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: The summer months have seen investors generally enjoying a melt-up. The bull market in (almost) everything has continued broadly unabated. Interest rates may be structurally lower than in previous cycles and Central Banks more interventionist, but this time is almost certainly not different. We wonder whether too-great expectations remain placed in the restorative power of Central Banks. At some stage they will likely reach the end of their abilities to convince and deliver, unable to solve a growing litany of problems. Group-think can be dangerous. Investors risk ignoring the warning signs of leverage, illiquidity and excess at their potential peril. Now is a time to be pragmatic; multi-asset portfolios need to continue diversifying.
• Equities: New highs in global equity markets have been recorded on an almost-daily basis. The inexorable decline in government bond yields (see below) is continuing to place upward pressure on stocks, while this asset class does still offer some growth in a world where it is looking increasingly scarce. The current season of earnings has also demonstrated remarkable resilience, at least relative to expectations. Although we clearly do favour equities over fixed income, our distinct preference remains for truly active and differentiated strategies. We also note that the current gap in valuation levels between value and growth within the equity arena is at its widest since the year 2000 (per JP Morgan).
• Fixed Income: Capital also continues to pour into safer assets. Government debt may be defensive, but it is also unattractive. Consider that there is currently a record $13.7tr of negative-yielding sovereign debt, equivalent to some 26% of total supply and 15% of nominal GDP (per Bloomberg). Yields can go lower still, particularly if Central Banks remain dovish in both their rhetoric and actions. For longer-term portfolios, however, the inclusion of such assets must be considered unappealing. Elsewhere, we see risks mounting in areas such as high yield and leveraged debt.
• FX: We have no active stances but observe the ongoing race-to-the-bottom. Central Bank policy globally seems to favour continued accommodation, yet currency is not a zero-sum game. The US Dollar looks overvalued on many metrics.
• Gold: Currently at a 6-year high, gold has continued to show strength. Relative to its history, it is one of the few asset classes that remains undervalued. It could trade higher, particularly if deflationary fears become more entrenched.
• Alternative Assets: We remain constructive on illiquidity premiums. In a low-rate environment, the case for owning longer-duration assets only continues to grow. Against this background, we consider allocations to uncorrelated assets such as infrastructure, niche private equity and real estate to be particularly attractive and see continued scope for high-quality assets with decent cashflows to outperform.
It seems only appropriate given recent record temperatures across much of the UK and mainland Europe to be talking of ‘melt-ups.’ This is not an expression readers will find in any dictionary, but it is commonly understood to refer to a rapidly accelerating rally driven largely by sentiment; a period when optimism starts to become untethered from fundamentals and investors seek to chase return by jumping onto a fast-moving bandwagon. At its most extreme, the scenario captures a dynamic of fear-of-missing-out or, more acutely, panic buying. The period of late 1999/ early 2000 is perhaps the classic case in point.
There are, however, marked similarities with where we stand today. A generation ago, it was all about the Internet, when turns of phrase such as ‘paradigm shift’ were almost ubiquitous (your author remembers this period well and was indeed somewhat complicit, having written equity research on European telecoms and internet businesses at the time). Famously, as John Templeton once put it, “this time is different are the four most expensive words in the English language.” While many corporates seem now to be using the term AI [artificial intelligence] with the same free-willed attitude as they did with the Internet 20 years ago, what investors generally seem to believe or hope with regard to ‘difference’ in this current cycle is that it is all about the restorative powers of Central Banks. Sure, there has been a ‘paradigm shift’ to structurally lower interest rates in the last decade, but increasingly great expectations are being placed in these entities; that they are a panacea, they can carry on underwriting the current economic boom and… that – maybe – they’ve finally abolished the business cycle.
We have constantly wondered whether these expectations are unrealistic. Equally concerning is that politicians have been increasingly vocal not only about whether Central Banks have too much power, but also if they are not doing enough to extend the current cycle. Of course, with interest rates at close to the zero bound, the monetary toolkit is looking more and more depleted. Even some dovish rhetoric and a just-announced 25 basis-point cut in US rates will only go so far. Or, put another way, given expectations, how can investors not be disappointed?
More specifically, it seems important to consider first, whether Central Banks are reaching the end of their power to convince and deliver, and next, whether they practically have the ability to solve the litany of growing problems facing the world. We will address both in more detail below, but in summary the answers would be ‘probably yes’ and ‘probably no’ respectively.
