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: the last part of the bull market is often the most dramatic. We cannot know when the bubble will burst, but feel comfortable asserting that with the extent of the rally and the elevation of current expectations, the margin for error is very low. Furthermore, the longer the cycle endures, the larger will become the misallocation of capital. Given valuation levels, strong returns today imply lower returns tomorrow. Now, therefore, is the time to consider which investment approaches will work best when caught between low returns and a late-cycle environment. We believe three considerations are crucial: look for value, diversify and preserve capital.

Asset Allocation:
• Equities: Equities continue to grind higher and achieve a variety of new records (in terms of nominal highs, unbroken stretches and the like). This is the result of improving earnings estimates and the absence of other liquid alternatives to this asset class. Even with earnings upgrades, equities are not cheap, but they continue to compare favourably with most fixed income metrics. It is hence a good moment to be considering truly active and differentiated managers. There are opportunities still to be found, particularly when value as a style is at a 17-year low relative to growth (per Bloomberg).

• Fixed Income: The fixed income bubble is bigger than the one witnessed inequities. It has also endured for longer, and this explains why the current search for yield is so pronounced. We note that European sub-prime debt currently offers a superior yield to US Treasuries while Mongolia was able last month to launch an over-subscribed first-time issue of Dollar-denominated debt, with a 5.5% yield. We do not believe that the current situation of repressed yields on mainstream debt can endure indefinitely, and would rather wait to see notably higher yields before revisiting meaningfully the asset class.

• FX: Given that the US Dollar was the worst-performing major global currency through to the middle of September, it is of little surprise to us that it has strengthened markedly since then. While it is possible that the next Chair of the Federal Reserve could be more reflationary in stance, the more fundamental point is that currencies do have a tendency to mean- revert over time. Dollar strength could continue for some time longer (probably at the expense of the Yen and Euro).

• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies. This is one of our highest conviction views. Within this universe, we consider allocations to catastrophic reinsurance (especially in the context of the recent hurricane season and resulting higher premiums), infrastructure assets, direct lending and niche private equity to be attractive. Such assets provide diversification and allow investors scope to harvest illiquidity premiums.

Enjoy it while it lasts?

Another month and further nominal new highs have been recorded in equity markets around the world. Meanwhile, conventional fixed income yields on government remain repressed, trading below start of year levels in many geographies. Bulls (and statisticians) have noted that if the S&P 500 makes it to 20 November without a 3% pullback, then this will constitute the longest period ever without a decline of this magnitude. Against this background, equity market volatility is at its lowest since 1984 (per JP Morgan), while cross-asset volatility is at a 20-year low (per Société Générale). Even if the current bull market may be ageing, it certainly does not appear to be finished quite yet.

Nonetheless, as markets grind higher, we are left pondering for how long such a roseate scenario can endure. Two observations bear consideration. First, history would suggest that the last part of the bull market is often the most dramatic, as emotions of greed prevail and a fear of missing out characterises investment decision-making. Next, crucially, the absence of risk does not mean the elimination of risk. This matters, particularly when many people are being forced to participate in a rally that is unloved. To regular readers, we may appear somewhat like a broken record, but there is a good reason for doing so. Given the extent of the rally and the elevation of current expectations, the margin for error is very low. Or, put another way, when things end, they will likely end badly.

It is, of course, disarmingly easy to make a case for the continuation of the present ‘Goldilocks’ scenario of balanced growth and inflation. Normalising monetary policy (and reduced Central Bank intervention) combined with potential expansionary fiscal policy (in the US, Japan and beyond) may add further fuel to the fire. Investors are certainly enjoying the most balanced and broad upturn in global GDP since 2009/10, even if there is less agreement either on the causes or the sustainability of such growth. Indeed, worldwide economic output has now been running above long-term trend for the last 13 consecutive quarters (per Citi) and many governments/supranational organisations have gained in sufficient confidence that they are now raising their projections for future growth. The IMF, for example, predicts a 3.8% gain for world GDP in 2018.

