro environment, not just in the U.S., but really for the world. And yet, the more recent economic data suggests that we were actually hitting a little bit of a strong patch in the economy, right? In the third quarter, you had revised up GDP. Fourth quarter looked similarly okay. Consumer confidence, a lot of things look like they're moving in the right direction already. So what happens when you add, perhaps, some deregulation, some fiscal stimulus, and some tax cuts, if we get those under a Trump administration? JULIAN EMANUEL: Well, one of these hallmarks of what we call the late innings of bull markets is that you tend to get the type of enthusiasm that can often lead to overvaluation. And those are the kind of elements that cause that brew to start brewing. In fact, the consumer has been confident this entire time. The consumer has been the bedrock of not only the economy and the market for the last couple of years as we've navigated all this noise about international slowdowns and volatility and so on and so forth. But against the backdrop of higher interest rates, it really does set the stage, interestingly enough, for the potential for the saver who has been a very neglected part of this entire environment. The saver who may not necessarily be in stocks as much as your typical sort of middle-aged investor. They're going to start feeling more confident. Because they're actually for the first time in several years going to start earning interest on their savings accounts. And that could lead to greater spending in the year ahead. MICHAEL SANTOLI: That's certainly one of the benefits of somewhat higher interest rates. What does it mean for the other side of the equation, I guess? We have treasury yields, ten-year treasury yields that have taken a pretty sharp move up. It's still, obviously, not really up that much versus a year ago if at all. Are we in a zone here where yields can climb a good deal more without really impacting, you know, costs of businesses financing themselves and equity valuations? JULIAN EMANUEL: Well, we're in a sweet spot. But by definition, the concept of a sweet spot when you're into year eight of the bull market is it's a reasonably narrow sweet spot. So what we've seen over the last several months is more than likely a very major low in global bond yields in July. The ten-year touched about 1.35 percent as opposed to being a hundred basis points higher at the present time. To us, if you start edging towards 3 percent, which was the high of the taper tantrum back in 2013, that's where we get concern about the potential for that discount to choke multiples and, you know, potentially slow down economic activity below where expectations are starting to build in that kind of level. MICHAEL SANTOLI: It's interesting. That would seem to maybe restrain exactly how much the overall equity market price earnings multiple can get to, right? We're already kind of toward the upper end of the range, not really at extremes. But one storyline that's really taken hold is that a lot of these forces might be driving you back to the old game of figuring out, "Okay, which companies and which sectors are gonna have accelerating earnings?" And more picking stock by stock and sector by sector as opposed to, you know, just a straight up, "What's the Fed gonna do? And what do I pay for the S & P?" JULIAN EMANUEL: The active managers that we speak with who've had their head down for the last several years are for the first time showing smiles on their faces. The game in our view has changed for the medium term. You had a number of years where investment inflows have been concentrated into passive products, into low yield, low volatility products. And the turn in interest rates, again, has changed the psychology such that particularly what we've seen in the month following the election is a very deep rotation. Not only between sectors that respond to interest rates, but within the stocks themselves. And so from that point of view, we think fundamental doing your homework, picking stocks, and picking sectors is really gonna pay off in '17. MICHAEL SANTOLI: So where does that bring you, I guess, first in terms of S & P 500 targets, where you think we might be headed? And then what sectors to emphasize? JULIAN EMANUEL: So our year-end 2017 price target is 2,300. And basically that-- MICHAEL SANTOLI: That's for the S & P 500? JULIAN EMANUEL: Right. That's basically a realization that, you know, what we've seen so far in this first month is a lot of enthusiasm. But we have to temper the enthusiasm for what an incoming Trump administration can accomplish and the potential for earnings with the fact that we all know that Washington has tended to be a place where things can be difficult to get done. And that's particularly within the context of seeing rates rise and knowing the fact that we've got $19 trillion worth of indebtedness to the globe. And so the bond market at some point is going to limit what can be achieved in terms of economic stimulus. Where that gets us is a preference for financials. Very clear interest rate beneficiary play. The slope of the yield curve has gotten steeper. As well, when you think about it, and psychology and valuation in general are very important to us. The psychology with regard to financials has been so bad since the financial crisis that it's not even a question of whether Dodd-Frank could be repealed or the D.O.L. rules could be rolled back. It's just the notion that a Trump administration is likely to mean less regulation rather than more that's going to boost the valuation in financials, which has hovered, you know, really toward decade lows still, even with the rally. MICHAEL SANTOLI: Sure. JULIAN EMANUEL: Second sector we continue to like is technology. Technology has been a beneficiary and will continue to be a beneficiary, is a cash accumulating machine. Technology has the lion's share of the offshore cash that is likely going to be repatriated in the event that we see corporate tax reform linked with repatriation. That'll clearly undergird M & A and buybacks, which have been a very important part of this entire cycle. And by the way, valuation in technology, which tends to be a sector that can get overvalued toward the ends, is very reasonably valued and continues to be so. Last place that we do like, a bit controversial, health care. Health care has been