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: complacency and excess do not make for an attractive combination. Even if worries over North Korean/ Trump dysfunction may be top of many investors’ minds, most still cannot (or do not want to) think of a scenario that would fundamentally alter the comfortable environment of steadily rising equity markets and falling bond yields. The product of such a situation is, however, excess – evidenced by valuation levels and the quest for ever-riskier assets. Even if history does not repeat itself, then it may at least rhyme. Meanwhile, the longer the period during which things remain stable, the worse may be the outcome when they finally crack. Against this background, we recommend caution: focus on valuation (emerging markets look attractive), look for uncorrelated (private) assets and preserve cash.

Asset Allocation:

  • Equities: We see stronger merits for this asset class than for fixed income, but investors still need to be highly mindful of valuation. The biggest problem for equities is that multiples have rerated faster than earnings have increased – revisions on a rolling three-month basis have turned negative globally for the first time since 2011 (per Credit Suisse). Investors have polarised towards growth stocks (and tech should outperform in a deflationary environment), but we highlight that the value-growth discount is now two times larger than before the rally of late 2016 (per Bloomberg). Emerging market equities also look particularly attractive from both a near- and medium-term perspective.
  • Fixed Income: Fixed income yields have continued to compress in the absence of sustained inflation. Increased risk aversion (over geopolitics) could push yields still lower. Nonetheless, we do not see this situation as being able to endure indefinitely, particularly given the context of the current bond bull market length. From a valuation perspective, most fixed income therefore remains fundamentally unattractive. Yields would need to be notably higher than present for us to consider revisiting meaningfully the asset class.
  • FX: The Euro has been the best-performing G10 currency year-to-date, and the contrast between its move and that of the US Dollar is particularly notable. Growing Eurozone optimism contrasts markedly with increased Trump pessimism. Such a move may create some near-term trading opportunities, as currencies tend to mean-revert over time. We remain sceptical about the case for imminent reflation and expect most policymakers still to have a bias towards weaker currencies. Be mindful too of the impact of recent currency moves on listed exporters.
  • 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.

Waiting for the Minsky moment

Markets may have wobbled during August – compounded by low volumes and geopolitical gyrations – but this belies the real story: investors are in a position of stasis, searching for and hence awaiting the elusive moment that may change the narrative. The story has become all-too-familiar: equities in general are expensive, and hence unattractive, but remain relatively more compelling than fixed income, where yields continue to compress further. Nonetheless, investors should be careful for what they wish: a disruption to this narrative may have severely negative ramifications, especially given the huge asset flows into passive strategies. Hence, we arrive at the words of Hyman Minsky, the American economist: “the more stable things become, the more unstable they will be when the crisis hits.”

The biggest problem – as we see it – is that most investors can’t think what might cause a deviation from the current scenario of rising equity markets and falling bond yields, especially with inflation seemingly so absent. Against this background – the elusiveness of a negative catalyst – and the fact that returns on cash are so low, investors have begun to worry more about being underinvested than about the possibility of losing money. Our second quotation of this piece is borrowed from Chuck Prince, the unfortunate former CEO of Citigroup: namely, even if investors do know that the good times will come to an end, for now, they feel they have no choice but to dance…

For inspiration, we turn finally to Mark Twain, who famously made the observation that even if history does not repeat itself, then it does at least rhyme. What seems evident to us is that the current low yield environment is forcing investors into ever-riskier assets, storing up potential problems further down the line. Indeed, the appetite for such bets – $25bn of junk bonds sold in the last quarter, five-year Iraqi debt priced with a 7% yield, more private equity money raised YTD than in 2008 – recalls some of the recklessness that led up to the previous financial crisis.

Several commentators whom we highly respect, such as Oaktree’s Howard Marks and GMO’s James Montier have recently made observations of a similar nature. If there is not complacency in the investment community, then there are certainly signs of excess. Much of the concern – with validity – focuses on valuation. We have made the point repeatedly that asset values should serve as a compass when all else fails. Beyond the work by others (academics and market commentators) highlighting some of the highest equity market valuations in history (particularly for the S&P), we note three other concerning factors: more investors think equities are expensive now than at any stage since 1998 (per the most recent Bank of America Merrill Lynch investor survey, which began in 1998); short interest in the S&P is at its lowest in a decade (per Bloomberg); and, Charles Schwab says it has opened the greatest number of new retail accounts since the year 2000.

