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 era of synchronised growth and coordinated policy is behind us. If we accept this, then the excess returns enjoyed in the recent past may be harder to achieve going forward. Sure, the bubble may continue inflating, but now is the time to prepare for what may happen when it does burst. Record indebtedness, constrained Central Banks and a frayed political centre create novel challenges. Shrinking global liquidity and the prospect of trade wars provide indicators of what may be to come. It therefore pays to plan ahead. Our strategy has been focused for some time on creating uncorrelated and diversified investment allocations.

01 August 2018

Asset Allocation:
• Equities: Growing divergences are apparent within the equity market. Developed world indices have markedly outperformed their emerging market peers year-to-date, but absolute gains have been restricted only to a few specific areas (especially the US IT sector). This is despite many corporates reporting a healthy operating environment. Headline valuation multiples do suggest that equities are expensive relative to history, but we still see this asset class as a more attractive one than fixed income. Within equities, we expect active (and value-oriented) strategies to prosper.

• Fixed Income: Even if equities have struggled year-to-date, fixed income has similarly failed to deliver returns.The aggregate flattening of the yield curve reflects the fact that monetary policy is tightening. In most cases, however, yields do not yet compensate investors adequately for the risks involved. Meanwhile, the year-to-date underperformance of Investment Grade and High Yield may be indicative of the fact that the health of many corporates would be pressured by tighter liquidity. We hence have limited exposure to fixed income at present.

• FX: The US Dollar Index stands at close to a 52-week high, having generated annualised returns equivalent to ~30% in the last year. Almost all currencies have correspondingly fallen on a relative basis. Beyond mean reversion, a weaker Dollar would (ironically) improve US terms of trade. We have no active currency stances.

• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies and our conviction in this respect only continues to grow. Such assets provide resulting diversification and allow investors scope to harvest illiquidity premiums. Within this universe, we consider allocations to infrastructure assets, direct lending, niche private equity and catastrophic reinsurance to be attractive. Holding some cash – as a form of capital preservation – also seems logical at this stage of the cycle.

Are we there yet?

This perennial question asked by children on the way to their summer holiday destinations is also a pertinent one for investors to consider. Put another way, when does the bubble burst? Even with lacklustre returns generated by most mainstream asset classes so far this year, the economy is still going strong (corporates remain bullish and consumers are not excessively indebted) and risk appetite is broadly positive. Our take on the above question is framed by three considerations:

• It is in the nature of bubbles that they can keep inflating far longer than most commentators expect, even if we can see the writing on the wall.
• No two crashes are the same, and so looking at the past to inform the future may be a limiting exercise.
• It pays to plan ahead, just as families setting off for their holidays generally prefer to leave for their destinations early. Against this background, we have advocated the merits of diversification for some time (which could be thought of as the financial equivalent to providing distractions for intemperate children on long journeys).

Context, as we regularly assert, also matters. Recall that it is very rare for so many asset classes to have underperformed so far in 2018, despite global growth and corporate profitability both being pretty decent. The best explanation we can find (beyond a recognition that we are late in the current cycle) is simply that the returns generated this year represent a broad payback, or natural consequence, of the benign investing landscape of prior years. A conventional 60:40 portfolio of equities and bonds would have delivered a Sharpe ratio (returns measured relative to risk) of greater than three in the period 2015 to 2017. Not only is this level abnormally high, but the period which allowed for such excess returns to be possible is now behind us. Beyond being believers in mean-reversion, the world has clearly changed since then. Against this background, the logic for diversification, or investing in alternative and uncorrelated asset classes has only grown in our view.

The purpose of this month’s commentary is to elaborate on the ways in which the world has changed. This may be a task that extends beyond the 2,000-word remit of these pages, but by seeking to understand this dynamic, we should at least have a more robust framework for anticipating from where the next crash may come. We point to three specific factors about which investors should be wary.

• Record indebtedness: Total global debt is now markedly higher than it was a decade ago, standing at $237trillion, or 217% of GDP, per the Bank of International Settlements. This compares to figures of $167trillion and 179% just prior to the collapse of Lehman Brothers. Investors who have read the seminal work of Rogoff and Reinhart may recall that the authors contend that debt levels in excess of 110% of GDP are not regarded as sustainable. Debt is the elephant in the room that refuses to go away. Moreover, the quality of debt has deteriorated in recent times. Only 11 Sovereigns and 2 corporates (Johnson & Johnson and Microsoft) have AAA-rated debt, the smallest number ever, per Bloomberg.
• Constrained Central Banks: The world’s Central Banks hold $15trillion of assets on their balance sheets (per Bloomberg) and interest rates are close to record lows. This implies that there may be limited room for a robust monetary policy response in the face of another shock. At the least, the ability to act quickly and decisively may be constrained.
• The political centre has frayed: Over the last decade, the rise of populism, the decline of established political parties and the collapse of trust in international order (or bodies such as the World Trade Organisation, the G7 and so on) together imply a lower likelihood of cooperation. Brewing trade wars may be a sign of things to come. Were another financial crisis to occur, its ramifications could be markedly different without international cooperation.

The above three factors are all inextricably interlinked and may all matter more than the fact that commercial banks are much stronger now than they were a decade ago. To phrase the problem in a different fashion, the consequence of too little growth and too much debt over the last decade is that the global economy has become more of a zero-sum game. As a result, any change in the current order can have unintended consequences. This is a potentially dangerous time for investors (maybe at least as dangerous as 2008) owing to the illogicity and unpredictability of politicians. In the event of a recession – which will happen at some stage – there is the clear possibility that an ‘everyone for himself’ mentality emerges, potentially compounding the severity of the problem.

We need to be aware of what is happening around us. As Central Banks continue to shrink the pool of global liquidity, asset prices will be vulnerable. Moreover, just as passive investors have hitched a ride on calm markets in recent years, when markets do lose momentum, outflows from ETFs and other similar products could exacerbate selling pressure. The disruption wrought by tighter Dollar liquidity may exacerbate a slow-motion credit crunch. Recall, that the last two cycles ended because of financial instability, and not owing to inflationary pressures.

Elsewhere, the consequences of trade wars are yet to be seen fully. It is hard to know what impact the talk of increased tariffs may have on both corporate and consumer confidence. Investors see the threat of such wars as being the largest tail risk to markets since the Sovereign debt crisis of 2012 (per Bank of America Merrill Lynch’s most recent survey). Only $34bn of tariffs have currently been imposed between the US and China, but the important factor to monitor is when reality replaces rhetoric, or the “are we there yet?” consideration becomes substituted by a potential point of no return. Economists of all persuasions recognise that trade wars have almost no positive consequences.

The tensions between the US and China need to be viewed in the broader context of how one superpower manages its decline relative to the emergence of another. Neither wants to admit defeat. The bigger picture consideration is that the fates of these two countries (and by implication the world economy) are tightly bound. China is America’s third-largest export market, while China is also the number-one source of US imports (per JP Morgan). Beyond this, investors should not forget the complexity of global supply chains, or put another way, the unintended consequences of potential tariffs. The IT sector is probably more exposed to this dynamic than any other. It is also the S&P 500 sector with the biggest share of non-domestic revenues (per Bloomberg) – as well as the best-performing year-to-date.

Even if the prospect of trade wars remains just that, it is hard to dismiss the idea that there is a growing disconnect between economies globally. At the least, the era of synchronised growth and coordinated policy seems like a distant memory. Against this background, we see only a reinforcement of the logic in diversification. We may not yet have arrived, but the road ahead would certainly seem to be somewhat bumpier.

Alexander Gunz, Fund Manager, Heptagon Capital