View From the Top
Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
View from the very top: making accurate predictions will likely be no easier in 2017 than it was in 2016. Rather, our focus is on fundamentals. A major shift is clearly underway, from a deflationary to reflationary mindset. This has clear implications for all asset classes. We caution, however, that this transition will not necessarily be linear. Its impact may also be significant, with the likelihood of both a boom and a bust in markets in the next year now looking plausibly high. Against this background, we return to two things: valuation and diversification: consider investments that look cheap (emerging market equities) and/or are highly uncorrelated (private market assets).
Equities: The current bull market in global equities now stands at 92 months, but has the potential to continue for some time longer, helped by a combination of the rotation out of fixed income and also improving earnings revisions. The prospect of higher rates should favour alpha strategies in general, but our preference is for value, which we see most strongly in emerging markets, but also in Europe (particularly when contrasted with the United States).
Fixed Income: The correction witnessed in bond markets since July 2016 has been abrupt, but it is far from over. Average corrections tend to last just under a year, while the context of a previous 30-year rally in bonds suggests that the shift away from fixed income could be secular in nature. At notably more elevated levels of yield than currently, Treasuries and other comparable debt would become attractive again, but for now we continue to avoid fixed income allocations.
Currencies: The US Dollar currently stands at a 14-year high and further strength in the currency is a very consensual view, especially if Trumpnomics delivers and the Federal Reserve moves towards a tightening regime. Consensual opinions can, of course, be the correct ones, but do not discount the possibility of mean reversion.
Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies and private asset classes in particular. Within this universe, we consider allocations to catastrophic reinsurance, infrastructure assets, direct lending and niche private equity to be attractive.
An incredible rotation
When investors look back on 2016 and consider fully what may have been the biggest event of a year which provided so much that was unexpected, it won’t be either Brexit or Trump’s victory that matter. Rather, it will be the date Friday 8 July, for it was then that the yield on 10-Year US Government debt reached a secular low of 1.35%, thus ending the 30+ year bull market in bonds. Today, debt of a similar maturity yields 2.43%.
In other words, in the space of less than six months, investors previously obsessed with secular stagflation and bond proxies have had to adjust to a world of rising bond yields and a potential monetary to fiscal shift. Thought of another way, there has been a marked move away from deleverage and towards releverage. Simultaneously, the seismic political swings that helped shape 2016 may well carry on into 2017, indicative of the realisation that, among other things, austerity does not work as a policy. By all accounts, this has been an incredible rotation.
Given where we have been for much of the recent past, the narrative of growth and inflation that is developing represents a still-novel concept. It will therefore take time for investors to adjust from a deflationary mindset to an emerging new reflation-oriented paradigm. However, the key thing to consider is how linear will be the shift and at what point may the resulting (and probably necessary) tightening in monetary conditions may push the cycle over. Maybe the key message worth emphasising is simply don’t get carried away. Do not forget that the absence of major news during the month of December has allowed for current optimism to propagate itself unchecked.
All may be well and good in the short-term. Indeed, three things suggest that the current rally can continue for some time longer. First, global industrial output (or PMI data) is at its highest in 2 years; next, earnings revisions across the world stand at their best in almost five years (according to Credit Suisse); and, finally, the bond market correction is only just getting going. Data provided again courtesy of Credit Suisse going back to 1990 show that the average length of a setback in the bond market is 11.2 months during which time there is typically a 182 basis point change in yield. Using 8 July as our starting point, then bond yields could still rise for around another 5 months.
This would take us neatly to the early summer. By then, it is very tenable that the initial optimism of 2017 could have given way to a more pervasive form of pessimism. It is a not inconceivable scenario to imagine the following: Trump’s reality when in formal office does not live up to the present hype and elevated expectation levels; a stronger US Dollar eats into US earnings momentum; the Fed begins to adopt a more hawkish note, yet is criticised by investors for being behind-the-curve; and, the prospect of material interest rate tightening looms large. In summary, the odds of both a boom and then a bust in 2017 currently look quite high. Investors should position appropriately.
