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: a number of deep fissures are emerging in the investing landscape. Quantitative easing is being replaced by quantitative tightening, yet our concern is that years of ultra-loose monetary policy may have made investors sufficiently complacent that they are now mispricing risk. With almost all asset classes in negative territory since the start of the year, problems are clearly building. The risk of policy error remains significant, while growing debt burdens should not be ignored. Against this background, now is the time for diversification. We hence strongly favour uncorrelated investment strategies.

Asset Allocation:
• Equities: Most global markets are down year-to-date, barring the exception of some US indices. Moreover, while the S&P 500 may be in positive territory (just), the Dow is negative for the year, yet the NASDAQ is up over 8%. Divergences are growing despite the fact that many corporates are reporting a healthy operating environment. Headline valuation multiples may 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 policy shift of the European Central Bank should imply a strengthening in the Euro relative to the Dollar, particularly since the US is further down the tightening path than the Eurozone. Recent Dollar strength also needs to be seen in the context of pronounced weakness over the last year. We have no active currency stances and note that history demonstrates the tendency of currencies to mean-revert over time.

• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies and our conviction in this respect only continues to grow. Within this universe, we consider allocations to infrastructure assets, direct lending, niche private equity and catastrophic reinsurance to be attractive. Such assets provide resulting diversification and allow investors scope to harvest illiquidity premiums. In addition, despite recent underperformance, the inclusion of gold in portfolios could help add a form of protection, particularly given its lack of correlations.

Another cruel summer ahead?

Thoughts of summer often centre on sunshine and beaches. However, recent history tells us that it can also be a period of marked stress for investors. Long-standing readers will recall that we first coined the expression ‘cruel summer’ in 2011 at the nadir of the Greek debt crisis when the US fiscal deficit created an additional source of concern. Since then, we have had recourse to the expression on several occasions. We wonder whether 2018 may see its further use. On the surface, it is simple to paint a roseate picture: geopolitical worries continue to be shrugged off, the US equity bull market is now one- month short of setting a post-War record, 10-year Treasuries have struggled to settle above 3% and the VIX Index of volatility averages little over 15 on a year-to-date basis.

However, such a picture masks some very important distinctions. Distinctions may even be too generous a word. Alternatively, one could argue that a number of deep fissures are emerging in the investing landscape. Begin with asset class performance: almost all major asset classes are in negative territory since the start of the year. The MSCI World global equity index (MXWO) is down 0.7%, while both corporate (Investment Grade) and High Yield debt in the US and Europe alike are also in negative territory, using Bank of America Merrill Lynch indices. Owning hedge funds has not helped, with the HFRX global index down 1.2% year-to-date. Gold is in negative territory too. Only oil and the S&P 500 Index have delivered positive returns so far in 2018. Now, look again at the latter asset class. While the S&P 500 has gained 1.7% since January, the Dow remains in the red, yet the NASDAQ Index has streaked ahead, up 8.8%. Furthermore, for the first time since 2000 (and we all remember what happened then…), the concentration of the five biggest stocks in the S&P has exceeded a 15% weight. Additionally, for the first time ever, all five are in the same sector – information technology.

What conclusions to draw from this? Investors are all being attracted to the same asset classes, often a classic late- cycle indicator. More positively, we can assert that this is clearly an environment where active and differentiated investment strategies should prosper. Looking ahead, pursuing such an approach seems abundantly logical, particularly in the context of the likely maturing of this current cycle. As Christine Lagarde of the IMF notes, the clouds over the economy are “getting darker” every day, with divergences widening between the US and Eurozone (doing well) and emerging markets (doing much less well). The prospect of further trade wars would only exacerbate this dynamic.

