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 bar is set high for 2018 given a starting point of pronounced valuations and low volatility. A conventional 60:40 portfolio of equities and bonds would have achieved a Sharpe ratio of over three in 2017, a rare occurrence, and a feat unlikely to be repeated this year. It is important to remember that low volatility does not mean low risk. Equally, elevated valuation levels will likely act as a constraint to medium-term returns. Against this background, even if 2018 is not characterised by a boom then bust scenario, the least investors should expect is a period of lower returns than that to which they have been accustomed. Moreover, potentially severe corrections can still occur in the absence of a bear market. We therefore believe there is a compelling logic in focusing on valuation and diversification: emerging market and uncorrelated assets look attractive.

Asset Allocation:

• Equities: Stretched valuations are more of a concern for equities than the end of the business cycle. After strong returns in global equities – particularly in the past year – it is tempting to take profits, but 2018 should mark a second consecutive year of upgrades to estimates. The positives still outweigh the negatives, particularly when other mainstream asset classes all look relatively uninspiring. Nonetheless, there is clear need for caution. We note that growth has outperformed value for the last decade (per Morgan Stanley) and that momentum as a style has enjoyed its best year since 1999 (per Bloomberg). Our strategy emphasises value in general, and emerging markets in particular.

• Fixed Income: Even if there is a bubble in equities, we see an even larger one in fixed income, as characterised by the desperate search for yield. We believe the current credit cycle as stretched and, in most cases, yield does not compensate investors adequately for the risks involved. Credit spreads and default rates could widen over the next year. Meanwhile, do not forget that over $10trillion of debt globally trades with negative yield (per Bloomberg). This implies guaranteed losses should the bonds be held to maturity, their magnitude exacerbated when rates rise and/or inflation returns.
• FX: We have no active views on currencies heading into 2018, but note that relative Dollar weakness over the past year may potentially continue further in the near-term. From a valuation perspective, emerging market currencies look particularly compelling, trading at a 20%+ discount to the Dollar (per Credit Suisse).
• 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 and higher premiums), infrastructure assets, direct lending and niche private equity to be attractive. Such assets provide resulting diversification and allow investors scope to harvest illiquidity premiums.

There is an alternative

Year-ahead outlook pieces generally begin with an assertion about which asset classes to own, but this works on the assumption that there is value to be found. When we look at the broad universe of conventional assets, we find little that offers evident value, particularly bearing in mind that equities finished 2017 on a high note, with the Dow Jones Index having

marked over 70 new nominal highs over the past year (a record achievement). Normally, something is cheap: in other words, when risk is expensive, safe havens are undervalued – as in 1999 or 2007. Now, the opportunity set is very different. Indeed, it is seldom the case that equities, bonds and credit are similarly expensive at the same time. The only precedents we have for this can be found in the late-1920s (pre-Depression) or early-1950s (post-War boom). Indeed, a composite measure of these three asset classes ranks in the 90th percentile in valuation terms, per Goldman Sachs research. Our starting point, therefore, is one of high valuations and low yields.

To compound the problem, many investors seem to have forgotten what bad times resemble. Put another way, even with the credit crisis, the last 30 years have been among the best in history from an investment perspective. A 60:40 equity-fixed income portfolio would have achieved a 7.1% annualised real return over this recent period, relative to a 4.8% figure for the last 100 (again per Goldman). In addition, 5-year rolling volatility is currently almost at its lowest for the last century. Our notional 60:40 portfolio would have achieved a Sharpe ratio of over three in 2017, a feat bettered in only three other years (1965, 1985, 1995). Such an outcome will be very hard to repeat in 2018.

Against this background, we believe it is critical for investors to consider the following two observations: first, low volatility does not mean low risk. Next, elevated valuations will constrain medium-term returns. In the near-term, valuations (and assets) have the potential to over-shoot, driven as much as anything by late-cycle optimism. We hence believe it is fair to suggest that even if 2018 is not characterised by a boom then bust scenario, the least investors should expect is a period of lower returns than that to which they have been accustomed. To borrow from the extensive work done on this topic by GMO, investors should therefore prepare themselves either for a scenario of ‘hell’ or alternatively one of ‘purgatory.’ In either case, we believe there is a strong case for diversification, away from liquid assets and towards those which are less correlated – there is an alternative.

