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: was October a much-needed correction for markets or just a dress rehearsal for things to come? What we do know is that Central Banks are withdrawing liquidity and inflationary pressures are rising. Excess liquidity and the absence of inflation have favoured certain asset classes over the past decade. As this dynamic now goes into reverse, it has significant implications for asset allocators, compounded by the fact the current starting point for assessing future returns is high relative to history. Given that the inverse relationship between equities and fixed income seems to have broken down, October demonstrated forcibly how there are few mainstream places to hide. We believe multi-asset portfolios need to adjust to the new reality: it is time to increase diversification and favour uncorrelated assets.

Asset Allocation:

• Equities: The most notable shift in global equities over the past month has been the abrupt rotation out of growth into value, compounded by investor selling of passive index-tracking products and ETFs. These trends may endure for some time longer, especially since growth has outperformed value consistently for at least the last decade. Beyond mean reversion, in a world of higher bond yields/ rates, investors may not wish to pay such elevated multiples as in the past for future growth. With the worst month in performance terms for US equities since 2011 and for global equities since 2012 (using the S&P 500 and MSCI World as proxies), valuation levels generally look less demanding, particularly given the robustness of earnings in the current reporting season. This creates clear opportunities for longer-term investors. We favour highly differentiated active managers – there is no substitute for fundamental stock-picking strategies.
• Fixed Income: As abruptly as equity markets have moved down, government bond yields (particularly in the US) have moved up. Given the length of the current bond bull market and the fact that monetary policy is tightening after a period of sustained loosening, the trend towards higher yields should continue. At some stage, fixed income will become more attractive, but we are not there yet, particularly given the growing size of state budget deficits (again, most notably in the US). The quality of corporate debt is also deteriorating in many cases. Our exposure to this asset class is relatively limited.
• FX: The US Dollar Indexhita 12-month high in October, driven by rising US Treasury yields and the prospect of more Federal Reserve tightening. Further Dollar strength may be possible in the near-term. We have no active stances.
• Alternative Assets: As the investing environment shifts from being one dominated by quantitative easing to one driven by quantitative tightening, we expect uncorrelated assets to outperform. There is a growing logic for investors to seek to harvest illiquidity premiums. Real assets backed by sustainable cashflows also provide an inflation hedge. We consider allocations to infrastructure assets, direct lending, niche private equity and real estate to be attractive.
• Cash: In the current uncertain environment, cash may act not just as a source of defence and form of diversifier, but also an asset that is now beginning to offer some marginal yield.

Nowhere to hide

If a week is a long time in politics, then a month in the investing world could be comparable to a lifetime. After the turbulence witnessed in October, almost all asset classes are now in negative territory year-to-date. Bear in mind that as recently as 20 September, the US S&P 500 equity index had achieved an all-time nominal high. The replacement of quasi-euphoria by seeming panic has been exacerbated by the long period of calm that preceded the events of the past month. It should not be surprising to see markets falling, but it is more the magnitude and severity of the decline that has proved unsettling, compounded by the fact that correlations between asset classes have increased. The inverse relationship between equities and bonds seems to have broken down; per Bloomberg, it is at its weakest in 20 years. The key question which now lingers in our mind is whether this recent correction has created an investing opportunity or, more worryingly, whether it is just a dress rehearsal for things to come?

What’s different this time?

If the rupture in positive correlations between equities and bonds proves enduring, then this would signal a notable break in the weak growth/ low-rate regime witnessed for the past decade. To the extent that history acts as a guide, markets that appear to be driven by negative tandem moves – yields up and shares down – tend either to be in the grip of inflationary pressure or a potentially over-heating economy.

Unlike the previous market sell-offs witnessed this year (in February and March), the bulls are now clearly fighting the Federal Reserve. The challenge faced by the Fed is how to reconcile a fiscal stimulus equivalent to 4% of GDP with an economy where there are more job vacancies than unemployed. Ironically, just as quantitative easing did not deliver real world inflation (despite expectations), so its reversal may be accompanied by higher inflation. Put simply, if the assumption that low rates will continue forever is now being challenged, then the corollary of a new regime – one of higher rates and the removal of liquidity – has worrying consequences for investors. It has become increasingly clear that the presence of (excess) liquidity has disproportionately favoured certain asset classes over the last decade, leading to the outperformance of more risky assets. This process now looks to be going into reverse. Consider that 10 of the 22 largest Central Banks monitored globally by Bloomberg have raised rates within the last three months.

