View From The Top
Thesound of music
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: When the sound of bullish music is this loud, something must surely go wrong. Negative real policy rates have created an environment that has forced up equity valuations and left investors searching for yield. It will be hard for policymakers to walk away from what they have created, especially since continued low rates arguably matter more for the general investing outlook than either GDP or earnings growth. Regardless of whether or not we are in a bubble, the logic that high valuation starting points for most asset classes mean lower future returns is inescapable. Further, with the path and duration of the current recovery uncertain, it is only reasonable to expect some drawdowns over the course of the year. Our counsel: strike a good balance between factors in your portfolio, diversify across all assets classes and be prepared to act opportunistically.
- Equities: We continue to struggle to identify a superior mainstream and liquid alternative to equities. Even if this asset class fails to deliver returns comparable to history, there is a strong case for equities still to outpace conventional fixed income. Valuation levels may be reaching extremes in some quarters (particularly when compared against long-term averages), but we continue to see pockets of opportunity. We advocate truly active management approaches and believe that strategies which embrace a good combination of both growth and value factors as well as quality and cyclical factors can prosper. Small caps and selected emerging markets have some attractions too.
- Fixed Income/ Credit: It is hard to ignore the impact that a pervasive zero interest rate environment has had on the investing landscape for this asset class. With $17.5tr of developed world sovereign debt and a further $1.5tr of corporate debt offering negative yield (per Bloomberg), little wonder that there have been record levels of Investment Grade (IG) issuance. The yearn for yield has depressed IG and HY (high yield) spreads at the same time that balance sheet quality continues to deteriorate. Invest only selectively.
- FX: We have no active views even if we note that the US Dollar has enjoyed recent strength. This can be partly attributable to mean reversion. Should US economic growth outpace that of other regions (which is possible, in our view), then this could argue for further Dollar strength. Varying fiscal deficits may also dictate relative currency strength.
- Gold: The asset remains not only a very good diversifier, but also a low-cost portfolio hedge against unforeseen risks. Rising nominal yields would be positive for the price of gold and even if real rates become less negative, we believe current levels still provide a good level of structuralsupport for the asset.
- Alternative Assets: We see a clear role for such assets in portfolios and are attracted to them owing to their diversification benefits, income generating potential and the protection they would offer in the event of higher inflation. We expect infrastructure assets to benefit from a likely increase in fiscal stimulus spend. Elsewhere, we see selected opportunities for business models with strong balance sheets such as seniors’ housing or logistics REITS.
If everyone is optimistic, how do you make effective asset allocation decisions? This is the key question we have been pondering as the clamour of bullish sentiment appears only to have expanded since the start of the year. When positioning is seemingly so polarised, a combination of both history and inherent scepticism suggests that things can only end badly. However, in the very near-term, the ‘everything rally’ may continue, driven by a perceived fear of missing out as much as anything else. We are reminded of the now infamous words of Chuck Prince (CEO of Citigroup at the time when the credit crisis struck): for as long as many investors still believe they can hear the sound of (bullish) music, they will continue metaphorically to dance.
First, let’s consider just how bullish current sentiment seems to be. We note with interest that the monthly survey of Fund Managers polled by Bank of America Merrill Lynch shows that equity allocations are at their highest and fixed income investments at their lowest in at least 3 years. The main reason for such a view is the belief that the global economy is in an early cycle expansion and that corporate profits will correspondingly expand (investor optimism on these two topics is at its most elevated in 10 and 19 years respectively). Gleeful consensus can, of course, herald the dangers of groupthink. Investments as superficially diverse as bitcoin, Tesla shares and SPACs (special-purpose acquisiton companies) all speak to this euphoric phenomenon. Embedded in each is the perception that an investment in it is a simple one-way bet.
The roar of the bulls can certainly be heard in many quarters. Their argument is based on the combined powerful effects of co-ordinated stimulus and fading risks. Take the former; its impact is undoubtedly huge. The monetary and fiscal levers pulled thus far by governments across the developed world average more than four times the amount dispersed during the credit crisis (per Bloomberg). Expect more too. President Biden is seeking approval for a $1.9tr spending budget – equivalent to 2 percentage points of GDP – and the Bank of Japan has also made proposals for more monetary purchases.