the casualty of a year's worth of political volleying. Both candidates have at one point or another, you know, decided that they wanted to make changes. Incoming President Trump has basically, if you look at the rhetoric, rolled back his view on eliminating Obamacare entirely. And has also made the pledge to make sure that the 20 million people that are newly insured remain insured. And to us, when we look at the fact that health care is trading at a 25 year discount relative to the S & P 500 leads us to believe that there's a very good risk/reward opportunity in the year ahead. MICHAEL SANTOLI: And largely that discount seems to be skewed toward the pharmaceutical biotech stocks within it? Or is it just across the board? JULIAN EMANUEL: At the moment, that is the case. There were pockets of health care where investors hid. But basically, the pharma and biotech also were casualties of the idea that there's gonna be greater drug price regulation. And in reality, the lesson that these companies have learned over the last year is to implement an element of self-policing. So the largest companies aren't really egregious price gougers. They're really reasoned about it. And given the fact that the demographic tailwind for health care (you know, the aging of the baby boom) is very robust. And we think it's a great opportunity. MICHAEL SANTOLI: A lot of the things you're laying out in terms of, you know, the economy looking like it could kick into another gear perhaps, revival of corporate earnings growth, and this storyline that goes along with it, that there's actually something happening on the policy front that could push a lot of this stuff along. I mean, it could leave you taking in this idea that the economy might be running pretty hot. And individual investors might be chased out of bonds as yields go up and actually finally buy into the idea that the stock market could continue going higher. First of all, do you expect something like that to happen? And would this be a good time for that to happen? JULIAN EMANUEL: Well, historically, it would be a good time. But we have to temper our viewpoint on that. Because if you look at it factually, the Fed has done a lot of the asset allocation job for individual investors over the last eight years. So if you look at it, equity allocations, because of the appreciation in price alone, are at 20-year highs, whereas money market is naturally (given the zero interest rate regime) at 20-year lows. Bond allocation has remained roughly stable. We could see some money coming out of bonds and into stocks. But we wouldn't necessarily view that as, you know, sustainable in the long term. Simply because, again, going back to the demographics, the same reason we prefer health care, the typical investor is more likely to take profits and sort of reduce risk, while we wait for millennials to get more involved in investing. MICHAEL SANTOLI: What would be the main pitfalls you look for here? You know, you're somebody who comes out of a derivatives background, focused on potential risks and maybe shocks to the system. So is it just about, you know, a runaway increase in interest rates? Is it the dollar gets too strong? Is it kind of global asset market destabilization or maybe something on the trade front? I mean, all these things, I think, are floating out there. JULIAN EMANUEL: Well, and literally, given the fact that people's assumptions on earnings and the economy have actually become wider, more volatile, which is a good thing, because as we spoke about earlier, those are skewing to the upside. But there's also a bigger room for disappointment on literally any one of these issues. We as derivatives traders have been a proponent of watching the VIX. It's a very simple indicator. When complacency sets in and by the standards of the last five or six years, that would be a VIX sort of around 11 or 12. That's when we want to be a little bit more cautious. However, all of this sort of brew that we've been talking about does mean that there is a potential for that upside overshoot, particularly in the early part of the year, before the reality of the limits of what a new administration can accomplish, perhaps. MICHAEL SANTOLI: So that upside overshoot would basically be, you know, all these things coming together or we're kind of gonna give the administration credit for getting some things done. And maybe you also have a tailwind of better growth. And the S & P just kind of, you know, accelerates to the upside? JULIAN EMANUEL: 2,500 is sort of a level that we would see that if you look at our earnings estimates, which calls for around 5.9 growth in 2017, gets you to around a 20 multiple, which has been a place where prior bull markets have tended to peak out in terms of their valuations. The good news of that is if we're wrong about our earnings estimate and there's upside, those levels could be sustained. MICHAEL SANTOLI: Do you think we're gonna be talking at all soon about the possibility that, you know, the Fed might have moved too slow or they might be at risk of being behind the curve here finally? JULIAN EMANUEL: Well, every time we talk about it, it seems to get shot down. You know, whether due to exogenous events or, you know, just rhetoric itself. Our view is the Fed is going to continue to it's measured. They may drop the reference to data dependency. Because in point of fact, the incoming data as you mentioned has actually pointed towards the need to be more aggressive. But we do think they will stay tempered. And you do perhaps at some point run the risk that the Fed will need to be more aggressive. We'll be looking at the long end. If we start moving towards 3% while the Fed doesn't, you know, completely signal exactly where they're going, there does need to be that element of uncertainty. It's been part of what Chair Yellen has basically said is required when you have a task like the Fed does, normalizing, looking at this enormous balance sheet that has to unwind at some point. And we think it'll start unwinding in mid-'18. But there is an element of surprise that actually is a positive for markets. Because when markets are not sufficiently volatile and there's complacency that sets in, whether it's in regard to the Fed or policy or earnings, that's when investors tend to be surprised to the downside. MICHAEL SANTOLI: Sure. What about the idea of this yield