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: higher volatility, rising bond yields and nervous equity markets may be the new normal. At the least, it is naïve to assume that the near future will resemble the recent past. We see increasing evidence of a new regime, one where globally synchronised growth is producing globally synchronised inflation just at a time when Central Banks are moving from expansion to contraction. Whether either investors or policymakers are appropriately positioned for such an environment remains open to debate. With high indebtedness globally, something may have to give. We believe it is best to be proactive: look for longer-term value; consider ways of protecting against inflation; and own uncorrelated assets.

Asset Allocation:

• Equities: February’s mini-correction notwithstanding, continued upward momentum in equities is being driven by a perceived fear of missing out. This is evidenced by global cyclicals trading at all-time highs relative to defensives (per Bloomberg, using MSCI indices). Admittedly the current earnings season has been supportive to this thesis, but consensus estimates discount a slowing in earnings growth going forward. The opportunity cost of not participating has to be balanced against elevated valuations. Logic therefore favours value over growth. We have an additional preference for emerging markets over developed and advocate truly active approaches in all regions.
• Fixed Income: Bond yields are higher across the developed world. Investors should not be surprised given the length of the recent bull market and the level of Central Bank intervention that drove it. Central Bank policy is now changing in response to increasing evidence of inflationary pressures. The direction of travel for bond yields should therefore be upwards. Nonetheless, in many cases, yields still do not compensate investors for the risks involved. Fixed income also remains highly correlated with equities. We believe it is still too early to move to a higher-conviction view.
• FX: Market volatility in February saw a natural flight to safe haven currencies such as the Swiss Franc and the Japanese Yen. The bigger picture, however, remains on the rate of change of Central Bank policy. With the European Central Bank and Bank of England moving now towards a tighter stance, the Euro and Sterling may continue to appreciate further against the Dollar in the near-term. On a relative basis, emerging market currencies look undervalued. •
• 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.

Regime change

Memories are short. Hard as it may now be to recall, but during February both the Dow Jones and S&P 500 indices briefly entered correction territory. Indeed, Monday 5 February saw the worst one-day move for equities since 2011. At the time, intra-day volatility spiked by more than 110%. Now, equities are back up and volatility has diminished, but something fundamental has changed. Sure, the move in early February was probably an accident waiting to happen given exceptionally low levels of volatility and arguably elevated investor complacency that preceded it. Moreover, corrections and bull markets are not mutually exclusive concepts. What’s different, in our opinion, is that the era of low rates and yields has ended. Put another way, the good old days of easy (quantitative) money and low volatility are ending. This constitutes a palpable regime change.

There has been a collective failure of the imagination in assuming that the near future will resemble the recent past. History, unfortunately, is not linear. The elephant in the room – or the question that perhaps haunts investors, yet they have been unwilling fully to acknowledge – is what happens when the economy returns to normal? This has major ramifications in all asset classes. Indeed, the magnitude of the problem is exacerbated by the fact that assets are now more correlated than was historically the case. In other words, previously, investors could look to own fixed income when equities were expensive, and vice-versa. Now, neither looks undervalued and both correspondingly suffered during last month’s market wobble.

Bond yields globally are markedly higher than where they stood one month ago, with the yield of US Government 10-year debt flirting with 3.0%, the highest it has been in the last four years. Investors have understandably begun to fret over what the significance of this more elevated level may mean. At the least, it is indicative of regime change. The assumptions that have helped to underpin the low bond yields for much of the post-crisis era – namely continued monetary easing and perpetual deflation – are now highly open to debate if not ready to be banished to the realms of history.

Higher bond yields may not be a bad thing, especially if they are indicative of faster growth and inflation. They constitute evidence supportive to the notions of a healthier economy, a normalisation of Central Bank policy and the fact that the long bull market in bonds has run its natural course. The corollary of globally synchronised growth is globally synchronised inflation. The challenge is whether Central Banks are equipped to deal with this environment. Not only is there the concern over whether Central Banks may already be behind the curve (whether current policy represents economic reality), but also if they have the appropriate tools at their disposal.

