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: it is easy to miss the bigger picture amidst much of the euphoria that currently seems to be gripping equity investors. Yes, many global indices made new highs in the past month, but the more interesting story to us has been the notable strength in bond yields. We wonder not only when a better growth outlook might translate into more inflation, but more importantly, how well investors in all asset classes may have discounted a scenario of higher inflation and spiking bond yields. We are not convinced that ‘this time it’s different;’ we are concerned about potential investor complacency, and we do believe that a strategy of diversification into cheap and uncorrelated assets is merited. Gold also has, in our view, increasing attractions.

Asset Allocation:
• Equities: Pronounced strength in global equities is reminiscent of late-cycle behaviour, or a perceived fear of missing out. Valuation levels for many indices are demanding relative to history, but this may not matter in the near-term, particularly given that consensus earnings estimates have now risen for five consecutive quarters (per Bloomberg) and continue to look robust. This is an environment in which active managers can prosper – less Central Bank intervention means more scope for price discovery. Our preference is for value over growth and emerging markets over developed.

• Fixed Income: Given the current macro back drop and the prospect of a potential shift towards tighter Central Bank policy, the recent strength in government bond yields should not be surprising. Even if the long bull market in bonds is not over, then at least the assumptions that have driven it – perpetual quantitative easing and deflation – are now highly open to challenge. Nonetheless, in many cases, yields still do not compensate investors adequately for the risks involved. We continue to monitor this asset class before moving to a higher-conviction view.

• FX: In light of recent comments from the ECB, Euro strength relative to the Dollar has become pronounced. Many commentators (e.g. Credit Suisse, Morgan Stanley) see the Euro still around 10% undervalued relative to the Dollar, suggesting this trade may continue to run for some time longer. Nonetheless, we note that emerging market currencies – in general – remain cheap relative to both the Euro and the Dollar. Over time, mean reversion still occurs too.

• 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.

This time is not different

Bull markets don’t come along very often and investors, understandably, want to make the most of them. It is hard to refute this desire, particularly when much of the recent rally has been fuelled by a perceived fear of missing out. Nonetheless, we cannot help but be reminded of the words of two famous investors. Stanley Druckenmiller highlights that capital flowsdrive short-term behaviour more than valuation, while for John Tempelton, the four most dangerous words in the English language are ‘this time it’s different.’ Put simply, ‘it isn’t,’ especially given that the median US stock trades in its 99th percentile of valuation (i.e. extreme over-valuation) since 1970, per analysis by Goldman Sachs.

We are not surprised by what we observe: investors always seem to latch onto bullish narratives late in the cycle; they seem logical at the time, even if madness with hindsight. The investor/ media hype surrounding bitcoin at present is a case par excellence of this dynamic. However, as with most parties, there will be a hangover. Put another way, no cyclical bull market has ever ended without some form of over-excitement from investors.

Looking ahead, even if there is no major bear market around the corner – and we don’t necessarily see this panning out in 2018 – then investors should at least prepare themselves for a period of lower returns. Moreover, as we’ve written previously, prolonged bull markets and pronounced corrections are not mutually exclusive concepts. Our counsel for quite some time has been to diversify, and to own cheap and uncorrelated assets. The purpose of this commentary is not to go over old or familiar ground once again, more to highlight how the narrative is evolving.

How do you measure euphoria?

Notwithstanding the slight wobble in equities at the end of January, the MSCI World Index has now enjoyed 15 consecutive months of straight gains (an outcome not many would have predicted when Donald Trump was elected President just prior to the start of this period). Indeed, it has been the best start to a year for equities globally since 2006 (per Bloomberg), with the S&P 500, America’s major equity benchmark, having now surpassed its previous record in terms of number of trading days without a 5% pullback.

