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: optimism does not die overnight, but animal spirits are being severely tested at present. The low volatility regime of 2017 was never going to endure forever, but the normalisation process is being complicated by two factors: political actions and Central Bank policy. Proposed trade wars have little economic logic and may metastasise. They would also be inflationary. Whether Central Bankers have an adequate grip on the current landscape remains unclear. From an investment perspective, these challenges are exacerbated by the fact that both mainstream equities and fixed income still look expensive. Our response is to stress once again the logic of diversification, investing in uncorrelated asset classes and seeking to identify value wherever possible.

Asset Allocation:

• Equities: Seldom have equities been this expensive, even if they remain relatively more attractive than much of the fixed income universe. It is key to consider for how long equities can tolerate higher bond yields. Nonetheless, in the near- term, increased market volatility undoubtedly creates an attractive environment for stock-picking alpha strategies, particularly when many appear to have sought refuge in relatively crowded parts of the market (such as US tech). Valuation remains a crucial factor, and on this basis emerging markets clearly win out over developed ones.

• Fixed Income: Bond yields are higher across the developed world. Investors should not be surprised given the length of the recent bull market and the level of Central Bank intervention that drove it. Central Bank policy is now changing in response to increasing evidence of inflationary pressures. The direction of travel for bond yields should therefore be upwards. Nonetheless, in many cases, yields still do not compensate investors for the risks involved. Fixed income also remains highly correlated with equities. We believe it is still too early to move to a higher-conviction view.
• FX: We have no active views at present. Nonetheless, we note that the US Dollar peaked in December 2016 and betting on weakness has been a strategy that has worked since then. Concerns over potential trade wars could cause further downside and drive strength in relative safe-haven currencies (Swiss Franc, Japanese Yen). In the long-run, currencies tend to mean-revert and a stronger Euro will have a detrimental impact on the region’s prospects at some stage.
• 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, infrastructure assets, direct lending and niche private equity to be attractive. Such assets provide resulting diversification and allow investors scope to harvest illiquidity premiums. In addition, the inclusion of gold in portfolios could help add a form of protection, particularly given its lack of correlations.

Looking beyond ‘as good as it gets’

It would be an understatement to say that we have moved beyond the low volatility phase that characterised markets last year. More forcefully, we may look back on 2017 and the first month of 2018 as being a halcyon period, perhaps one that marked the top in terms of sentiment. Now, we are in a period of normalisation. With this adaptation process has come wild gyrations in both directions for the equity market accompanied by a slow but gradual increase in government bond yields. The problematic investing landscape is, of course, exacerbated not only by the fact that many seem to be hiding out in the same somewhat crowded areas (such as tech equities) but also that seldom have both bonds and equities been this expensive.

Evidence seems to be building that we are getting to the final stages of this bull market – as a reminder, one of the longest in recent history, with the US S&P Index marking the ninth anniversary since its post-crisis low last month. Optimism does not die overnight, but animal spirits are being tested. Beyond valuation concerns, investor faith in economic transition to an environment of higher and more inclusive global growth is – unsurprisingly – being shaken by more frequent talk of trade wars. Political leaders (Trump, Xi and Putin) are emerging as the chief actors responsible for influencing investor sentiment. The coming months may bring further crucial flashpoints, particularly with a meeting between Donald Trump and the leaders of North Korea due to take place in May. Nonetheless, Central Bankers have not disappeared and uncertainty over the pace of monetary tightening is another crucial element to add to the currently unappealing cocktail of concerns.

Protectionism and tariffs

To focus on the detail is to miss the point. The 25% tariff on steel imports and 10% on aluminium announced by Donald Trump accounts for just 2.0% of US imports and 0.2% of American GDP (data per Morgan Stanley). Moreover, the $50bn of China-specific tariffs also announced by the Trump administration do not come into force until the start of May, allowing for potential negotiation prior to implementation. China’s current response is equivalent to $3bn of levies on US goods. Rhetoric is one thing (Trump says his actions are “the first of many;” Xi says there will be a “necessary response”), undermining fifty years of economic best-practice is another. Planned tariffs constitute a populist move with little economic logic; should they be implemented, they would not only be detrimental to growth, but also inflationary.

