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: 2017 could still be the year in which markets experience both a boom and then a bust. Equities have rallied and bond yields compressed, but there are clear signs of excess building in both markets. Risks are compounded since the likelihood of the sponsors of this rally (Central Banks) committing a major error seems to have grown. The dichotomy between macro data and policy action is widening, and tightening against a backdrop of potentially worsening economic fundamentals can only likely end badly in our view. We continue to use valuation as our compass through these challenging conditions, favouring undervalued equities (especially in emerging markets) over fixed income, and private assets above both. There is also good logic in running with higher cash balances during what could be a potentially volatile summer period.

Asset Allocation:

• Equities: With c10% gains in H1 and c15% returns over the past year for global equities, there is a case for tactically taking some profits, particularly ahead of the second quarter reporting season which may struggle to keep pace with the momentum achieved in the first. Nonetheless, equities remain clearly more attractive than fixed income on valuation grounds while still-positive earnings momentum could drive stock markets yet higher. Our preference is for investing in businesses in undervalued regions (emerging markets especially) and focusing on distinct alpha-generating strategies.

• Fixed Income: A scenario of lower government bond yields and a flatter curve may have further to play out (particularly in the US) as investors continue to price an outcome of possible policy error. In more general terms, most fixed income assets globally appear fundamentally unattractive to us, particularly from a valuation perspective. Yields would need to be notably higher than present for us to consider revisiting meaningfully the asset class.

• FX: The Dollar stands at an eight-month low relative to other global currencies, while the Euro is at a one-year high. Over time, currencies have a tendency to mean-revert. We remain sceptical about the case for imminent reflation (despite current Central Bank rhetoric) and expect most policymakers still to have a bias towards weaker currencies. Note, current Dollar weakness/Euro strength also has near-term implications for the earnings of listed exporters.
• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies, and private asset classes in particular. This is one of our highest conviction views at present. Within this universe, we consider allocations to catastrophic reinsurance, infrastructure assets, direct lending and niche private equity to be attractive. Such assets provide diversification and allow investors scope to harvest illiquidity premiums.

How long can animal spirits drive the current cycle?

This has been the key topic on our mind for some time. Indeed, in our first View of 2017, we posited a scenario in which the year could be characterised by both a boom (in the first half) and then a bust (in the second half) in equity markets, with clear implications for all other asset classes too. Six months on, our conviction in this scenario remains broadly undiminished although our reasoning for such an outcome has shifted somewhat. Back in January, we imagined that the post-election rally would wane as Donald Trump increasingly disappointed investors by a lack of concrete policy action (this has been true, although expectations are now, of course, much lower), yet that the strength of the US economy and the Dollar might put the Fed in such a position that it would be perceived as being behind the curve by the investors.

As we approach the ‘dog days’ of the summer (a time the ancient Greeks and Romans both believed was characterised not just by thunderstorms, lethargy, fevers and mad dogs, but also by bad luck), our concerns have shifted. Indeed, economic data have generally disappointed (especially in the US) and our concerns now relate to the risk that the Fed may be committing a policy error by tightening too rapidly – this is certainly what the bond market seems to believe. Meanwhile, we see clear signs of excess building across markets. If – as we have characterised in previous commentaries – a fear of missing out has been responsible for driving (equity) markets higher, when the correction comes, its impact could be severe. Investors would need to go back to January 2016 to find the last time that there was a greater than 5% monthly drawdown in global equities. Since then, the MSCI World has delivered annualised returns equivalent to 19%, with volatility of just 7%. This implies a Sharpe ratio of 2.6 – implausibly high, and hence most likely unsustainable in our view.

Other signs of excess

If a global equity index with a Sharpe ratio of 2.6 were not concern enough, then there is a multiplicity of other factors that also worry us, both in the equity and fixed income markets. Taking equities first, we note how growth and momentum as styles have markedly outperformed value. The price momentum index in the US is, for example, currently overbought by a multiple of more than two standard deviations (per Credit Suisse). Nowhere is this perhaps more prevalent than within the technology sector. We have observed tech fund inflows rising at their fastest annualised rate in 15 years (per BofAML), while the market capitalisation of Facebook is currently bigger than that of MSCI India! A recent visit by your author to Silicon Valley in California also confirmed that sentiment/euphoria there was not dissimilar to levels last witnessed in 1999.

