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: is this as good as it gets? A seemingly perfect combination of improving growth and inflation is boosting earnings revisions and hence equity markets. New highs are being marked as investors count the opportunity cost of not being involved. Complacency and greed are almost inevitably set to follow. We cannot help but note elevated valuation levels across many asset classes. Debt and discontented electorates also lurk in the background. As hard as it may be to contemplate, now is the time to consider the longer-term. Our preference for uncorrelated assets is well-documented. We also believe that investing in assets with exposure to local markets (over global ones), deregulation (over regulation) and changing (ageing) demographic trends make much sense.
Asset Allocation: Equities: Further near-term highs in equities seem likely, helped by positive earnings revisions and the fact that there are fewer other liquid substitute options for investors. However, generally high valuations may constrain overall market returns. With only three monthly drawdowns of more than 5% in the last 5 years, a correction is possible at some stage, but calling its precise timing is not easy. Instead, our focus remains on investing in undervalued regions (emerging markets and Europe) and favouring alpha-generating managers (with correlations at their lowest since December 2014).
Fixed Income: We continue to see this asset class as fundamentally unattractive in general terms. After a 30-year bull market in bonds, it is hard to make a compelling case on valuation grounds. Meanwhile, growing evidence of inflation would further undermine fixed income prospects. At notably more elevated levels of yield than currently, Treasuries and other comparable debt may become attractive.
FX: We have no active views in this space at present and believe most major currencies may exhibit some near-term volatility. A strong Dollar seems a highly consensual stance yet stands in contradiction to some of Trump’s desired policy outcomes, particularly on trade. Meanwhile, the fate of the Euro may be influenced by near-term political outcomes.
Alternative Assets: We continue to favour with high conviction 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.
Perfect cocktail or perfect storm?
At first glance, the glass is amply more than half full. It is replete with a mixture of easy credit, loose fiscal and monetary policy, and high confidence levels from consumers and corporates, fuelled by increasingly business-friendly political strategies. The fact that investors are paying a high price for this seemingly enticing combination almost seems not to matter; where, other than equities, might it be potentially more attractive to invest at present? We see five factors (which we detail more actively below) that can continue to drive equity markets still higher, obviously at the relative expense of other asset classes. However, we can also identify (at least) three areas where investors currently appear somewhat complacent, in our
view; and also, four concerns that are more fundamental in nature. These all have clear implications for asset allocation decisions. In summary, while the current rally has the undoubted potential to continue for some time longer, we fear that the further it endures, the bigger will be the correction when the bubble bursts. We do not believe that there is ever a bad moment to be considering further portfolio diversification, particularly into uncorrelated assets.
First, the good news... Five factors currently look encouraging to us: better economic data, improving inflation trends, positive earnings revisions, benign central bank policy and potential upside from fiscal stimulus. Begin with the economy, and it is clear that the data, for the first time in years, are strong. This is particularly the case in the US and the Eurozone, while Japan, China and the broader emerging market complex are all showing clear signs of improvement. The global economy delivered 4.0% annualised growth during the fourth quarter of 2016, the first time it has exceeded its pre-crisis trend level, according to Morgan Stanley. In the US, consumer confidence currently stands at its best in 16 years, and corporate confidence at its most elevated in 13. Meanwhile, in Europe, industrial output is presently at a cycle-high, with the rate of French GDP outpacing German, indicative of the fact that the Eurozone’s recovery may now be becoming broader based. Even in Japan, there is evidence to suggest Abenomics is delivering, with GDP in 2016 expanding at more than double long-term average levels.
A combination of better growth and improving inflation trends is creating a mutually reinforcing, virtuous circle effect at present, which some have taken to liken to a ‘Goldilocks’ scenario. In other words, the economy is running at just the right level. Indeed, inflation rates across most of the developed world are almost double where they stood a year ago. Under normal circumstances such an outcome might be seen as disturbing, but given the low starting point, the emergence of reflation is being treated as a positive outcome. Producer prices in the emerging world are also rising strongly (up 6.9% year-on-year in China, for example), suggesting that the spread of inflation is extending its reach more globally.