For the first time since Donald Trump was elected in November 2016, trade wars have ranked as the number-one investor concern (per Bank of America Merrill Lynch’s monthly survey), replacing inflation. The irony, of course, is that trade wars are – by necessity – highly inflationary. It is only natural, therefore, to wonder why America should be considering such a course of action. Three (not mutually exclusive) responses spring to mind. Tariffs can be seen as a response to US under- investment, a huge savings deficit and/or a chronic debt problem.

Taking these observations in reverse order, it is not unreasonable to speculate whether tariffs may be a deliberate action on the part of the Trump administration. If they spur inflation, then – by magic, or at least an accounting sleight of hand – debt levels reduce. Bear in mind, total global debt now stands at $147trillion, 32% higher than in 2008 (per the Bank of International Settlements). The government deficit is, of course, not the only deficit with which the US has to contend. America has a $56.6bn trade deficit (source: US Bureau of Trade). This should be thought of as the statistical companion to the savings shortfall in the US: America has borrowed to finance consumption instead of paying for imports with exports. Furthermore, tax cuts will only likely exacerbate this problem if consumers save rather than spend – more imports at higher prices are necessarily inflationary.

Finally, proposed tariffs are an indictment on US under-investment (particularly in an industry such a steel). Investment as a percentage of US GDP has fallen from 15.3% to 12.7% over the period 1991-2017. At the same time, consumption’s share has risen from 60.2% to 69.1% (all data per the St Louis Fed). Interestingly, buy-backs have risen during this period from close to 0% of GDP to ~2.5% at present (per Bloomberg). While these have been loved by many investors, buy-backs clearly do not contribute directly to growth in fixed assets. At the least, with surging deficits and threats of increased protectionism, the US has become a more unpredictable place to invest in the near-term.

Rates and inflation

The Federal Reserve has now hiked four times since March 2017. Inflation is not only “moving towards” its 2.0% goal, but is also “expected to move up in the coming months” per the words of new Governor Jerome Powell. Americans expect inflation of 2.8% in a year’s time (based on the University of Michigan consumer survey), while five-year US inflation break- evens at 2.1% are the highest they have been since 2015. There has been an undoubted change in mindset away from deflation towards inflation. Moreover, inflation is occurring just at the time when the rate of industrial production (measured by purchasing manager indices) appears to be slowing. History suggests that this combination may increase volatility. As a reminder, our thesis for some time has been that there is never just a ‘bit’ of inflation. In other words, investors tend to forget just how disruptive inflation can be.

Where to invest

Stronger economic growth is a necessary but not sufficient condition for higher asset prices. The prospect of tariffs and/or tighter monetary policy would clearly be detrimental to growth. Regardless, in the long-run, it’s all about the price you pay for assets. Given today’s high starting point, it is only natural to expect lower returns going forward. This is why we have been forthright and consistent in our message that investors need to consider diversification, in particular into uncorrelated assets.

Near-term, another important consideration worthy of mention is that investors may not fully appreciate just how different the US macro backdrop may look relative to Europe and Asia over the next year. As discussed, the US is adding fiscal stimulus in the form of higher deficits to an economy that is already at full employment. By contrast, in Europe, deficits are being reduced, the region is running a small current account surplus and given region-wide unemployment of 8%+, there is still spare capacity within the economy. Furthermore, compare a likely path of US hiking with the fact that the European Central Bank (ECB) remains on course to add €270bn to its balance sheet this year. Mario Draghi has said that ECB policy shifts will be “predictable and measured,” a logical response given not only possible trade wars but Italian political uncertainty and a relative slowdown in industrial output. ECB deposit rates are still negative relative to US overnight rates at above 1.0%. Meanwhile, the Bank of Japan continues to expand its balance sheet, and will likely do so until inflation reaches 2.0%. Finally, let’s return to valuation – the evidence is clear: using Bloomberg estimates for 2018, US equities trades on 21.1x earnings, which compares to 15.1x for the Eurozone, 14.1x for Japan and 12.5x for emerging markets.

Alexander Gunz, Fund Manager, Heptagon Capital