Turning to the fixed income market, bond issuance is at a record high. We wonder how many investors see merit in owning a 100-year bond issued by the Argentinean Government, even with a c8% yield. For reference, the country has defaulted six times in the past 100 years. Elsewhere, we see European banks looking to securitise direct credit lines. If this isn’t 1999, then it’s 2006. Animal spirits are back. No wonder Janet Yellen has described current asset valuations as ‘frothy.’ However, this observation by the Chair of the Federal Reserve’s Board of Governors is not without some irony, since the Fed, along with the world’s other major Central Banks, has been the de facto sponsor of the current rally. All we know is that recessions are normally a function of a build-up of excesses – the internet (1999), housing (2006) and now potentially Central Bank largesse. For context, Central Banks globally own c$18trillion of bonds, equivalent to around one third of those traded worldwide (per JP Morgan). Unwinding this will likely be painful and complicated.

Much scope for policy error

Relative to a year ago, all the world’s leading Central Banks are now either actively tightening policy, setting the groundwork for doing so or reducing stimulus. The question is whether this can be achieved without any mishaps in either financial markets or the global economy. History would argue against a successful execution and it is worth bearing in mind just how small the margin of safety is currently, given both valuation levels and the febrile political environment. Our concerns relate primarily to the US, the world’s biggest economy. What happens here has clear implications for all asset classes globally.

At present, the Federal Reserve and investors seem to stand at polar opposites. Take the data: it does not look compelling. Personal consumption expenditure (a proxy for inflation) has only hit the Fed’s target of 2.0% in one month over the last three years, while on a three-month rolling basis, the figure of 0.1% for the time to the end of May ranks as the third lowest ever (behind the post-Lehman and post-9/11 periods). We also observe the emerging bear market in oil – a function of a supply gut. This is inherently deflationary. Similarly, the current bull market in technology could be taken as an effective endorsement of deflation. Since tech productivity continues to rise at an incredibly high rate, prices continue to fall. The cost of 1MB/s of storage has, for example, dropped from c$250 in 1990 to less than $0.01 today. Nonetheless, the Fed not only raised interest rates in June, but seems set to hike again in September, a time when it may also start unwinding its balance sheet.

This dichotomy – the Fed seemingly seeing something that the market does not – has led to real rates moving higher, while US inflation break-evens are simultaneously moving lower. The five-year break-even rate (i.e. where investors discount inflation will be in five years’ time) is now 40 basis points lower than it was at the start of the year. This is a bad outcome for equities relative to fixed income (and indeed for the average consumer) as inflation is going lower, but the rate at which money can be borrowed is moving higher. In other words, financial conditions are tightening against a backdrop of worsening economic fundamentals. Don’t forget household debt in the US is now higher than its was in 2008 (per the Fed’s own data), while national bank credit card defaults are at a 46-month peak (per Experian). We have also written previously about concerns over US auto finance. Here, it might be worth pausing to wonder what the Fed may see that investors do not. A cynical response could be that Central Banks are tightening into deflation simply to have the flexibility to loosen again in 2018. For now, at least until better data are forthcoming, the Treasury market will continue to trade as if the Fed is making a grave policy error.

Use valuation as your compass
We have said before and will repeat again, the only strategy that really works is buying cheap assets. US equities (in general terms) certainly do not fall into this category. We make this assertion considering not only Shiller P/E or other relative valuation metrics, but also taking Warren Buffett’s favoured approach of comparing the S&P’s total market capitalisation to US GDP – which is currently at its second most expensive level in history (1999 being the other). Even if bond yields may compress further, fixed income can hardly be seen to constitute an attractive asset class given that the bull market here has endured for substantially longer than that of the current equity cycle. Against this background, our preference is to consider emerging market equities (trading at a c30% discount to developed world markets on forward earnings, per Bloomberg) among liquid assets, but also to reiterate the case for private, uncorrelated assets. Finally, with the ‘dog days’ soon upon us, raising cash now and preserving it for subsequent opportunities constitutes a strategy which we would be hard-pressed to dispute.

Alexander Gunz, Fund Manager, Heptagon Capital