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: something has changed since the start of the year. We see a growing disconnect between financial markets and the real economy. Many investors seem to be operating in a world where they attach greater significance to dovish Central Bank policy than to macro growth prospects. Now is the time to be opportunistic. Strategies that have worked well in delivering outsized returns in the recent past may not continue to do so going forward. The new reality is a trade-off between the risk of a Japan-like environment of slow growth with stunted inflation and the pursuit of further unconventional policy tools to avoid such an outcome. Our pragmatic response is to diversify. We favour real assets, undervalued assets and truly differentiated investment strategies.

Asset Allocation:

• Equities: In a world of mainstream asset allocation, equities win by default over fixed income in terms of potential risk-reward characteristics. Most global markets have begun 2019 strongly and so may logically now pause for breath, particularly if the upcoming earnings season brings disappointment in the US, while political uncertainties cloud the Eurozone. We remain acutely conscious of valuation (the gap between the cheapest and most expensive stocks globally is its widest in 70 years, per Bernstein Research) and have a clear general preference for value over growth. EM equities look attractive for the longer-term. Overall, the importance of high-conviction, active approaches has never been greater.
• Fixed Income: 10-year US Treasury yields are at their lowest in over a year, while German Bunds of a similar maturity are negative for the first time since 2016. The stock of negative yielding debt globally may have fallen from its $12.2 trillion peak in 2016, but still amounts to ~$10.0 trillion (per Barclays). As bond yields fall, equities become relatively more attractive. We see little case for owning negative yielding debt for the long-term. We have limited exposure to fixed income beyond select tactical allocations but note some pockets of EM debt do appear interesting.
• FX: We have no active stances at present. The Dollar has remained remarkably strong and may continue to do so in the near-term, particularly relative to the Euro (where economic trends are worsening more rapidly). Nonetheless, consistent with our thesis on equities and credit, some emerging market currencies should benefit from the likely rebalancing of capital flows away from the US Dollar over time.
• Alternative Assets: We see scope for high-quality assets with decent cashflows to outperform. Now is the time to be constructive on illiquidity premiums. We consider allocations to uncorrelated assets such as infrastructure, direct lending, niche private equity and real estate to be particularly attractive.

It can’t happen here?…
2019 has begun well for most investors. Indeed, the dovish pivot by Central Banks has resulted in every major asset class (global equities, US Treasuries, High Yield debt, emerging market bonds and commodities – per Bloomberg) beating inflation year-to-date. Despite such an outcome, scepticism remains high and many investors continue to ask whether now is as good as it gets. If Bank of America Merrill Lynch’s monthly fund manager survey is to be believed, 1 in 3 managers are of the view that the S&P will go no higher. Such a response is perhaps not unjustified given the length of the current cycle.

Yet even if we do recognise that cycles rarely die of old age, it is still fair to consider whether we have already seen the majority of 2019’s returns delivered in the first quarter of the year. From here onwards, things may get more difficult.

The sober reality is that there is a growing disconnect between financial markets and the real economy. In other words, investors currently seem to attach greater significance to dovish Central Bank policy than to macro growth prospects. Our view: be careful what you wish for. Japan represents a superb test-case for the future of the developed world. It is a fine line between when Central Banks run out of policy ammunition and when their credibility begins to diminish. Viewing the argument from a different perspective, were economic growth prospects to improve later in the year, how may investors react to directionally more hawkish Central Bank policy? Not well, we sense.

Additionally, there is the perspective of returns. $21 trillion of stock market wealth has been created in the US since March 2009, equivalent to a ~400% return for the S&P 500 Index, or ~18% annualised (per Bloomberg). For how long can this be sustained? The S&P’s performance over the last decade ranks it in the 94th percentile of best 10-year annualised returns in global stock market history (per Goldman Sachs). Repeating such a performance in the near future will be exceptionally hard. Investors should expect lower returns from mainstream asset classes going forward. Against this background, we would not be surprised were markets (particularly equities) to take a breather. Practically, it’s time to diversify.

Importantly, something has clearly changed since the start of the year. Compare the December 2018 statement from Jerome Powell, Fed Chair, that “we have a strong forecast for 2019” to his March 2019 commentary that the US and China have “slowed substantially.” Whereas investors began this year anticipating two further hikes in US interest rates, a potential interest rate reduction is now being discounted as the Fed’s next move. The data do at least support Powell’s contention (which is also endorsed by Mario Draghi at the ECB): Bloomberg’s global GDP tracker estimates that the world economy is currently growing at 2.1%, almost half the 4.0% rate reported a year ago. Such a pace of growth is the slowest recorded since the Global Financial Crisis. All around the world, indicators are pointing downwards: consider the Baltic Dry Shipping Index, Chinese industrial output, Eurozone productivity and so on.

