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: it’s back to the good old times. Global equities have now risen for six consecutive months, a feat last achieved in 2006. Challenged demographics, poor productivity and high leverage, however, haven’t gone away. This backdrop – combined with the fact that the best equity market returns often come at the end of the cycle – provide an explanation for why markets continue to rise. Put simply, in a low-return environment, investors cannot afford to miss out on this rally. We see several concerns (most notably, leverage within parts of the financial system) and our favoured approach remains one of concentrating on undervalued businesses within the equity space while increasing diversification levels across portfolios. Private assets continue to look attractive.

02 May 2017

Asset Allocation:

• Equities: Most global equity markets continue to make new near-term highs, helped by currently strong earnings momentum. While there is scope for these positive dynamics to continue in the very near-term, investors should remain mindful of elevated valuation levels, particularly in the US. The logic in taking some profit from recent gains is strong. Our preference is for investing in businesses in undervalued regions (Europe, Japan and EM) and focusing on alpha- generating managers with distinct strategies.

• Fixed Income: We continue to 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. However, it is worth noting that long Dollar stances appear much less consensual now than at the start of the year. Meanwhile, the Euro has continued to strengthen in light of a more stable political environment. This trade may have further to run, although we believe most policymakers continue to have a preference for 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.

The fear of missing out

On the surface, everything looks very rosy at present. An environment of strong economic growth, positive earnings momentum, still-easy monetary conditions and subsiding political tail risks should clearly be supportive for further equity outperformance. Indeed, the MSCI World has now recorded six consecutive months of gains, a feat last achieved at the end of 2006. We find it hard to refute these arguments, but feel it necessary to remind investors of the importance of keeping perspective. As we discuss in more detail below, it is right to be concerned about valuation levels and financial leverage in particular. Although change is often hard, recent equity strength could logically provide an opportunity to consider other asset classes. We have asserted previously the case for increasing exposure to uncorrelated and diversified assets.

First, the good news. Begin with economic growth. It is now almost back to its pre-financial crisis trend rate. With all global regions growing broadly in sync (a feat in itself), the IMF now forecasts 3.5% GDP growth for 2017 and 3.6% for 2018. This compares to an average annual level of 3.7% achieved in the decade prior to 2008. At the same time as growth is improving, so are corporate earnings. Even if the correlation between the two is limited, global earnings growth is currently running at c15% (according to JP Morgan), a marked improvement on last year’s rate of c8%. A better macro backdrop has clearly helped, but there is also clear evidence of both pricing power and operating leverage being achieved. Moreover, for the first time since 2010, emerging market earnings growth rates are outpacing developed market trends. A benign monetary outlook (particularly in the US) clearly helps the EM outlook, but policymakers in Europe and Japan too also seem clearly committed to keeping monetary policy loose for now. Finally, populist political momentum may have peaked (based on recent electoral results in Europe), leading hopefully to a more stable environment.

The key question, however, is what price are investors paying for exposure to these positive dynamics? Bloomberg highlights a multiple of 22.1x for the MSCI World, well ahead of its 10-year average multiple of 17.9x. Of more interest to us than a simple headline figure which evidently masks a number of value opportunities within the market are the following three observations. A quick review of the last set of Federal Reserve Minutes would highlight the comment that asset prices are “highly valued.” Surely, when the effective underwriter of the current bull market starts to question equity market valuations, then investors should be worried? Next, consider that US insiders sold the highest amount of stock last month since the beginning of 2011 ($9.7bn, per TrimTabs data). Finally, the most recent BofA Merrill Lynch investor survey shows that 32% of participants see global equities as being overvalued. This figure is close to a 17-year high, in other words, at levels last seen pre- the bursting of the tech bubble. Yet, by definition, 68% still see equities as undervalued…

So what’s going on? Very simply, in a low-return world, investors cannot afford to miss out on the end of the equity cycle. While there is little doubt that optimism is typically a late-cycle phenomenon, history suggests that the best returns within equities do come towards the end. This was the case in both 1999-2000 and 2006-2007. This time around, the quest for delivering returns is arguably even more pronounced given the extent of financial repression that followed the last crisis. Optimism hasn’t translated into euphoria yet, but even the most bullish of investors shouldn’t forget that the narrative of poor demographics, weak productivity and high leverage hasn’t gone away. Last year’s populist surge may have temporarily muted its importance, but even if the world is now delivering better growth and inflation relative to a year ago, politicians are still not making sufficient structural changes, focusing on improving productivity and boosting immigration.

