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: something is going to break. A macro environment of improving growth yet still very benign monetary policy is helping to push equity markets higher and bond yields lower. We do not believe this is sustainable, particularly against a context of demanding valuations for both asset classes. Several factors both market-based (narrower equity breadth and a flattening yield curve) and structural (high debt, poor productivity) concern us. Valuation provides the best compass through the current field of conflicting signals. We favour undervalued equities (especially Europe and emerging markets) and continue to advocate strongly the case for increasing diversification levels across portfolios, particularly towards private assets.

Asset Allocation:
• Equities: Robust economic growth and positive earnings momentum (the best in six years, globally) should continue to be very supportive for equities, particularly at the expense of fixed income. At the same time, the risk of a short, sharp correction in markets cannot be ruled out. The logic, therefore, in taking some profit from recent gains is strong. Our preference is for investing in businesses in undervalued regions (Europe and emerging markets especially; Japan to an extent) and focusing on alpha-generating managers with distinct strategies.

• Fixed Income: Government bond yields have continued to weaken, but despite this trend we see most fixed income assets as being fundamentally unattractive, particularly from a valuation perspective. At notably higher levels of yield than currently, Treasuries and other comparable debt may become compelling – but we do not see major evidence for upward pressure in the very near-term.

• FX: We have no active views in this space at present. Even if the Dollar currently stands at its weakest level since the US Election, we note that other currencies (particularly the Euro) appear still relatively undervalued on a purchasing power parity basis. Longer-term, we believe that a race-to-the-bottom remains the default strategy, with policymakers seeking to prefer weaker currencies.

• 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.

Come St. Leger Day on 16 September, we will know whether the much-invoked strategy of ‘selling in May’ has worked. Its track record of predictability is, at best, mixed. And, clearly having adopted such an approach in the past month would have been unhelpful. Equities continues to march relentlessly higher. At the same time, however, bond yields are continuing to weaken. That bonds and equities appear to be discounting divergent of the global cycle strikes us as a major discrepancy. At some stage, it must break, we believe. Knowing when, of course, is a lot harder.

Few would disagree with the assertion that relative to a six months ago, the investing outlook appears structurally much more positive. In other words, global growth has accelerated, especially in emerging markets. Similarly, earnings growth has improved in every region globally. At the same time, there has been no European political crisis (yet) while Donald Trump’s policies have not been perhaps as bad as feared, especially given the absence of increased protectionism. Beyond the above, as we described in last month’s commentary, a fear of missing out is also helping to drive equities higher, particularly since the best returns often come at the end of market cycles. At the same time, owning fixed income in such an environment can be seen to make sense, especially if it constitutes a hedge; or, less charitably, an indication of investor uncertainty.

Perhaps the most coherent explanation for what is currently going on can be found in the idea that the macro environment constitutes the best of all worlds – if a combination of improving earnings growth and only gradual monetary tightening can be sustained for some time longer, then both equities and fixed income may be able to deliver further returns. The statistics paint a compelling picture: earnings globally saw their strongest set of quarterly results since 2011 (per Morgan Stanley), while 2017 is set to be the first year since 2010 when all major regions post positive growth, a phenomenon that has only occurred seven times since 1990 (based on data compiled by Citi). Moreover, one contributory factor behind such strong earnings growth has been the fact that labour has gained less pricing power than would be normal for this stage of the cycle. Put another way, the absence of upward pressure on wages has allowed not only profits to grow, but also has helped put a cap on bond yields.

However persuasive these observations might be, it is important to guard against complacency. This matters particularly in the context of volatility being so low. Indeed, only 0.13% of all trading days since 1980 have seen the VIX Index of volatility drop below 10 (per Bloomberg), yet this result was recorded on four separate days during May. Even if the bull market can endure further, we believe that the probability of a short, sharp correction remains high. Do not forget that there have only been two months during the last five years (in August 2015 and January 2016) when equities have witnessed a drawdown of more than 5%. Furthermore, all good things will/do eventually come to an end: the current equity market rally is now 98 months old and has seen an absolute return of more than 200%, whether measured for the MSCI World or the S&P. These figures compare to an average cycle of 54 months and a return of 116% (according to Credit Suisse, for global equities).