The corollary of better growth and some inflation is a clear improvement in earnings revisions. Upward revisions are now positive for the first time in ten quarters on a global basis, while in the US the ratio of companies benefiting from upgrades relative to downgrades is at its best in six years (both figures courtesy of Morgan Stanley). As with inflation, this positive trend is permeating across the world, and in emerging markets revisions currently stand at their best since mid-2011 (according to Credit Suisse). It should also not be forgotten that even if the direction of travel for US interest rates is upwards, across the world monetary policy remains generally very loose. This should be enhancing to corporate lending and may boost further the positive trends highlighted previously. Finally, there is also the potential upside from fiscal stimulus to come. Investors have already begun to give credence to this trend and this matters; regardless of ultimate delivery, it remains clear that some infrastructure investment is coming back to the western world after an absence of at least 30 years.
Next comes complacency...
A quick glance at any financial publication is enough to serve as a reminder that many equity markets continue to make new highs. The MSCI World has risen by more than 25% since its most recent low of February 2016, with a gain of over 10% marked just since the election of Donald Trump in November. Obviously the trends outlined above have been contributory factors, as has the record level of M&A activity. With $224bn of deals announced in January alone, the market has seen its best start to a year in this respect since 2000. Indeed, whether it is deal activity, or pending initial public offerings (Snap being a case in point), there is much to suggest that signs of late-cycle behaviour are emerging. We note that the best performing assets in the current rally have included non-financial cyclicals, US high-yield credit, industrial commodities and small caps globally. Meanwhile, the VIX index of volatility currently stands in its lowest decile since 1990, according to Goldman Sachs. Finally, do not forget that the global equity market has only seen three monthly drawdowns of more than 5% in the last 5 years (May 2012, August 2015 and January 2016). Maybe we are due another?
In terms of what may be the contributory factor to provoke such an outcome, politics and central bank policy spring to mind as being the two most obvious sources. With regard to the former, in the US, Donald Trump’s agenda remains ambitious with still as-yet highly unclear outcomes as to what may happen. Scepticism over implementation seems to be growing as the gap between elevated expectations and deliverable reality continues to widen. In Europe, post-Brexit it would be inappropriate to dismiss entirely the likelihood of a Marine Le Pen victory in France. Were she to win, the upshot would almost certainly be negative, but just the increasing prospect of such an outcome may be enough to destabilise markets, particularly those priced for perfection. Finally, don’t forget about central banks. Not only do concerns remain about whether the Fed may be ‘behind the curve’ in terms of its approach to raising interest rates, but it is also worth wondering how might the ECB respond were German inflation to continue accelerating at the same time as countries like Italy remain mired in deflation. Additionally, the Bank of Japan might not be able to retain indefinite control over the bond market.
And finally, the more fundamental concerns These can be enumerated in one sentence: rarely have financial assets (equities and fixed income) been more expensive, while global debt levels have never been higher. Take the first point and consider that average US equities multiples stand in their 89th percentile. In other words, on only 11% of other occasions in the last 47 years have they been more expensive, according to Goldman Sachs. Similarly, using Robert Shiller’s ratio of long-term rolling average earnings multiples, the market is currently trading at its most elevated level since 2000. Such an outcome is partially a consequence of the extreme liquidity situation created by central banks since the financial crisis. Asset-price inflation has drastically out- placed consumer inflation. Inevitably this has benefited certain segments of society at the expense of others, hence the current regime change being witnessed in much of western politics. The struggle between the 1% and the remaining 99% will be one of the key battlegrounds for at least the next decade. This will also be compounded by the demographic challenge enforced by slowing and ageing working populations.
Where to invest? We have made the case in many of our previous monthly commentaries for increasing allocations towards uncorrelated assets. Our conviction in this respect remains undiminished. To add a further dimension to our analysis, we believe there is a strong logic in adding a thematic dimension to this thought-process. In other words, based on the structural landscape we have characterised above, we believe that gaining exposure to the trends of greater localisation (relative to globalisation), the beneficiaries of deregulation and plays on demographics and ageing make a high degree of sense – if not through equities, then certainly via private assets.
Alexander Gunz, Fund Manager, Heptagon Capital
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Swans, cake and elephants 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: The polarisation towards an almost unqualified bullish consensus has been rapid. We sit in the […]
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: Optimism seems the order of the day. The news of positive vaccine trials and their subsequent deployment over the […]
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