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: this time is never different. Cycles rarely die without some form of policy error exacerbating an already overvalued investing environment. Many of these elements appear currently to be in place. Potential complacency and heightened volatility do not make for a good combination, particularly when consensus earnings estimates for equities are being revised down at the same time as government bond yields are rising. With so much capital concentrated in certain areas of the market, investors may be subject to a collective failure of the imagination. Now is the moment – before it is too late – to shift mindset. We believe that the case for diversification into alternative and non-correlated asset classes continues only to strengthen.

Asset Allocation:
• Equities: Valuation levels are elevated against history and the current earnings season has been mixed for equities.Growth as a style has outperformed value globally by some 60% over the last decade and we believe this dynamic will at some stage alter. It is not clear for how much longer the current cycle will endure nor the extent to which equities can tolerate higher bond yields. We see a compelling logic in active stock-selection strategies, especially given high levels of investor concentration in certain market segments (such as tech). We also prefer emerging markets to developed ones.

• Fixed Income: Bond yields are higher across the developed world with headlines focusing on the importance of the yield on ten-year US Treasuries surpassing 3%. We see this as purely being psychological, but believe investors do need still to adjust to the fact that the long bull market in bonds is now over. The direction of travel for bond yields should remain 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: We have no active views at present and see current Dollar strength as being a natural response to rising US bond yields and the charge that the Federal Reserve may be behind the curve in terms of policy development. The reality is that currencies tend to show mean-reverting tendencies over time. Emerging markets offer relative value at present.

• 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.

The beginning of the end (or, what next after peak positioning)?

It certainly feels like we are very late in the current cycle. One statistic that came to our attention over the past month and which reinforces such a view is the following: some 80% of US companies that listed last year were loss-making. Even if tech and biotech were to be stripped out of the analysis, then the figure would still be over 55%. These numbers are higher than comparable levels at the peak of the 2000 technology boom (all data courtesy of the University of Florida). Meanwhile, the optimism of American CFOs is the highest ever-recorded (per a recent study by Deloitte). Deal-making globally is up 50% year-on-year and has surpassed $1trillion. Perhaps this time is not different; the more things change, the more they stay the same…

Global equities peaked on 26 January this year. Whether they surpass this level remains to be seen. What has occurred since then have been two very pronounced drops (of 11.8% in late-January/ early-February and 8.9% in March – measured from peak to trough for the MSCI World). Markets did recover on both occasions, but there is an inescapable sense of equities being range-bound. The adage of ‘sell in May’ might have greater resonance than usual this year, particularly in the context of a highly febrile global geopolitical environment.

At the least, higher volatility (or bigger market swings) should not be surprising – rather, the new normal. The transition from monetary accommodation to its removal, combined with the erosion of spare capacity in the economy was never going to be simple. Perhaps the correct way to think about today’s investing environment is that higher volatility now is the ‘payback’ for having enjoyed significantly lower, more repressed volatility in the recent past.

Our bigger concern is to wonder whether investors have not just ‘borrowed’ reduced volatility which they are now having to pay back, but whether the same charge can be made concerning growth. Total global debt stood at $273trillion at the end of 2017, $70trillion higher than a decade prior (per the Institute of International Finance). Against this background, future growth may have been ‘borrowed’ through higher leverage. We have little doubt that the next round of problems for the economy globally will undeniably be exacerbated by the access that has been provided to cheap capital.

‘But there is no sign of economic recession yet.’ We hear and read this message regularly although we sense also that the truth is somewhat more complex. When viewed in isolation, certain data points (of which more below) do not appear concerning, but when taken together, the outlook appears much worse. Investors need to be mindful of two things: first, consensus earnings estimates for equities are being revised down, just as government bond yields are rising. Next, it would be easier to feel more relaxed (or justifiably complacent?) about the macro environment were many conventional asset classes not trading at peak multiples – but since they are, the margin for error is very low.

In the context of our previous observations about leverage, note that the US government is set to borrow 4.2% of GDP this year (presumably to fund all those tax cuts), the most since the Second World War, per the Federal Reserve. This may not be enough, given the conundrum of deteriorating growth and rising prices. Industrial production indices are reporting declines while manufacturers’ assessment of the outlook in the New York area (per the Empire Survey) are more negative on the outlook six months out than at any time since 2001. This is perhaps not surprising given that core producer prices are at their highest since 2011 and core inflation at its most elevated since 2014. Rising inflation naturally eats into consumer discretionary income. Consumption constitutes some 70% of US GDP, but consumer confidence metrics are currently declining. The picture does not look markedly better in Europe, where industrial production arguably peaked at the start of this year (there have been three consecutive months of declines) and retail indicators are also tumbling.

The prospect of trade wars would only compound this unappealing cocktail of lower economic growth and higher inflation. Even if rhetoric differs from reality, the real test of policy transition for Central Banks is still to come. At some stage in the next twelve months it seems reasonable to assume that the Federal Reserve will have to start hiking amid more difficult economic conditions. Meanwhile, neither the European Central Bank nor the Bank of Japan has yet to withdraw liquidity and start tightening. The debate about when/whether the yield curve may be inverting is a potentially misleading one in our view (since its shape may well be distorted by the burden of unconventional policy implemented in the recent past), but it remains fair to wonder whether Central Banks do have the necessary skills to manage a more complicated future.

Bigger-picture, we worry about a collective failure of the imagination. Just because Central Bankers have provided a backstop in the past does not mean that they will in the future. Their behaviour has promoted moral hazard at the expense of rational consideration. This time around, the world’s key political leaders are more unpredictable and less conciliatory in their policy. Investors do need to be worried for – put simply – a decline in US equities would spell declines for global equities, given the weight that the world’s largest stock market carries in most benchmarks. Furthermore, never has so much capital been concentrated in one area. The seven biggest companies in the world ranked by market capitalisation all fall into the tech sector, a higher concentration than at the peak of the technology boom, and a level matched only by Japan’s dominance in 1989. Passive investing algorithms only compound this issue. Something will have to give.

Investors need to adapt their mindset. Equities are not the only game in town, even if they have for long been more attractive than fixed income. A ‘buy-the-dip’ mentality needs to be replaced by one of ‘sell-the-rally.’ Asset allocators need to think about the case for value relative to growth, especially since the former has underperformed the latter by 60% over the last decade (per Goldman Sachs). Investors have favoured growth since it has been scarce, but are paying the price: the MSCI World Growth Index trades on 22.7x forward earnings, compared to a multiple of 16.2x for the Value Index. Similarly, investors can choose between owning developed world equities for 19.0x earnings or emerging world equities for 15.0x (again using MSCI proxies – all data per Bloomberg). Against this background, active strategies should prosper. More broadly, and as we have advocated for some time, the case for diversification only strengthens. Now is the time to be considering the merits of alternative and non-correlated asset classes.

Footnote: turning points in history

As if investors did not have enough with which to contend, we believe it is worth considering how close we may be to a critical turning point in history. Stepping back from the more immediate headlines, the inevitable conflict that seems to be emerging is between the United States and China. Put another way, it is one between a reigning superpower and an up-and- coming one. There appear to be irreconcilable ideological and economic differences between these two major nations, which are now increasingly escalating into the open, per the exchanges over trade and geopolitics. The current leaders of America and China both want to make their countries ‘great’ again but the methods being deployed in order to reach this end appear orthogonal. The inevitability of some form of conflict at some stage seems relatively high. It is unlikely there would be a clear ‘winner’ (at least in the near-term), but from a much longer-term perspective, investing in the US is becoming riskier.

Alexander Gunz, Fund Manager, Heptagon Capital