There is much that concerns us too. From a market perspective, within the equity world, breadth is narrowing, particularly in the US. In other words, a shrinking number of stocks is becoming increasingly responsible for driving returns. This can often be a sign that the top of the cycle is fast being approached. The seeming infatuation with the ‘FANG’ (Facebook, Amazon, Google, Netflix) complex has some parallels with how investors felt towards the Nifty-50 in the 1970s or the TMT sectors in the late 1990s. Towards cycle ends, investors migrate to where they believe growth remains, in the absence of better alternatives. At the same time, in the world of fixed income, it is important to note that the yield curve is no longer steepening and is instead flattening rapidly. Indeed, the spread between the US two-year and ten-year is back to pre- Trump levels. Steeper curves generally imply an improving environment with the converse equally true.

In addition, there are major structural factors to consider too. Debt burdens remain significant. Recent data released by the Federal Reserve highlight that non-financial debt in the US is now higher than at the peak of the last cycle (equivalent to 255% of GDP versus 249% in 2009) as is business debt (73% of GDP, versus 70%). Meanwhile, US consumer credit continues to grow at a substantially faster rate than real per capita disposable income (6.2% against 1.7%). At some stage, this will likely prove unsustainable. We can already observe warning signs of stress in markets such as auto loans (a concern we first highlighted in our April ‘View’), while over the border in Canada, there have been instances of niche property lenders collapsing. For debt to diminish, sustained growth and/or inflation is needed. Both continue to prove elusive. In the US, we also note that despite an improving macro backdrop, productivity – the key to long-term growth – remains exceptionally poor. It has now fallen for four of the last six quarters. What can be described as, at best, a mixed political landscape globally is also unlikely to be conducive to the implementation of policy initiatives aimed at driving major productivity gains.

Valuation ‘trumps’ everything

We believe that the most logical and defensible strategy in an environment characterised by so many uncertainties is to focus on undervalued (and ideally uncorrelated) assets. From a bigger-picture perspective, our view is that it is easier to foresee a scenario of rising bond yields than falling equities, especially should inflationary pressures gather in force. Put another way, the reality is that – for the remainder of this year, at least – stronger economic growth in the US and Europe, combined with very good earnings momentum should be supportive for equities, not bonds.

Two important additional observations deserve mention too: first, regional allocations matter; next, don’t forget about the longer-term. In terms of the former, 2017 to-date has been characterised by emerging market equities outperforming their developed world counterparts and, European indices outperforming their US peers. Part of the explanation could be attributed to the weaker US Dollar and a less-bad European political environment, but the more fundamental reason is simply that better value can be found in Europe and in emerging markets than elsewhere.

We find the case for Europe particularly compelling, even if it has become much more consensual than was the case at the start of the year. The last time that Eurozone GDP and earnings growth was better than in the US, European indices traded at a 10% premium relative to the US. At present, a 16% discount exists between these two markets in valuation terms (per Credit Suisse). Meanwhile, the S&P’s 200%+ return over the last 8 years is more than double that delivered by the Stoxx Europe 600. Europe remains in ‘catch-up’ mode, with its profits still c40% below peak, a level already surpassed in the US. The strongest European earnings season in a decade (per Morgan Stanley data) is a highly encouraging sign.

Turning to the longer-term: regardless of differing perspectives on where we may be in the current cycle, it is unambiguously the case that the historic returns generated by equities and fixed income will not be achieved in the near future. This is the consequence of a combination of current valuations (starting points), high debt levels and the impact of financial repression. Recent analysis by KKR, highlights that over the next five years, the estimated annualised returns for equities (of 4.5%) and fixed income (1.3%) stand in poor contrast to those forecast for private equity (10.2%) and real assets (6.5%). These findings come as little surprise to us. We have made the case previously for diversification and believe that its logic remains as compelling as ever.

Alexander Gunz, Fund Manager, Heptagon Capital