WhatwedoknowisthatCentralBanksaremovingfromaperiodofmonetaryexpansiontocontraction.Additionally, we see clear evidence that wages are rising and that inflation risks are weighted on the upside. There is, however, never just ‘a bit’ of inflation. Once it starts, it becomes self-perpetuating, with upward pressures reinforced by higher expectations. The current Central Bank mantra of policy gradualism does not sit well with such an environment.

Let’s consider the environment. To the extent that history rhymes, it is worth bearing in mind that every major inflation bout since 1973 has been fuelled by higher oil prices. Oil is ~15% higher than a year ago. US businesses as diverse as Whirlpool, Sysco, Harley Davidson, Sherwin Williams and Tyson Foods have all cited higher input costs in their recent updates to investors. Workers are similarly asking for higher wages, with US wage growth up 2.9% year-on-year last month, the fastest rate of growth since the recession ended. Upward wage pressure is exacerbated by the tight labour market observed by ‘many participants’ in the US (per the last minutes released by the Federal Reserve). It is also interesting (worrying?) to contemplate what impact the Trump fiscal stimulus will have on inflationary pressures/ expectations: the US is getting stimulus when it is highly debatable whether the economy needs it.

Furthermore, upward pricing pressure is not a uniquely US phenomenon. In Japan, wage growth is currently running at its highest level this Century, with Prime Minister Abe requesting at least a 3% rise, while some unions are demanding as much as 4%. The current negotiating season ends in March, with increases implemented from the start of April. In Germany, the country’s largest trade union (IG Metall) secured its most significant pay hike for workers since the credit crisis. Meanwhile, the latest Minutes from the Bank of England describe inflation risks as being ‘weighted to the upside.’

Our worry relates not just to the scope for policy error – should Central Banks be unable to manage the threat of inflation – but that something will have to give. Higher rates are coming at a time of elevated indebtedness. When debt is high and default rates low, things may well end badly. Investors should note that global debt stands at 318% of global GDP (compared with 280% in 2007), and non-financial corporate debt at 92% of GDP (versus 77% – all data courtesy of the IMF). In the US – which is closest to policy normalisation – household debt has now risen for five consecutive years and stands at a record $3trillion (per the Federal Reserve), with savings at their lowest in a decade. New Fed Chair Jerome Powell may describe the global financial system as “incomparably safer” than during the last financial crisis. Such a statement is naturally intended to reassure, but it is almost certain that the seeds of the next crisis have already been sown – and, that when it comes, it will be from an area not anticipated by most.

Time to diversify

Regular readers of our commentary will have heard this message many times before, but we believe the logic for such an approach is reinforced by the price action witnessed last month. In other words, mainstream asset classes are increasingly correlated. Neither developed world equities nor fixed income (in general terms) represents a logical place to hide, or seek shelter from a valuation perspective. We would prefer to be early rather than participating in the final innings of the already-long equity market rally. Projecting forward some months, inflation will likely be higher, Central Banks tighter (in rhetoric if not policy) and equity earnings upgrades constrained (tax reform has already happened).

Our strategy is threefold: look for longer-term value; consider ways of protecting against inflation; and own uncorrelated assets. These strategies are not mutually exclusive. In terms of the former, consider that emerging markets will account for around 75% of global growth this year and drive the world’s economy over the medium-term, yet equities in this region trade, on average, at a ~20% discount to their developed world peers (using MSCI proxy indices). In the equity world, businesses with pricing power and robust balance sheets look best-placed to manage the regime change to higher inflation and higher rates. Gold, as we have noted in previous commentaries, provides probably the best form of downside protection in the event of equity market drawdowns. Meanwhile, for those with the scope to diversify fully, owning alternative private assets such as infrastructure, direct lending and the like offers the best form of long-term diversification.

Alexander Gunz, Fund Manager, Heptagon Capital