We need to add three additional interlinked elements into the mix. First, there remains the lingering fear of policy error; might Central Bank action hasten the end of the current cycle? Next, given where rates currently stand, the available ammunition for resurrecting a stumbling economy (let alone stock market) looks more limited. And, finally, the elephant in the room: the growing size of the US budget deficit.

The deficit is equivalent to 4.0% of GDP, rising to 4.6% by 2019, per Bloomberg. For context, Italy’s budget proposal to the European Union is equivalent to just 2.4% of its GDP. In other words, America’s deficit is not only large, but growing, just as tax receipts are falling and expenses are increasing (as more baby boomers reach retirement). Moreover, if the deficit is expanding while unemployment is falling, imagine what may happen to it when the economy starts to stutter. Borrowing may beget more borrowing and selling more selling. Thought of another way, investors may be in denial about the amount of debt out there. When we talk about debt, we don’t mean just the size of the Federal deficit, but the fact that US

corporates have over $5trillion of outstanding debt, two times higher than a decade ago (per Bloomberg). It probably won’t be consumers or banks that are the cause of the next downturn, but some combination of corporate excess and government balance sheet mismanagement.

It’s not all bad

Sentiment in the past month has certainly become extremely negative. Declines also tend to have a history of feeding on themselves. However, even if forecasts for global GDP growth are being trimmed, concerns over trade wars remain significant and the geopolitical environment highly febrile (think US mid-terms, Brexit, the Italian budget, Saudi Arabia etc.), the world economy is still growing at over 3%, unemployment is at multi-year lows and corporates are producing generally very decent earnings.

Exactly half of the constituents of the S&P 500 have reported results for the three-month period ending 30 September (per Bloomberg, as of 30 October) with annual sales growth of 8.7% and earnings growth of 24.2%. If we accept the global nature of many of these businesses, this snapshot would appear to suggest an operating environment that remains in robust health, even if the rate of earnings growth is somewhat flattered by the quantity of share buybacks currently being undertaken. To provide a further perspective, of the 80 businesses in Europe within the MSCI Europe that have reported for the equivalent period, sales growth has been 6.3% and earnings growth 13.4%.

Some investors have suggested that we now may be at a stage of ‘peak earnings’ where it becomes increasingly hard for corporates to beat (elevated) expectations, particularly as wages and other input costs are rising, the benefits of fiscal stimulus are wearing off and the cost of servicing debt may become more pronounced. These are all valid concerns, but IBES estimates do not seem unrealistic for the year ahead, assuming just under 10% earnings for global equities. Meanwhile, investors can now pay just 14.2x forward earnings to own the MSCI World (i.e. the average multiple of its constituents 12 months out), which compares to a rating of 17.1x at the start of the year.

How to position

The pervasive mentality of recent times has been to ‘buy the dips.’ Even if it may be hyperbole to suggest that we should now ‘sell the rallies,’ we are left confronting an undoubtedly complicated environment. This complication stems not just from the length of the bull run, but also given the implicit knowledge that what’s worked in the past may not work in the future. Few investors have seen – and so are not prepared – for a concurrent potential bear market in both equities and fixed income. Bond yields may have risen, but relative to history, they remain very low in both nominal and real terms,.

Even if a bear market in either bonds or equities is not imminent, then at the least investors should expect lower returns going forward, especially given the currently high starting point. Furthermore, if it seems reasonable to assume decreasing returns, then the corollary is that the pressure to generate alpha increases. Multi-asset portfolios need to adjust to the new environment. Just as excess liquidity has underpinned the outperformance of certain asset classes over the past year, so its removal may lead investors to rediscover real assets and other similar potential investments.

Alexander Gunz, Fund Manager, Heptagon Capital