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: when the reset comes, it will be significant. The problem, however, is knowing when. For now, investors continue to play a waiting game, trapped in a situation where the opportunity cost of exiting from strategies that have performed well remains high. This is not a normal cycle and despite its current length, it may continue for some time longer, particularly with no immediate sign of global recession on the horizon. Nonetheless, a world in which monetary policy is gradually tightening while debts are growing does represent – at a minimum – a headwind to capital growth. We believe it is better to be too early than too late: there is a greater logic in seeking to preserve gains than to chase bubbles. Our focus is therefore centred on three things: valuation, uncorrelated assets and the preservation of cash.

Asset Allocation:
• Equities: 11 consecutive months of unbroken gains for equities (per the All-Country World Index) constitutes a trend last witnessed in 2003. While equity valuations look stretched in general terms, they continue to compare favourably with most fixed income metrics. Moreover, the current rally has been driven not just by an ongoing rerating but also by fundamentals, with global earnings growth at its best since 2010 (per Morgan Stanley). Our strategy is one of pragmatism, namely, to lock-in returns where appropriate and rotate to relative value within the market, both in terms of geographic and sectoral positioning. Value as a style is cheaper today than it was before the late-2016 rally (per Bloomberg data).

• Fixed Income: Even if there is a bubble inequities, it is substantially larger in conventional fixed income, and has endured for far longer. US 10-year government debt now has a lower yield than at the start of the year, a picture repeated in much of the rest of the developed world. Against this background, the search for yield remains desperate: the first- ever Dollar-denominated debt issue by Tajikistan last month stands out as an emblematic example of this trend. 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: The recent reversal of Dollar weakness points to the idea that currencies do – over time – mean-revert. Even if the Dollar may remain overvalued against some of its peers on a purchasing power parity basis, relative Dollar strength could continue for some time longer. This could come most notably at the expense of the Euro especially.

• 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), infrastructure assets, direct lending and niche private equity to be attractive. Such assets provide diversification and allow investors scope to harvest illiquidity premiums.

How far can the elastic stretch?

This is the main question we continue to ask ourselves regularly, particularly in a year which has thus far been characterised by equity gains, supressed bond yields and exceptionally low volatility. With just a quarter of 2017 remaining, our stance remains unchanged, namely, the current scenario will persist until it breaks. But when it does, the outcome is unlikely to be pleasant. The problem is that the unconventional actions of Central Banks have created a feedback loop where everything has become connected: quantitative easing has resulted in lower yields; this has provoked equity inflows, which have acted as a huge boost to passive investing, which in turn, has lowered volatility. It therefore doesn’t take a genius to see how it may all unwind.

The VIX index of volatility has averaged 20 since 1990, two times current levels – despite uncertainty being presently higher than for quite some time (think North Korea as just one example). Against this background, we would contend that tail risk has got fatter rather than thinner. The next correction – when it comes – may well be larger in magnitude than previous ones simply because volatility has been chased all the way down. Recent comments from Central Bankers only add fuel to the fire: Janet Yellen seems to believe that another correction is only a matter of time, stating at Jackson Hole in late August that she expects “the evolution of the financial system…will result sooner or later in the all-too-familiar risks of excessive optimism and leverage.” Meanwhile, Mario Draghi’s observation at the ECB’s last press conference that “we don’t see systematic danger from asset bubbles” speaks of potential complacency.

Just because there has not been any dislocation in financial markets for quite some time – 10 months have elapsed without a 3% downward move in global equities – this is not the same thing as saying that there won’t be another correction around the corner. It is worth repeating the words of the American economist Hyman Minsky which appeared in last month’s commentary: “the more stable things become, the more unstable they will be when the crisis hits.” The current equity bull market has run for 102 months (obviously, the bond bubble has endured much longer), which makes it the second longest in history, exceeded only by the 147-month run which culminated in the bursting of the dot-com bubble. We understand the argument why the rally can endure further. History says that such rallies generally end only when a recession comes along. And there is no evidence for this: global GDP and EPS growth are at their strongest since 2011, with very good breadth across the developed and emerging world. At the same time, many investors remain far from euphoric; this has been an unloved bull market.