Of the three more fundamental challenges highlighted above, the myth of deleveraging is probably our biggest near- term concern. Global debt levels are now higher than they were before the last financial crisis. Total worldwide debt stands at $220 trillion, three times higher than global GDP and double the level reported at the peak of the last cycle (per IMF data). The seeds of the next financial crisis may be contained within this burden. Various trends in the US constitute particular cause for concern. Corporates’ levels of interest cover (the ability to service interest payments on debt as a multiple of operating profit) is at its weakest since the last financial crisis, standing at around six times, compared to a long-term average of ten times (again per the IMF). Clearly, should US interest rates rise at a faster-than-anticipated pace, many corporates may be left exposed. Elsewhere, there is $1 trillion of outstanding motor vehicle loans in the US (and 2m consumers behind on their repayments), $1.3 trillion of student loans (with 3,000 borrowers defaulting daily) and $3.7 trillion in commercial real estate debt. These areas could all be at risk too in a higher rate environment. Also, do not forget that both the US housing and sub-prime markets peaked in 2006, but the recession did not follow for another eighteen months…

These concerns only reinforce the case for increased allocations to alternative (and uncorrelated) assets. However, we recognise that part of the attraction of equities is that they are liquid and that they continue to represent a more compelling option relative to fixed income, at least for as long as interest rates remain low. A logical response to this conundrum – of equities being the least bad major asset class – is to consider which equity markets look currently most undervalued. Our preference within equities is for Europe, Japan and emerging markets.

The case for Europe looks particularly forceful at present. Economic lead indicators are very strong, with industrial output at its highest in six years and growth across the continent becoming increasingly broad-based. Despite continent- wide unemployment being its lowest since May 2009, at 9.5%, the output gap in Europe remains larger than in any other region globally, implying scope for clear operating leverage. Elsewhere, the banking system is recovering, while monetary policy continues to be very loose. Political risks in the region also appear to be diminishing, following the victory of Emmanuel Macron in the first round of the French Election. A reinvigorated pro-European core of countries may be a driving force for increased structural reform over time. Beyond these positives, valuation levels stand out, particularly when contrasting Europe with the US. The latter region would also appear to be facing a more challenging near-term political environment, given current legislative gridlock. Europe’s valuation disparity on all main metrics relative to the US is substantially wider than long-term average levels: a 45% price/book discount (compared to a 36% average over the last 15 years), a 54% cyclically adjusted earnings multiple discount (29% average) and 27% forward earnings discount (14% average).

Beyond Europe, investors may want to consider Japan and emerging markets. Japan stands out as being the worst- performing major global equity market this year. This is despite the fact that positive earnings revisions are at an all-time high and business confidence is at its most elevated for a decade. The TOPIX trades on 18.5x forward earnings, close to a 20% discount to global markets (although in-line with its historic average), a level which should narrow as the impact of structural reform becomes more prominent. Meanwhile, both corporates and the government state pension fund continue to buy equities actively. There is also a currently attractive picture across most emerging markets, with accelerating earnings growth being fuelled by improving domestic demand and high leverage. Macro trends seem very strong in China and the government is likely to be keen to ensure continued stability in the economy ahead of its Party Congress in the Autumn. The 15.7x earnings multiple commanded by the MSCI Emerging Market Index stands out as constituting clear value when compared with other global regions. This seems an appropriate note on which to conclude the month’s commentary: for the longer-term investor, valuation (and diversification) trump almost all other considerations.

Alexander Gunz, Fund Manager, Heptagon Capital