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: It is important to guard against complacency. The business/ economic cycle has not been eliminated forever. Furthermore, close to ten years of low interest rates and excess investment returns mean that risk may currently be mispriced. Going forward, the rate of growth is becoming less certain, monetary policy is tightening, and the huge debt overhang looks unlikely to shrink. Investors therefore need to prepare themselves for a world of higher interest rates and lower returns. Equities – for now – remain relatively more attractive than most fixed income, but the logic only grows for pursuing ongoing diversification into uncorrelated asset-classes.

Asset Allocation:

• Equities: The 16x multiple of earnings commanded by the MSCI World places it in-line with its average level over the last 30 years. However, this masks important disparities: the gap between growth and value is at its widest since 2000, as is that between US and Rest of World equities (per Morgan Stanley). Against this background, there are clear opportunities for longer-term investors. Our perspective is to favour truly active and differentiated high-conviction managers.

• Fixed Income: With monetary policy tightening (or becoming less loose) across both the developed and developing world, this implies that bond yields should move higher. At the same time, while equities trade in-line with long-term averages, global government bond yields are 250 basis points below their 30-year average. In most cases, however, yields still do not yet compensate investors adequately for the risks involved. Our exposure remains relatively limited.
• FX: Despite higher US Treasury yields over the last month, the Dollar peaked in mid-August. Long-term, we continue to believe that the Trump-inspired shift to deglobalisation should mean a structurally stronger Dollar over time (since it implies higher growth and asset returns in the US than elsewhere). In the short-term, however, currencies will likely retain their tendencies to mean-revert. We have no active stances.
• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies and our conviction in this respect only continues to grow. Such assets provide resulting diversification and allow investors scope to harvest illiquidity premiums. Within this universe, we consider allocations to infrastructure assets, direct lending, niche private equity and catastrophic reinsurance to be attractive.

Celebration, or reflection?

The timing was not quite perfect. It was only a matter of days. Yet close to exactly ten years after the collapse of Lehman Brothers, both the Dow Jones and S&P 500 Indices made new all-time nominal highs. However, the champagne corks and cheers were notably absent. The general mood seems much more sober. Indeed, if the monthly Fund Manager survey conducted by Bank of America Merrill Lynch is to be believed, then economic optimism is currently at its lowest in seven years, while cash holdings are at their highest in 18 months. Anniversaries are, of course, arbitrary events, while the dichotomy between fear and greed is nothing new. Ultimately, it is all about plotting a defensible course for investing; finding the right assets at the right prices. When all else is in doubt, consider valuation. Below we mull four principal topics of pertinent interest (as well as a footnote worthy of contemplation).

1: What did we learn from the collapse of Lehman Brothers?
In six words: one big lesson – quantitative easing worked. Clearly, we can consider the counter-factual (what might policymakers have done, had they not pursued such a strategy?), but the facts are indubitable. While it took the US stock market 25 years to recover to its pre-crisis level after the 1929 market crash, it took the S&P 500 less than four years to regain its losses post-Lehman. Despite the market having fallen 47% between September 2008 and March 2009, by January 2013, all this decline had been erased. At the same time, had investors owned bonds over this period, then they would have enjoyed positive returns.

However, there were unintended consequences which resulted from the policies adopted. First, asset-price inflation came at the expense of real-world inflation, widening inequalities. While this outcome may have been positive for many investors, it also perhaps provides an explanation for the more recent unsavoury rise of the populist politician. Next, it is hard to deny that moral hazard has only grown. In other words, many investors (and arguably, corporates too) feel prepared to take risks in the knowledge that Central Bankers and politicians remain as back-stops. Finally, there is the irony that despite increased moral hazard, there is now probably less policy flexibility than in the past. This is a function of the limited ‘dry powder’ available given how low interest rates are, combined with growing evidence of diminishing global policy coordination (again, sadly, a consequence of burgeoning populism).