Pandemic shocks, of course, are different to typical recessions in that they enjoy a stronger bounce back, given that the hit to the economy was exogenous as opposed to structural. In general terms, the current cycle has been characterised by unprecedented momentum, from recession to recovery in only a matter of months. There are early signs that stimulus has had an effect (beyond the counterfactual that things would have been much worse in its absence): US industrial production has risen for three consecutive months, Japanese exports are growing for the first time in two years and Chinese GDP is expanding at over 6%, to name but a few data points. At the same time, many risks appear to be fading: the US Election and Brexit have passed, the prospect of an all-out trade war is fading and governments have game plans (after a fashion) for managing COVID-19 challenges.
The momentum may continue too. Bear in mind that large output gaps remain in economies globally. With 9m US jobs destroyed over the last 12 months, the US is probably only halfway back to pre-pandemic employment levels. Central Banks also seem to have learned their lessons and remain highly wary of withdrawing stimulus too soon. Some even have suggested that with supportive accommodation in place, 2021 could be the start of one of the longest economic cycles in history. We all know what happened after the Great Financial Crisis of 2008/9: the S&P 500 rose 322% over the next decade.
Have no doubt, it’s going to be very difficult for Governments/Central Banks to walk away from what they have created. To continue this line of argument, the somewhat complacent view seems to be that with the Fed et al on your side, equities will maintain their upward trajectory. Add into this mix the clear opportunity cost of not participating, particularly in the context of negative real rates. It is certainly hard to escape their pervasive impact on the investing landscape: one-third of all developed world Sovereign Debt has a nominal yield of less than 0% (per JP Morgan). Sure, growth expectations for equities may have been pulled forward, but the story is less about earnings in either 2021 or even 2022 and more about interest rates remaining structurally low.
Now we come to the problem of confirmation bias: just because the last decade has seen the longest sustained period of negative real policy rates recorded in US history, excluding the Civil War and the two World Wars does not automatically mean that the next decade will automatically mean more of the same, even if arguments can be made for such a view. Regardless of where you sit in this debate, the inescapable corollary of negative real policy rates is high equity valuations. Relative to long-term average metrics dating at least to 1970, the valuation levels of the S&P 500 sit in their 97th percentile on historic earnings, 94th on forecast earnings and 100th on both EV/EBITDA and median price-to-sales (per Deutsche Bank). Similarly, the insatiable search for yield has pushed the Barclays High Yield Index to its lowest yield in almost six years and its Investment Grade index to its smallest spread relative to Treasuries since 2017.
The polarisation of both sentiment and valuation suggest that, at the least, the stage must be set for some periodic profit-taking. Put another way, if everyone appears bullish, then something must surely go wrong. There have been five equity market sell-offs of at least 10% since 2015 (with the last coming in March 2020). Don’t bet against another one in 2021.
What might burst the bubble? Hindsight will probably only provide the answer, but there are certainly a host of factors that have the potential to dent investor sentiment. Do not forget, we are still in the midwinter of the pandemic. Global COVID-19 cases are approaching 100m, with 25m now recorded in the US alone. Having vaccines is not the same thing as achieving vaccinations. The rollout may take longer than expected owing to a combination of differing government policies and complex logistics. Herd immunity may be up to a year away, even in the best-equipped countries. Meanwhile, with borders and large swathes of many economies shuttered, the chances of a double-dip recession are only increasing.
Even if further stimulus is avoided, the cost of current policies is hard to ignore. Global debt (ex-financials, but comprising households, corporations and governments) has risen some 70% since 2008 and now sits at a record 270% of GDP, per the Bank of International Settlements. This may ultimately be a problem for future generations, but there are still some significant near-term impacts to consider, not least that of moral hazard. Investors should not forget the ongoing deterioration in corporate credit ratings and fundamentals. Net debt/EBITDA ratios within the high yield space are, for example, higher than in 2008 (per S&P).
There is an important lesson to grasp here, and one which equally applies to all assets, including bitcoin: know what you are investing in and only invest in things you can understand. An additional crucial consideration is that high valuation starting points mean more modest future returns. There is an unimpeachable logic attached to this observation, regardless of whether or not we are in a bubble. It is clear that we have already borrowed a lot of future returns in almost all asset classes. With the path and duration of recovery remaining highly uncertain, we believe it crucial to strike a balance in asset allocation strategies, between growth and value, quality and cyclicals while continuing to diversify into uncorrelated areas wherever possible.
Alex Gunz, Fund Manager, Heptagon Capital
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