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: don’t chase the bull. We would rather be too early than too late. The nature of bubbles is that they can continue inflating, often for longer than many anticipate. The logical response, therefore, is to focus on investment strategies not in bubble territory. Our approach is to consider the bigger picture: valuation, geopolitics and the direction of travel. We are moving towards a tighter monetary environment globally and also a more uncertain world, where many policy responses are untested. Against this background, we favour value over growth, active over passive, emerging markets over developed ones, and strongly advocate more diversification.

Asset Allocation:

• Equities: After two sell-offs year-to-date, equity markets have now recovered close to peak levels. However, with global equities up less than 1% year-to-date and US equities barely 2% higher, we wonder whether we are close to the beginning of the end. Not only might markets be at peak earnings (the Q1 season in the US was the best in 25 years), but they may also not be able to tolerate higher bond yields indefinitely. We note that the yield on 3-month US debt now exceeds that of the S&P Index. At this stage of the cycle we see an increasing logic in favouring active approaches over passive ones and are reassured to see that active equity funds have had their best start to a year since 2009 (per Bank of America).

• Fixed Income: Yields are moving higher, with US 2-year and 10-year debt now yielding the most since 2008 and 2011 respectively. With 30-year debt at its highest since 2015, the bond market sell-off would seem to be spreading even to the most resilient parts of the market. For us, it is about two things: being cognisant of the direction of travel (upwards, for yields) and respecting the adage of not fighting the Fed (or other Central Banks – who will likely continue with tightening). At some stage, yields will start to compensate investors more adequately for the risks involved. We’re not there yet, but are monitoring developments before moving to a higher-conviction view.
• FX: History demonstrates that currencies have a natural tendency to mean-revert over time. Recent Dollar strength may be a response to policy developments, but needs to be seen in the context of pronounced weakness over the last year. We note that the Euro currently stands at a year-to-date low versus many major currencies, potentially creating opportunities, although some emerging market currencies offer even better value. We have no active views currently.
• 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 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.

When the tide goes out…
The two key questions with which we need to concern ourselves are: how close are we to the end of the cycle; and, how can we know when we’ve arrived? These are particularly pertinent given that the setbacks witnessed in equity markets earlier this year have seemingly been forgotten. Global equities are within 5% of their all-time (nominal) highs, while the VIX index of volatility has subsided below 15, in contrast to levels of more than 35 recorded back in February.

Part of the problem seems to be how investors treat news. There is a natural tendency to look through events perceived as bad, instead focusing more on the good. Nonetheless, more of the former might bring a much-needed dose of sobriety to the current investing environment. It is clearly in the nature of ‘bubble’ periods that they can keep on inflating – and generally last longer than most assume. This is because we know that markets can go far beyond any objective valuation metrics. We are reminded of Keynes’ dictum about the irrationality of markets and the solvency of investors.

What is more interesting, however, is to consider what happens when the bubble does pop. At the least, it seems fairest to contend that we will all know about it. Rather than Keynes, Buffett springs to mind here: “when the tide goes out,” we will find out who has metaphorically been swimming naked. Put another way, when things break, investors may get some nasty surprises. By way of example, we were interested to read that the number of outstanding leveraged loans in the US ($1tr+) is now more than double where it stood at the end of 2010, while those classed as covenant-lite comprise 77% of the market, versus less than 20% a decade ago (all data courtesy of Bank of America Merrill Lynch).

As we have written previously, we believe it is better to be early rather than seek to chase the last stages of this bull market. Now is the time to be thinking about the long-term rather than focusing on short-term market gyrations and – what seems to us – an unhealthy fixation on arbitrary numbers. We have wondered regularly why a 3.00% yield on US 10- year debt should matter specifically more to investors than either a 2.95% yield or a 3.05% yield. Similarly, should a notional 10% drop in equities matter more than, say, a 9% or 11% fall? Such a fixation runs the risk of missing the bigger picture.

It is worth bearing in mind that once Central Banks globally (and not just the US Federal Reserve) stop buying bonds, then the yield curve will become more relevant again. Many investors have perhaps become too used to a low-rate environment and so cannot recall what it may be like to manage assets in a rising-rate environment. This sort of cognitive bias is particularly dangerous at the current stage of the cycle.

Against this background, the most logical approach is to focus on investment strategies not in bubble territory and instead to focus on what really matters. To summarise in four words: it’s all about valuation. We have found it somewhat reassuring in our recent meetings with investors across the world that valuation has come up increasingly as a topic for discussion. We care more about this topic than about the economic backdrop, especially since correlations between the performance of some asset classes (such as equities) and GDP growth is limited.

To spend a moment, however, on the economy, investors should be aware of the anomalous nature of the current (US, but by implication, global) expansion. At 105 months in nature, it is the second longest on record. But, with average annual growth of 2.2%, the rate of expansion has been the slowest since the Second World War (per Bloomberg). This is a function both of the Financial Crisis and the policy response – Quantitative Easing – which followed. While there is little in the current data that suggests recession is imminent, there is still no scope for complacency. While the Federal Reserve seems happy at present to tolerate some overshoot in inflation after years of having undershot its target, there is no precedent for the Federal Reserve and Congress working in opposite directions. Put another way, the former is hitting the brakes on monetary policy, just as the latter is pressing the accelerator in fiscal expansion. The risk of policy error, particularly in the context of this being year-ten of an economic recovery, looks high to us. Moreover, the US template seems to be one that several other countries around the world also seem to be contemplating…

When we view the world through the lens of valuation, there are few places to hide. Historic correlations between equities and fixed income seem to have broken down and neither asset class offers mainstream value. A more rigorous approach would be to frame the valuation debate in the context of the current investing environment. In other words, as we move from a world of (broad) quantitative easing to one of quantitative tightening, so a reversal of the strategies that have worked in the recent past should now begin to deliver: active approaches deserve consideration over passive ones; we favour value over growth and momentum; emerging markets look more attractive than developed ones. And, above all, diversify into uncorrelated assets.

Earlier, we mentioned the phrase ‘focus on what really matters.’ Our observations about valuation and asset allocation should be clear. Two other related things also matter to us: politics and, the direction of travel. With regard to politics, we worry about investor desensitisation to the topic, since crisis has been imminent for so long in both the Middle East and the Eurozone. This potentially breeds complacency. Moreover, the risk of miscalculation (and potential error) is also exacerbated by the fact that geopolitics is evolving into a significantly more complicated game than previously, now best thought of as one being played with economic weapons in a multi-polar world. At the same time, the challenges implied by such an environment are exacerbated by the long-term decline in US power contrasting with the gradual rise of China.

Against this background, we see a strong case for gradually growing allocations to Emerging Market assets in general and China in particular. Such an approach would come at the expense of developed markets and the US. The logic is underpinned by valuation. Emerging markets are currently trading at 1.5 standard deviations below their 10-year valuation average on a P/E basis, while using the same approach, developed markets trade at 2.0 standard deviations above this average (data courtesy of Goldman Sachs).

Concerning China, investors remain consistently underweight in their allocations to this market, by an average of around five percentage points (per research from Citigroup). Some of this positioning may relate to a potential misunderstanding about the changing positioning of the Chinese economy. 80% of current Chinese economic growth is currently coming from consumption, with consumer confidence at a secular high (per National Bureau of Statistics). Meanwhile, concerns over debt levels look to be misstated. Overall leverage peaked in 2013. Since then, the domestic savings rate has been gradually increasing, while the country runs a current account surplus – in marked contrast to the US. It’s all about the direction of travel.

Alexander Gunz, Fund Manager, Heptagon Capital