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: investing is never simple. This is especially so when the opportunity cost of not participating in an equity market rally that could continue further needs to be set against the idea that the best time to buy assets is when they are most out of favour. The ‘default’ strategies of owning equities over credit and momentum over value may endure for some time longer, but we believe something will eventually have to give. Looking forward, investors need to contend with a more uncertain global economic environment, exacerbated by monetary policy normalisation and trade war risks. Knowing when the bubble will burst is not easy: therefore, stick with what works, but also build diversification and invest in cheap uncorrelated assets for the longer-term.

Asset Allocation:
• Equities: More notable than the out performance of equities over credit is the marked divergence between US and Rest of World equities. Strong earnings growth, helped by share buy-backs has fuelled this dichotomy and there are reasons to believe that it may endure. Momentum and tech have become consensual longs, largely at the expense of value and emerging markets. There are clear opportunities developing for longer-term investors cognisant of valuation. Our perspective is to favour truly active and differentiated high-conviction managers.

• Fixed Income: Despite the strength in the US Dollar and the prospect of tighter US monetary policy, Treasury yields have failed to strengthen this year, even if the curve has flattened. Other developed markets have broadly followed this pattern. For now, equities seem the only game in town. In most cases, yields do not yet compensate investors adequately for the risks involved in either government or corporate debt (Investment Grade and High Yield also continue to underperform). Against this background, and with more tightening likely to come, we have limited credit exposure.

• FX: The Trump-inspired shift to de-globalisation 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. With the Dollar at close to a year-high and the Euro correspondingly at a year-low, there are good reasons to expect this trend to reverse. Emerging market FX may be more challenged. 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.

Party until it’s time not to

The somewhat hysterical headlines of the mainstream financial press screamed at the end of August that US equities were enjoying their “longest bull market ever,” having surpassed previous records. There remains debate over the statistical accuracy of this claim, but more importantly, investing is not a geometric project. The length of a bull market or the nominal level of an index matter are relevant more from a psychological point of view than a fundamental one. Of greater significance is to consider for how much longer the current investing environment can endure.

It is easy to be sceptical, especially since we are in year-ten of the current period of economic/ stock market expansion, during which time over $18trillion has been added to global equity indices (per Bloomberg). However, calling when downturns will occur is as difficult as estimating the length of bull markets. Recessions are not due on a calendar basis – they are a function of an unsustainable build-up of excesses. We have been regular commentators on this matter in recent publications and could clearly point to debt levels above previous cycle highs or excess concentration levels in the mega- cap tech sector among others, but, for now, we wouldn’t want to bet against an outcome of more of the same. The ‘default’ strategy of owning equities (at the expense of credit), might well continue for some time longer.

Take a step back and consider the bigger picture: a decade on from the collapse of Lehman Brothers and the ensuing credit crisis, the global economy is expanding at ~4% GDP, inflation is running at ~3% and corporates are set to record 16% earnings growth in 2018 (all data courtesy of Goldman Sachs). Brian Cornell, the 34-year industry veteran who is Chief Executive of Target, the US retailer, recently described the current consumer environment as “the best I’ve seen in my career.” Meanwhile it was hard for even the more measured Jerome Powell, Chair of the FOMC not to sound upbeat at the recent Jackson Hole symposium. There are “good reasons” for the strong economy to continue, per Powell, particularly since there “doesn’t seem to be elevated risk” regarding inflation at present.

Of course, trying to gauge when optimism turns to hubris or excess is much more challenging, but against the backdrop described above, it does seem conceivable that the current environment could continue in the near-term. Global equity markets in general, and those in the US in particular, continue to show a remarkable ability to shake off perceived negative newsflow. Many investors seem to have stuck with what has ‘worked’ so far this year (namely being long US tech and momentum) and shunned the laggards (value, emerging markets and commodities).