Moreover, there is, of course, a lot about which to worry. To compound demanding equity valuations (not that fixed income is any more attractive; rather, the contrary), globally, three-month rolling earnings revisions have now turned negative for the first time since 2011 (per Credit Suisse). Meanwhile the correlation between earnings beats and higher share prices has now broken down in the US, a phenomenon that has not occurred on a quarterly basis since Q2 2000 (per BofAML). Then, in the near-term, there is the looming and unquantifiable threat of geopolitical fissure – whether it be North Korea, Russia or the Middle East. Such uncertainty may make corporates more risk averse (potentially pressuring earnings) and simultaneously push safe-haven fixed income yields down even further.

These challenges occur at the same time as we observe growing headwinds for the world’s largest economy, where its Central Bank is transitioning (as are others around the world) into a more uncertain monetary environment. Much has been elsewhere of the growing dysfunction of the Trump administration, but this just makes dealing with the country’s other challenges even harder. We note that consumer debt is at its pre-crisis levels in America with credit card delinquencies having now risen for three consecutive quarters, a trend not witnessed since 2009 (data per the New York Fed). Meanwhile, the country’s savings rate of 3.6% is at its lowest since the end of 2007 (per the Department of Commerce). Furthermore, there remains an absence of tangible policy with which to target the country’s major structural problems – tepid productivity and adverse demographic trends. In the near-term, there is also the issue of the debt ceiling, and a need for imminent resolution.

We might additionally wonder with some good reason how Central Banks may deal with deteriorating economic prospects, particularly were these to be compounded by some exogenous geopolitical event. It should not be forgotten that the major Central Banks around the world have been unable to deliver inflation anywhere close to their mandate, (indeed, core CPI in the US is currently at its lowest since January 2014 even with this being year-eight of economic expansion) despite having indulged in an unprecedented usage of unconventional policies. Yet now, Central Banks are – perhaps counter-intuitively – talking about withdrawing liquidity from the financial system, thereby tightening financial conditions. Not buying any more government bonds effectively constitutes the inverse of quantitative easing – think of it more as quantitative tightening – and is an exercise fraught with difficulties especially since Central Banks own around 20% of their government’s total debt (per Morgan Stanley). When the next crisis hits, pursuing a strategy of easing once again will likely have diminishing marginal returns, and so Central Banks may be forced into an even more radical approach, perhaps direct money-printing. While we are not close to this stage, it is worthwhile wondering how much ability such actors have, to ‘do what it takes.’

What now?

Consistent with the view we have expounded since at least the start of the year, we believe there is little upside to be gained from chasing the dying embers of this ageing bull market. In other words, it is a good principle to turn cautious too soon rather than too late. It is worth reiterating that against this background, valuation should be the factor that helps inform most investment decisions. Within the world of liquid assets, we see a strong(er) case for emerging market equities than many others, while we also see clear attractions in diversifying into other uncorrelated (private) assets.

Global GDP growth of 3.6% may be tracking at its fastest level since 2011 (per Morgan Stanley), but this is being driven by the world’s developing rather than mature economies. The IMF forecasts that the emerging world should deliver 4.5% GDP growth in 2017 helped by the emergence of Brazil and Russia from recession, more than double the 2.0% rate it forecasts for the developed world. Notably, as discussed above, the pro-growth agenda advocated by Donald Trump has seemingly stalled for now. Moreover, the notional $1trillion figure mooted by Trump for infrastructure spend should be seen in the context of the $10trillion spent by China in the last decade (per the World Bank) on similar projects – in other words, investing for the future. On most indicators we assess – GDP growth, capex cycle, profit margins – the emerging world seems at a much earlier stage of the cycle than the developed world. Meanwhile, EM earnings revisions are currently rising at a rate five times faster than those in DM economies (per CLSA), while emerging market valuation levels are markedly cheaper than those of their developed world peers across a variety of metrics, both in the near-term and the medium-term.

Alexander Gunz, Fund Manager, Heptagon Capital


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