2: What do we know about the future?

Even in the absence of the metaphorical crystal ball, we can feel fairly confident in asserting the following three observations: economic growth going forward is becoming less certain, monetary policy will tighten, and the huge debt overhang is unlikely to shrink. We can add into the mix additional uncertainties regarding trade and the prospect of lengthy disputes over tariffs as well as the ongoing pressure of febrile geopolitics, exacerbated by a growing number of unstable actors. The key point, however, from all of the above is that many investors (and borrowers) are not familiar with a world of rising interest rates. We haven’t seen inflation for quite a while, and we haven’t seen accelerating inflation for a really long time. It will be important to adopt a different mindset and positioning for such an environment.

3: For how much longer can the current cycle endure?

Cycles don’t run to fixed time periods, however profound our concerns may be. Rather, attempting to time them is almost impossible; they do not die of age, but more, because of excesses. If asked the question though, what factors ought investors to be most mindful of when seeking to assess the likelihood of another downturn/ crisis, then consider that excess leverage matters most. This would probably be followed by extreme deregulation and/or financial innovation. We have discussed in many previous commentaries how indebtedness now is markedly higher than a decade ago, even if much of that debt has been shifted from the private sector to the public sector.

Nonetheless, it is unlikely to be one single and discrete event that is responsible for the next crisis. ‘True’ crises tend to be very rare and unforeseen, caused by disparate factors interacting in unpredictable ways and intensified by poor understanding of the root causes. Just as few ‘got’ what collateralised debt obligations and rehypothecation were a decade ago, we wonder today whether the full magnitude of trading algorithms and ETFs are appreciated. At the least, it is worth contemplating how many of the lessons of the past have been learned. Central Banks have not created all the tools to balance out and eliminate market cycles forever. Moreover, in the last decade, there seems to have been a palpable absence of new ideas about how to deal with future crises. Even if the cycle may endure, risk may also have been mispriced.

4: What is reasonable to assume going forward?

If excess liquidity has bred excess returns over the last decade, then by implication, lower liquidity going forward should result in lower returns. Put another way, the formula that has worked effectively in the recent past (allocating to equities and bonds) may not work so well in the future.

With regard to bonds, we think it reasonable that yields should move higher. Some of this reflects a reversal of the structural decline in yields that has endured for close to 40 years. More importantly, inflation and the corollary of higher interest rates will matter increasingly. Developed world core inflation of 1.6% is currently at its highest since 2008 (per Bloomberg), with labour markets tightening in most geographies. High and rising rates of labour utilisation and tight labour markets are promoting faster compensation gains. With low productivity, this puts upward pressure on unit labour costs. Anecdotally, we have heard many management teams talking about cost pressures in recent meetings. All the above argues for higher yields.

What does this mean for equities? Equities remain – for now – relatively more attractive than fixed income (in general terms), but consider that the expectations embedded within many businesses’ valuations are high. The rate of earnings growth enjoyed in the first two quarters of 2018 may not be sustainable going forward. Against this background, our approach is one of focusing on relatively undervalued businesses and regions, particularly selected emerging markets for the very long-term. Beyond this, the logic in asset-class diversification remains high.

Footnote: what happens to Central Banks?

Many may have forgotten that it was less than 50 years ago that Central Banks weren’t independent. We also can’t help but notice that there seems to be a growing politicisation of Central Bank behaviour, with their actions subject to increased scrutiny, criticism and potential interference. Such behaviour may be explained by the fact that many of the Banks’ policies are, arguably, hard to understand, while there seem to be a diminishing number of political advocates for Central Banks. At present, they are perceived legitimate targets for blame, now that the period of accommodation is over and liquidity is diminishing. When the next crisis happens, what is the likelihood, therefore, that governments use this as an opportunity to bring increasing elements of the Banks’ mandates under their aegis? An enticing prospect to ponder…

Alexander Gunz, Fund Manager, Heptagon Capital