When thinking about positioning going forward, the opportunity cost of not participating in a rally that could continue for some time longer (or perceived ‘FOMO’) needs to be set against the idea that the best time to buy assets is when they are most out of favour. To the extent that these two standpoints are reconcilable, we note that even if equities are notably outperforming credit, then the level of outperformance of US equities relative to those in the rest of the world is almost unprecedented. Over the last year, the S&P 500 Index has gained ~17%, while the MSCI World ex-US has added only ~3%. Such a divergence has not been seen over the last 20 years (per Bloomberg). Correspondingly, while US equities trade on cyclically adjusted P/E (or CAPE) multiple of 32x, this compares to a level of just 20x for the Rest of the World (per research from Citi). New nominal highs for the S&P in August contrasted with 12-month lows in emerging markets.

What explains such a marked divergence? It largely comes down to supply and demand. First, consider why earnings growth globally (and specifically the US) is so strong. Sure, the impact of Trump-inspired tax cuts has been helpful, but a large part of the story is also being driven by share buy-backs. With $697billon of equity bought back by US corporates through to the end of July, and with over $1trillion of cash still held abroad (data per JP Morgan), it is easy to see how a shortage of ‘available’ US stocks has been created. The matter is compounded by the policies of the Federal Reserve and Donald Trump: monetary tightening and the prospect of pending trade wars/ sanctions are both helping to boost the US Dollar. Put another way, just as globalisation was a headwind for the US Dollar, deglobalisation is symmetrically bullish. Higher growth and asset returns can currently be found in the US than elsewhere. Moreover, this story may also have quite a lot further to run, especially since China is moving from being a partner for co-operation to a source of competition, with high-end technology emerging as a key battleground. Neither side is likely to want to admit defeat.

One conclusion that could be drawn from this analysis is that for as long as the Dollar remains strong, then emerging markets, commodities and gold may continue to underperform, despite any more fundamental considerations around value. However, our more measured contention might be that something has to give: a stronger Dollar is the exact opposite of Donald Trump’s desire to make the US more competitive. A number of US-based exporters are indeed already reporting cost pressures. If it were a choice of either the US equity market underperforming, or the rest of the world (and particularly emerging markets) catching up, then we would feel more comfortable with the latter scenario.

Investing is, however, rarely this simple. We can point to a list of multiple unknowns which may complicate matters: a more uncertain global economy, trade policy and Central Bank normalisation. Turkey also merits brief consideration. The first three factors are inextricably interlinked. Nonetheless, it seems fair to highlight that with the uncertainties around trade policy and the likely ongoing path of tighter monetary conditions that the rate of economic growth will slow in the remainder of this year/ early 2019. Economies rarely go from boom to bust overnight, but they can peak and then roll over.

Turkey appears to be an isolated situation for now and the size of its economy (accounting for less than 1% of world GDP, per Bloomberg) remains small in a global context. The country’s problems – a high current account deficit and accelerating inflation in an over-heating economy – were well documented, and the crisis exacerbated by a combination of policy errors and political posturing. Turkey has neither raised interest rates nor gone to the IMF for funding. Until there is a stabilisation in the country, emerging markets may be subject to capital outflows in general. It is, however, both dangerous and complacent to group all ‘emerging markets’ together. Sure, Turkey constitutes one risk among others – politics in Brazil, over-leverage in China, sanctions in Russia and so on – but for investors with longer-term perspectives, assets in countries with responsive policy stances, large international reserves and few debt mismatches provide some attractive valuation opportunities.

By way of conclusion, commentators (ourselves included) are wont to use the expression ‘bigger picture.’ The term is an easy journalistic sleight of hand intended to convey sagacious perspective. If we wanted to highlight perhaps one over- arching observation then it would be the following: even if we can imagine enjoying the party for some time longer, the after-effects of nearly a decade of financial repression, free money and the distortion of market signals will, inevitably, have unintended consequences. Knowing what these are and when they will occur, is of course, a lot harder.

Alexander Gunz, Fund Manager, Heptagon Capital