How to position
The old rules no longer work. The returns investors historically enjoyed from a conventional portfolio of bonds and equities will be hard to replicate from a combination of the same assets going forward. Indeed, the Sharpe ratio (a measure of returns relative to volatility) from a 60:40 bond-equity portfolio in the last decade has been among the highest in the last 200 years. Average annualised real returns from these holdings were 9.1% from 2000-2015, almost double the level achieved during the 1900-2015 period, according to data from Goldman Sachs. Moreover, three of the four best decades for returns during this 115-year timeframe have occurred since 1980. Bonds have been both a key diversifier in portfolios and a major source of returns. It will be harder to make this case going forward.
With yields in the bond market now climbing, at the least, equities should benefit from flows out of fixed income. Even if the equity market is expensive, with the current global bull market having now endured for 92 months, the rally has the potential to continue for some time longer. History suggests that equities should continue to rerate until inflation reaches ~3% and/or 10-Year Treasury debt reaches ~3.5% (according to Credit Suisse). At this level, excesses tend to be present in the financial system; cycles rarely die of old age, but more as a result of a build-up of excesses.
Inflation, a word barely mentioned on these pages for the last few years, except when bemoaning its absence, is probably the single most important factor to consider. By inflation, we do not just mean headline figures, but also future expectations; this latter element matters, since expectations tend to feed on themselves, creating a potentially vicious circle. Pressures are already building. The Atlanta Fed’s national wage tracker highlights 3.9% current wage growth in America, its fastest pace since the recovery. It is hard to square the circle. If wages rise, then this eats into corporate profits, especially for those employers that lack pricing power.
Other factors represent a cause for concern. The price of oil, a consumer tailwind for much of 2016, now stands at an 18- month high. OPEC’s agreed supply reductions are also inherently inflationary. Meanwhile, factory gate prices in China, the world’s largest exporter, are now at their most elevated in two years. Finally, the charge can perhaps be levelled at the Federal Reserve that its stance is too complacent, being willing to allow inflation to overshoot rather than risking tightening too early. Of course, this is just how investors wanted the Fed to position itself six months’ ago; but now, with a Fund’s rate of 0.5% and core US inflation at 2.2%, the disparity is already wide, and one which may widen further.
Two logical conclusions present themselves. First, if you do want to be invested in equities, then now is a time for focusing on value. Value as a style may have rallied more strongly (according to Société Générale) since the election of Donald Trump than at any stage since March 2009 when the worst of the credit crisis was deemed to be over, but it has the clear potential to go further, especially given the still-pervasive deflationary and yield-oriented mindset of many investors. Next, in order to achieve those returns that investors historically enjoyed from bonds and equities, it is necessary to go beyond these conventional assets, by considering uncorrelated private assets in particular.
In terms of value within equities, our focus lies in emerging markets and Europe. For sure, emerging markets may continue to be pressured in the near-term by the strength of the US Dollar, but investors here have a relatively unique opportunity to acquire assets which offer a rare combination of cheap valuations, depressed currencies and positive economic fundamentals. Earnings revisions troughed across the region in February 2016 (according to Goldman Sachs), at which time the market traded on a Shiller (10-year average) earnings multiple of less than 10 times. Today, the comparable multiple stands at 11.2 times, still undemanding in the context of the market having reached a level of 13 times at the nadir of the 2008 financial crisis.
Finally, a word on Europe and politics. While political risk will likely remain a driver of performance in all asset classes, just as the market under-priced (or failed adequately to discount) scenarios of Brexit and Trump, so it may now be over-pricing the likelihood of a Eurozone collapse in 2017, with elections due in France, Germany and elsewhere. The opportunity cost for Eurozone countries to walk away from this union is significantly higher than for the UK, which has its own currency. Furthermore, should Trump be successful in reflating the US economy, then this policy will likely catch on in other countries too. As a strategy, it certainly works better than austerity. Even in its absence, the Eurozone should benefit from the major tailwind of a weaker currency, just as industrial output stands at a 5-year high and unemployment at a 7-year low. On a multiple of earnings, European equities trade on a 4-year relative low to American equities.
Alexander Gunz, Fund Manager, Heptagon Capital
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