While undoubtedly encouraging, our criticism of such arguments is premised on the fact that there is little historic correlation between GDP and earnings growth. Bulls may argue that equities can continue to outperform for as long as earnings keep improving, and their case may be strengthened by the fact that 2017 will likely constitute the first year since 2010 when all major global regions will report annualised EPS gains. 2018 could see similar strength. However, this misses the point: neither growth nor earnings is early cycle. Multiples are already rich and even an improving economy cannot remain in denial of the massive structural headwinds imposed by (deflationary) demographics.

It should also not be forgotten that all good things do come to an end. Central Banks (however unconventional and miraculous their strategies may have been), have not succeeded in banishing the business cycle altogether. From an asset allocation perspective, this is crucial, for the longer the current cycle continues, the larger the misallocation of capital will become. We note that flows into global equities are at record levels (per JP Morgan). Blackrock reported that at the end of September it had received more inflows into its ETF products ($246bn) than recorded for all of 2016 ($202bn). Meanwhile, a majority of US households believe ‘there has never been a better time to buy equities’ per the most recent University of Michigan consumer confidence survey.

The logic is highly flawed: just because equities have been the best mainstream asset class to own for the last decade, it does not mean that it will be for the next ten years. Moreover, within the world of equities, the S&P 500 has been the best-performing major global equity market (beaten only by Argentina, Thailand, the Philippines and Sri Lanka). During this period, growth has massively outperformed value as a style. As a result, US equities now comprise over 50% of the world’s equity market capitalisation, a level not seen since 2001, while tech constitutes a 24% weighting in the S&P 500, not seen since the start of this decade (per Société Générale).

Put another way, starting points matter. An investor today is paying 21.7x forward earnings to own the S&P 500. A decade ago, the index traded on 17.4x, and hit a nadir of 11.1x during the credit crisis. Furthermore, value now trades at a 17-year low relative to growth globally (per Bloomberg). The problem is further compounded by the huge shift that has occurred towards passive investing during this period. The cult of passive investing means that the same assets are constantly chased upwards in a virtuous/ vicious cycle. Many seem to overlook that the same will likely occur on the way down.

We therefore think it is important to assert that strong returns today imply lower returns tomorrow. Morgan Stanley calculates that a conventional 60:40 portfolio comprising equities and bonds will deliver just 4.2% annualised returns over the next decade, the lowest level in the last 40 years (excluding 2000). Separately, we wonder to what extent many investors are currently miscalculating tail-risk. Relative to previous cycles, bonds will be much less likely to offset equities when the next crisis comes due to low rates and already-sizeable Central Bank balance sheets. The consequences of risk-parity funds all potentially having to unwind at the same time are unlikely to be pleasant.

Which strategies?
Investors need to consider which investment approaches will work best when caught between low returns and a late-cycle environment. We believe three considerations are crucial: look for value, diversify and preserve capital. In terms of the former, we note that forecast 10-year real returns for equities are highest in emerging markets (7.4%), followed by Japan (5.5%) and Europe (4.2%), with the US ranking lowest (3.2% – all data per Morgan Stanley).

We have long made the case for emerging markets. Consider that China and Asia will account for 60% of incremental global growth this year and will comprise 62% over the next decade. This compares to a level of 43% for the previous two decades (per KKR). These regions (and emerging markets more generally) are seeing a huge expansion in their middle-class populations, who are increasingly spending on services. This contrasts notably with the secular stagnation evident in parts of the western world, which has likely contributed to the re-emergence of ugly populism. From a structural perspective, most emerging market economies have improved their macro stability and strengthened their current account balances relative to the last cycle, meaning that they should be better placed to withstand higher developed world interest rates.

To return to other strategies, we believe there are clear benefits attached to diversification. Now is a good time not only to be adding active equity managers (because of rising dispersion and declining correlations), but also to be diversifying into other asset classes, especially differentiated ones such as private assets. Finally, we believe it behoves investors to preserve capital. This may sound very unfashionable and unloved as a strategy, but within the next five years, capital preservation may well be back to its former glory.

Alexander Gunz, Fund Manager, Heptagon Capital