We do not definitively know which grain of sand will cause the pile to collapse. To continue with sand-based metaphors (it is the summer season after all), we do not, however, want to be the ostrich – in wilful denial about the realities of the current investment environment. What worries us is that years of ultra-loose money may have made many investors so complacent that they have mispriced risk. This mispricing seems most evident to us in the fact that a subtle yet significant shift has occurred: we have moved from a world characterised by systematic and stability risk to one where policy is dominated by perceived inflation risks. The era of quantitative easing has ended, replaced by one of quantitative tightening. Correspondingly, assets which did well in the former regime should do less well now, and vice-versa.

The biggest risks, therefore, relate to policy. Put another way, it will be crucial to monitor two things: when tighter money in the US and Europe becomes an issue for emerging markets; and, when commercial banks follow the lead of Central Banks in tightening. There is the additional concern that there may be unintended (and potentially adverse) consequences arising from monetary tightening occurring at the same time as fiscal loosening, particularly in the US. For now, the burden of proof lies on Central Banks not to commit errors. When the next crisis does come, we sense that it won’t be the the commercial bankers (per Lehman) that get the blame this time, but the Central Bankers.

Jerome Powell of the Federal Reserve describes the US economy as being “in great shape” at present. Meanwhile, Mario Draghi at the ECB believes that the Eurozone economy is “strong enough” to overcome increased risks. Many of the corporates with whom we engage also support these contentions. The Q1 reporting season was one of the strongest in recent history and indications are that the impending Q2 season should also be robust. This perhaps explains why equities (even if most markets are down) continue to deliver relative outperformance versus other asset classes. Furthermore, if we believe more inflation is coming, then equities should prosper, at least on a relative basis.

However, we would suggest that the bullish tones of Central Bankers do require some moderation. We wonder whether an American economy that has seen government debt grow at a faster compound annual rate than nominal GDP over the last five years (4.6% versus 3.9%, per Grant’s Interest Rate Observer) can be described as being in “great shape”. The fact that during the ten year-period to the end of 2017, the US has added more than $3 of incremental debt (defined as credit to non- financial institutions, per the Bank of International Settlements) for every incremental Dollar of GDP is also rather sobering. Against this background, we should not be surprised when the IMF highlights that at least 20% of US corporates are “extremely vulnerable” to a rise in interest rates. More broadly, the legacy of quantitative easing is that it has papered over a lot of cracks. The underlying cause of the next market retreat could well be the dawning realisation that many parts of the economy/stock market that were ‘assumed’ to be healthy are in fact quite a lot more vulnerable than perceived.

Every indication suggests that we are moving towards a tighter monetary environment. The message disseminated by the Fed after its last meeting was that investors should now expect four (rather than three) interest rate hikes this year, while arguably the biggest policy change in the last month was the formalisation of a shift in European Central Bank policy. When its bond-buying programme comes to an end later this year, there will be implicit tightening, even in the absence of imminent interest rate rises.

The consequences of such a policy shift are already manifesting themselves in emerging markets, even if not yet closer to home. A quick tour around the globe provides stark evidence that diminishing Dollar liquidity is having an adverse impact on both emerging markets bond and currencies. Argentina has just received a $50bn bail-out from the IMF, the largest in its history; Turkey’s debt has been downgraded by Moody’s, its currency is at a secular low and its leader seems set on pursuing even more disruptive policies; the Brazilian government has had to intervene to support the Real; the Pakistani authorities have been forced to devalue the Rupee three times so far this year; officials in India and Indonesia have warned the US not to tighten further for now. The list goes on. Add into the mix the negative impact of trade wars and simmering geopolitical risks, and the seeds of a more pronounced crisis could potentially be being sown. If history is any guide to the future, then fear can feed on itself, and concerns can become self-fulfilling prophecies. Many emerging market asset classes (including Chinese equities) are now in formal bear market territory, down at least 20% from their highs. For the longer-term investor, this constitutes a clear opportunity, although careful selection is crucial. Nonetheless, things may get worse before they get better. Welcome to another possibly cruel summer…

Alexander Gunz, Fund Manager, Heptagon Capital