In terms of the former, the economic reality does not appear encouraging. The G7’s latest report talks of risks being “tilted to the downside,” while Mario Draghi has highlighted how the outlook for Europe is getting “worse and worse” and Jerome Powell has noted that “uncertainties continue to weigh on the outlook.” With China having just reported its slowest rate of global GDP growth in 27 years and Germany its weakest industrial production figures in 7 years, 2019 is set to mark the most disappointing year for global growth since 2013 (per Goldman Sachs). Sure, there are some pockets of strength, particularly in the US based on recent jobs and retail figures, for example, but no economy operates in a vacuum.
If then, we consider what tools policymakers can deploy to right economic weakness, monetary stimulus remains the most favoured (at least for now). However, there is a clear law of diminishing returns effect at work; each announcement from a Central Bank to this end has successively less impact than the previous one. Furthermore, making cuts at this stage of the cycle – particularly in the US – is unlikely to be costless, especially if it encourages more risk-on behaviour and so makes any future pullback more costly. There is also the additional danger that if the economy really is slowing, then Central Banks may run the risk of moving in a classic incrementalist fashion and so may be too late to forestall any recession. Finally, there is the pragmatic observation worth making that negative rates in regions such as Europe and Japan perhaps mask their true problems. What such economies need is structural reforms, especially given their deteriorating demographics.
Where else are we concerned? We recognise that problems are building in several areas. Which additional grain of sand causes the mountain to collapse is, of course, unclear, but we would point to the following (interlinked) issues as being factors to monitor. First, we have written repeatedly about leverage. Consider the size of the leveraged loan market in the US ($1.3tr, per Bloomberg) and then consider the potentially worrying precedent of Clover Technologies. This hitherto-unknown private company may be the metaphorical canary in the coal mine. During July, a covenant-lite leveraged loan of Clover’s lost a third of its value based on a Moody’s downgrade to its debt. The rating agency cited “aggressive policies” and “debt-fuelled acquisitions” as concerns. Clover may be a poster-child for how quickly leveraged companies can implode when their fortunes change.
There is a related issue – illiquidity is becoming a concern. No two market resets are the same, but we do worry about liquidity, not just for businesses such as Clover but also how its lack may manifest in financial markets. We note, for example, that daily turnover in US high yield debt is at its lowest since 2014 (per Bloomberg). The problem can become increasingly self-fulfilling. Lower asset prices can cause solvency/ liquidity constraints to bind, pushing asset prices lower still, and so on. The recent issues at organisations such as H20 and Neil Woodford’s Patient Capital may be a sign of things to come.
The dangers of group-think can also exacerbate the liquidity issue. It seems increasingly difficult for many investors to see the world differently. Consider that just 2% of Fund Managers interviewed in Bank of America Merrill Lynch’s monthly investor survey expect value to outperform growth over the next 12 months. Group-think is also pushing investors into certain areas, particularly if they offer the prospect of growth in a world where it is looking increasingly scarce. This helps explain the success (at least for those selling out) of many recent IPOs. The percentage of stock market listing with negative earnings is currently at its highest since the year 2000 (per Renaissance Capital). To frame any debate about potential excess, take just one example: Beyond Meat, manufacturer of the famous planted-based burger has seen its valuation increase almost tenfold since listing at the start of May. A market capitalisation of $11.8bn has been awarded to a business which is currently forecast to generate only $240m of revenues this year and no earnings. In other words, investors are valuing Beyond Meat at over 40 times consensus sales (per Bloomberg). History may not repeat itself, but it does rhyme.
Finally, we have to note the general and pernicious erosion of trust and confidence. These values are looking increasingly scarce – and hard to resurrect – in a world of rising tensions, trade wars and weakening multicultural organisations, which is lacking true global leadership. Over time we could see Central Banks potentially renationalised and extreme fiscal experiments (modern monetary theory, anyone?) with untold consequences deployed. This is not meant to be depressing; more a reflection of the modern world. Against this background, the worst thing would be for investors to ignore blithely the current global environment. Now is a time to be pragmatic. The current ‘bull market in everything’ implies that multi-asset portfolios need to continue diversifying.
Alexander Gunz, Fund Manager, Heptagon Capital
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