This latter point is important: the reason the bull market is so unloved is because this is not a normal market cycle. We already characterised the feedback loop that has generated asset price inflation at the expense of real-world inflation (with the unintended consequence of populism in the ascendant globally). Meanwhile, a full eight years of near-zero interest rates has yet to spur the growth in GDP, inflation or wages that has been so frequently predicted by the likes of Janet Yellen et al. Take Japan as an extreme example: Bank of Japan Governor Kuroda initiated a 2.0% inflation target in April 2013. It is just 0.5% today, despite unemployment at sub-4% and the jobs-to-applicants ratio at its best since 1974. Structural factors (a permanent loss of labour’s pricing power after the last financial crisis, demographics and the deflationary nature of technology) may help suppress inflation for some time longer, notwithstanding the reflationary rhetoric of Central Bankers.

What might end the bull market?

If we accept that the elastic can continue stretching, it behoves to consider what may make it break eventually. History would suggest that the circumstances behind each previous collapse have been unique. Nonetheless, three factors seem commonly to appear: the end comes with some combination of overvaluation, excess and/or recession. If we consider each in turn, then equities (in general) are undoubtedly expensive on almost all metrics relative to their history, but remain markedly undervalued relative to most conventional fixed income. Next, we do clearly see some signs of excess (particularly regarding FANG-infatuation and bitcoin-hype), but also only limited signs of euphoria (M&A volumes are currently less than half the peak levels witnessed in either 2000 or 2007, per Morgan Stanley; and US short-sellers at a one-year high, per IHS Markit data). Finally, given the current growth backdrop, a major recession does not seem on the immediate horizon.

We need, therefore, to consider what may possibly alter the current roseate scenario: an error on the part of the actors responsible for the present macro backdrop (i.e. Central Banks) or an exogenous factor seem the most likely. Take Central Banks first. It is important to recognise that even with the Federal Reserve now embarking on an effective policy of quantitative tightening (i.e. reducing the size of its balance sheet), given the ongoing purchases by the Bank of Japan and the European Central Bank, globally Central Banks’ balance sheets are unlikely to contract in aggregate until at least this time next year. Moreover, the $300bn balance sheet reduction scheduled over the next 12 months on the part of the Fed needs to be seen in the context of $9trillion of global expansion since 2009. However, a world in which monetary policy is gradually tightening while debts are growing does represent – at a minimum – a headwind to capital growth. It is sobering to remember that total global debt stands at $217trillion (per the Institute of International Finance), equivalent to 327% of global GDP, having doubled in the emerging world over the last decade. Meanwhile, some 32% of US consumers have a credit rating that is sub-prime. The more things change, the more they stay the same …

What about an exogenous factor? Growth, globally, seems more balanced than it has for some time, thereby reducing this risk. Even China – often cited as a concern for the world economy – seems to be managing successfully its economic transition from producer to consumer. If GDP trends reported in the first half of the year prevail for the remainder, then 2017 will mark the first year since 2010 that China will report an acceleration in GDP growth. The upcoming 19th Party Congress may also provide scope for further progressive reform and rebalancing. Nonetheless, geopolitics may prove highly disruptive, both for China and more generally. North Korea is currently occupying most headlines, but the following year may also see flashpoints emerging following general elections in Brazil, Italy, Pakistan and Turkey. Meanwhile, the full fall-out from Brexit is far from resolved. The next crisis will most likely come from an unexpected source. If prediction were easy, then crises wouldn’t happen.

Investment implications
Take all the above and view it from a different perspective: we would argue that the challenge may lie less in identifying the peak of the current bull market, but more in knowing when the next bear market has begun. Problems viewed with hindsight are always easier to ‘explain’, while crises naturally carry a high level of unpredictability. Furthermore, even if not all the classic conditions are in place for a bear market, it is still very possible for a persistent period of low (or lower than current) returns to prevail. We recognise that many current approaches to investing are characterised by a fear of missing out; in particular, there is a high perceived opportunity cost attached to exiting from strategies that have worked (being long equities and conventional fixed income). However, we would contend that it is better to be too early than too late: there is a greater logic in seeking to preserve gains than to chase bubbles. Against this background, we reiterate a familiar mantra: use valuation as a compass, and diversify.

Alexander Gunz, Fund Manager, Heptagon Capital