It gets better. The University of Michigan’s latest survey into consumer sentiment shows that 65% of Americans polled believe that the stock market will rise over the next 12 months – the highest on record. While money is, however, flooding into the equity market (much of it, unfortunately, into price-agnostic vehicles such as ETFs), we observe that US consumer credit is at an all-time high of 28.2% of personal consumption expenditure, 2 percentage points above the pre-Financial Crisis peak just as personal savings are at a decade low (per the Department of Commerce). Meanwhile, mutual fund managers are holding the lowest amount of cash on record, while equities as a percentage of financial assets stand at the second highest level in history, surpassed only in the TMT boom (per Citi). French journalist Jean-Baptiste Alphonse Karr may have been right when writing over 100 years ago, “the more things change, the more they stay the same.”

The bigger picture

While equities may be in (or close to) a euphoria phase, some very interesting things have been occurring in the world of fixed income. For those who may have missed it, the yield of 2.7% that investors can earn on 10-year US Treasury debt is the highest witnessed since August 2014, while the last time 2-year US debt yielded more than 2.0% was around the time of the collapse of Lehman Brothers. Over in Europe, German 10-year debt now offers the highest yield witnessed since early 2015. At the same time, the Euro is touching a rate of 1.25, a level not witnessed since the last days of 2014.

How to explain all the above? Beyond the major shift in European Central Bank policy (of which more later), many have begun to question whether these moves may signify that the bull market in bonds is over. We think the more pertinent question to be asking is when does a better growth outlook translate into more inflation? Or, how well have investors in all asset classes discounted a scenario of higher inflation and spiking bond yields? Despite generally good messaging from Central Bankers and the like about growth and inflation prospects, our sense is that an uncontrolled rise in bond yields is not well discounted.

First the data. The IMF raised its world growth forecasts in January by 0.2 percentage points relative to its previous estimate as of October 2017. The guidance is now for 3.9% global GDP growth in both 2018 and 2019. Furthermore, per the IMF, the fewest number of countries ever will enter recession over the coming 12 months. Citi notes that one would need to go back to 1995 to find a period when the US, UK, Eurozone and Japan were all simultaneously experiencing accelerating productivity. However, while at the end of 2017 inflation was below-target in all these regions, by the end of this year – and notwithstanding the structurally deflationary impact of demographics and technology – inflation may well be above-target.

The easy part of the equation is explaining why; the harder element is characterising the way in which policymakers may respond. In terms of why, put simply, we are entering a world free from post-Financial Crisis drags where global growth is at its most synchronised since the Eisenhower administration. At the same time, there is less spare capacity left in economies to absorb this growth, while expectations are now substantially higher. Some 18m new jobs have been created in the US since 2010 and unemployment stands well below 5%, while Eurozone unemployment (at 8.7%) has tumbled to its lowest since 2009. Inflation expectations (measured by five-year break-even points) are now markedly higher in both regions than a year ago. The problem with inflation is that there is never just ‘a bit’. When inflation comes, it has the potential to disrupt the policy status quo. Whether Central Bankers are equipped to deal with the challenge remains unclear. The ECB is, at least, shifting its stance and highlights that it is “open” to tweaking its policy to align it with a strengthening economy. Over at the Federal Reserve, the new Chair will have to set expectations appropriately and also deal with the impact of a tax stimulus coming at a time when it is not necessarily needed. Looking forward, investors need to prepare themselves for a potential change not only in rhetoric, but also policy.

How best to protect portfolios?

Given the crisis that came before, it is hard to compare this bubble to previous ones, particularly when taking into account the impact of quantitative easing and the financial repression it has wrought. Nonetheless, what we do know is that longer- dated Government bonds are so richly priced that negative correlations with equities can no longer be relied upon. Against this background – and beyond our consistent message regarding diversification – we believe that gold may be a potential solution for investors to consider. We note that in periods when equities deliver adverse returns, gold has generally generated a positive return. In the 10 most difficult months for the S&P over the last 30 years, where the market has fallen by an average of 12%, gold has gained 0.8% some 80% of the time (per Meb Faber Research). In times of complacency, we see a strong logic for ‘playing defence.’

Alexander Gunz, Fund Manager, Heptagon Capital