Let’s be generous to policymakers and say that they are acting rationally in the face of new information (being ‘data dependent,’ as we are told is their raison d’être). Nonetheless, something has surely changed. Remember Paul Volcker? He was Fed Chair from 1979-1987. He is widely credited with having conquered the threat of inflation in the US. Read now the comment from the current Fed Chair in his last testimony: (too) low inflation is “one of the major challenges of our time.” For the record, the Fed has not hit its 2% inflation target consistently since establishing it in 2012.

Where have we heard changing Central Bank rhetoric before? Where have we seen slow growth, stubbornly low inflation and low equilibrium interest rates as a semi-permanent feature? The answer is Japan. 20 years ago, its interest rate was set at zero; now it is negative. Think about it like this: consumers and corporates may, at some stage, lose faith in the Fed’s ability to hit its 2% inflation target. Households and businesses could therefore defer their spending/ borrowing today, since they believe the cost of doing so will be lower tomorrow – no matter how far Central Banks reduce rates.

There are worrying portents from Japan, but the parallels are not perfect. We see Europe as potentially doomed more to ‘Japanification’ than the US, as is perhaps reflected in the lower valuation multiple/ perennial discount of its equity and fixed income markets. At least the US has been able to generate some slow and steady growth since the last crisis, in contrast to the absence of ‘normal’ growth in Europe, despite the presence of super-easy monetary policy. Lack of structural reform perhaps provides an explanation. Across the region, Europe’s working age population (like Japan’s) has been shrinking since 2009, even if there are clear country-specific differences. Moreover, Europe – similar to Japan, but in contrast to the US – remains overly dependent on the rest of the world for demand stimulus. The US scores more favourably in both respects.

The more important debate, however, is not to discuss relative ‘Japanification’ but to ask whether we have reached the end of the road in (monetary) policy terms. Consider that Japanese gross public sector debt is 240% of GDP (more than double the comparable ratio in the US or Europe), the Bank of Japan’s balance sheet is bigger than the country’s output and that the Central Bank owns 43% of its government’s debt and 5% of the local stock market (all data per Bloomberg). Despite this, there is no evidence of a sustained weaker Yen, a stronger economy, increased inflation or wage growth, even if there have been a few fits and starts along the way.

Against this background, we should not be surprised by the pernicious creep of MMT (Modern Monetary Theory) as an idea. By way of a primer, MMT constitutes both a theory of money and a policy programme used to justify large increases in public spending. The notion is that any government that issues its own currency can – theoretically – always pay its own bills. In the context of low inflation, deficits are said not to matter. Such a policy approach is both populist and seductive, particularly in the context of ageing populations, stagnating middle class incomes and decelerating global growth. Regardless of global debt already having risen by $72 trillion in the last decade and now being higher than before the Financial Crisis (per the Institute of International Finance), the idea of MMT is gaining traction, however flawed the economics underpinning it may be. Its advocates suggest that an independent fiscal authority could be designated to manage the business cycle.

Of course, we all thought quantitative easing (QE) was crazy and economically unorthodox a decade ago, yet it is now mainstream and conventional. More than that, investors have become addicted to the stimulus it provides. MMT could, arguably, be thought of as the sibling to QE: QE allows Central Banks to print money to buy securities, Treasuries, mortgage bonds and bad loans; MMT proposes the printing of money to fund governments. QE was hailed as a success. We may well say the same about MMT within the next decade. Reference here is worthy to Joseph Overton of the Mackinac think tank in Michigan who developed the concept now known by its eponym, the ‘Overton Window.’ It relates to a range of ideas that at any given time are tolerated in political discussion. Politicians will only voice acceptable ideas, hence the progression (or ‘window’) from unthinkable to radical; from radical to sensible; from sensible to popular; and from popular to policy. So what about MMT; might policymakers embrace it to kick the ‘Japanification’ can further down the road? It can’t happen here*…

Alexander Gunz, Fund Manager, Heptagon Capital

• For those unaware, It Can’t Happen Here is the title of a remarkably prescient political satire written by Sinclair Lewis in 1935 about the dangers of casual complacency. It suggested, even in the light of Hitler’s ascendency to power in Germany, how many believed that populist demagogues ‘couldn’t’ ever come to rule America. Sinclair may not have been right in his lifetime, but recent history has helped bear out some of his assertions.