trade? So if you're looking for 3% maybe to be some kind of ceiling-- does it mean it's gonna give you a chance to buy these dividend sectors? Or would you just sort of avoid them in general? JULIAN EMANUEL: (SIGH) We continue to be cautious on the yield sectors, simply because in our experience of trading the markets, when you get to valuations, which we got to this summer, when you saw the low in global bonds, that kind of valuation disparity particularly against the rest of the market doesn't clear up overnight. And frankly, the fact that utilities and the other defensive sectors more or less went sideways as the rest of the market rallied in the last several months, the pain hasn't been felt sufficiently. And if you look at it, while we don't specifically think that yields are likely to shoot higher on the long end, there's no question about the fact that what's happened is with the incoming administration and the data improvement that we've seen that the risks are now asymmetric to the upside. And that's gonna keep restraint on defensives performance. MICHAEL SANTOLI: You alluded to, you know, when it comes to the Fed outlook, the possibility of these kind of global events, something, some kind of shock out there that might knock them off course or maybe has a reset effect. What do you think an investor's approach ought to be in terms of the global markets right now? I mean, U.S. has had such great outperformance. Do you actually think that that can be sustained? JULIAN EMANUEL: Well, look, so this entire environment has not been one of, you know, incredibly strong returns, year in, year out. It's been three yards in a cloud of dust essentially in football terms. And that's what we're seeing this year. And that's more or less what we expect next year. Any portfolio at this point should probably have an allocation to international exposure. Our firm, UBS, prefers Europe at this point simply because the elements in place for an earnings rebound in Europe, particularly relative to the earnings trajectory in the U.S., are very appealing. And the valuation, as you said, after years of underperformance, is quite compelling. So the risks, which we all know, politically, you know, whether it's France or Germany or Italy or what have you, they're known. And they certainly could be a surprise. But we do believe they're reasonably fully discounted. MICHAEL SANTOLI: Yeah, I mean, and this interestingly has been a year of intensely anticipated, possibly scary events that once they come don't really create lasting damage, right, whether it's the Brexit vote or the election, in this case? JULIAN EMANUEL: It is truly incredible. And our experience in the derivatives markets really stood us well. Because what we saw prior to the U.K. referendum was this intense hedging, whether it was in the currency markets or, you know, the bid to S & P put protection or what have you that really led us-- MICHAEL SANTOLI: Or the VIX futures and exchange rated products themselves, right? JULIAN EMANUEL: The volumes in those products was absolutely off the charts. And, again, very strong into the U.S. election, as well. And when we see that kind of emotion taking over the logic in an environment where arguably multiples are stretched by the standards of the last eight years, but by the standards of prior tops and by the standards of the fact that you're still only at a 2.3% yield in the ten year. You know, that kind of emotional response was something that we felt, you know, investors were provided with an opportunity much the same way they were provided with an opportunity in the summer of 2015 off of the Chinese FX evaluation, which again was very emotionally driven. And this kind of environment is typical of late stages. Emotionally driven with opportunities for those that are patient and have a balance attitude. MICHAEL SANTOLI: Yeah, I guess the opportunity to buy fear is one that people have to learn to embrace once in awhile. And just on that point before we finish up, we like to ask about some lessons that you've picked up over the years or things that you really feel like you should have to keep an eye on as you go through these cycles. What would it be when it comes to the way investors deal with those emotions? JULIAN EMANUEL: Well, so the most important thing in our view is for an individual to know him or herself. You have biases, an individual. You may be more or less risk averse. You may be conscious about, you know, what your friends down the block are doing and saying about the markets. And certainly in the environment of 2016, you can fall prey to what you see on the television. And what we would say there is it's very important to know where your weak spots are. If the market's down 10% and you're feeling nervous, you shouldn't be as exposed to equities in the first place. What you want to do is, again, have a psychological setup to buy fear. And which we think might happen some point in the next year or two, because we are in fact eight years into the bull market. There may be an element of selling into greed, as well. Very important to stay balanced. MICHAEL SANTOLI: All right, Julian, thanks very much. Appreciate your time. JULIAN EMANUEL: Thank you. MICHAEL SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

"The change in [market] psychology is very profound ... to us, it's essentially getting away from eight years of worrying about zero interest rates as the guiding principle for alpha generation, for searching for yield and for stock selection, which actually has also led to more passive investment," Emanuel said in the exclusive interview.

In 2017 and beyond, however, a resetting of interest rates along with pro-growth economic policies proposed by Trump should result in investment opportunities for stock pickers.

"The active managers that we speak with who've had their head down for the last several years are for the first time showing smiles on their faces. The game in our view has changed for the medium term," Emanuel said.

In this in-depth conversation with CNBC's Mike Santoli, Emanuel, who has more than two decades of investment experience, also discusses:

How to profit from changes in the investment landscape.
The likely winners and losers from the rise in interest rates.
The best sectors to own in 2017.

PRO subscribers can also read the entire transcript of the exclusive interview below.