An additional consideration for investors is to contemplate whether the metaphorical option of hell or purgatory may be preferable. The latter implies a temporary state and works on the assumption that higher returns may be once again available in the future. However, knowing when this more roseate landscape becomes apparent is not clear. A period of low returns may be a worse outcome than a severe bear market/ plunge into hell, since this second outcome does at least imply a reset, whereby a clear opportunity to invest in undervalued assets may present itself.

Back to 2018 and investors should be aware that even if there is no bear market this year, this does not rule out the possibility of a (potentially severe) correction. Most outlook commentaries we have seen suggest that consensus assumes the year ahead will be OK – providing investors with more of the same – yet that 2019 will be much harder. The problem with a contention such as this is not just understanding when investors start discounting a more difficult future, but also how this impacts asset allocation decisions.

We believe that the odds are in favour of another year of growth, but there is an abundant need for caution given that 2018 marks the 10th year of the current bull cycle. Moreover, the circumstances that have paved the way for this growth remain in place. Thought of differently, the QE world is not the real world. Despite moderation during the past year, the four largest Central Banks (the Fed, ECB, BOJ and BOE) saw their balance sheets expand by $2trillion over 2017 – per Bloomberg. This is still the era of easy money.

It is important to remember that while Central Bank stimulus has smoothed the business cycle (and markets), it has not – and cannot – abolish it. There is the additional irony that while Central Banks have reduced the probability of shocks, skewing the odds in favour of growth and calm markets, at the same time, their policies have encouraged risk-taking. This has occurred not only at a consumer and corporate level (cheap refinancing) but has manifested itself in the investment community too. The latest Bank of America Merrill Lynch investor survey shows that a record number of fund managers say they are willing to take on higher-than-normal levels of risk. We are not in this camp and also cannot help but observe the irony that in the same survey, a record number of investors state that they believe equities to be overvalued…

We believe that there are three additional problems that the current environment brings to the fore. First, persistently loose policy leaves little room for ammunition in the event of a slowdown. Next, the inevitable flipside of quantitative easing has been increased inequality (asset-price inflation while sustained real-world inflation remains mostly absent), and correspondingly a rise in ugly populism. And, finally, we wonder how much better things can get from here: global purchasing manager indices of industrial output are at 7-year highs, while earnings revisions are also close to peak. At the least, the rate of change will likely decelerate from here, potentially disappointing some. Furthermore, investors should be aware of politics as a further source of potential uncertainty/ dislocation. We would highlight that Italy – the country which has the lowest approval rating for the Euro within the Eurozone – must hold a General Election before the end of May. Additionally, the unpredictable behaviour of North Korea, mid-term elections in the US, ongoing tensions around Catalonian independence from Spain and a febrile atmosphere in the Middle East may be other flashpoints to consider.

Where to position

Valuation and compounding remain the biggest drivers of returns, in our view. Moreover, the best time to buy assets is when they are undervalued. The corollary of these observations is to prioritise value as an investment style. Using valuation as a compass, emerging market assets stand out as attractive. Take emerging market equities: despite a 34.5% gain for MSCI’s Emerging Market Index in 2017 relative to 20.1% for the MSCI World, the former trades on 15.7x forward earnings, whereas the comparable developed world index trades 21.5x (per Bloomberg). Furthermore, the cyclically-adjusted earnings multiple for emerging markets is 2.5x lower than that of the comparable levels for developed markets (12.5x vs. 30.0x, per Credit Suisse). To return to our observation earlier, given high-starting points, emerging market equities and bonds are probably one of the few asset classes currently capable of offering positive annual real returns over the medium-term.

Beyond value, our emphasis lies on diversification: we see considerable merit in less conventional and hence more uncorrelated assets such as catastrophic reinsurance, direct lending and niche private equity. Now is the time to be proactive; before it is too late. With best wishes to all our readers for the year ahead.

Alexander Gunz, Fund Manager, Heptagon Capital