View From The Top

The better part of valour

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: A bubble is building. We caution against complacency and believe that there is a strong case for discretion over valour. Investors should also not forget that currently high valuation starting points imply lower future returns than enjoyed in the past. Sure, a more sustained economic and earnings expansion looks likely in the second half of 2021. Equally, it is hard to ignore the current momentum behind the reflation trade. However, recoveries are rarely linear and setbacks undoubtedly will occur, creating opportunities. We also believe that the debate over inflation is far from resolved. Establishing balance therefore strikes us as important. There is a high logic in portfolio diversification especially in the context of how polarised opinion appears to have become. We favour a blend of growth and value, quality and cyclical investment styles.

Asset Allocation:

• Equities: A combination of investor inflows, strong earnings reports and a perceived fear of missing out have pushed equity markets globally close to new all-time nominal highs. It is hard to deny that fundamentals are improving, but much of this may be reflected in headline valuation multiples, with the MSCI World trading on its highest price-to-earnings ratio since late 2009, per Bloomberg. As a result, stocks with a value and/or cyclical bias (especially in the energy and financials space) may continue to outperform in the near-term. We favour a balance across investment styles and advocate truly active and diversified managers. We also see a growing case for emerging market equities. 

• Fixed Income/ Credit: Rising yields have been the story of 2021 to-date, with the Barclays Global Aggregate Bond Index experiencing its worst start to the year since 2013. Although longer-dated bond yields have risen markedly, the shorter-end of the curve has remained anchored for now. We generally see risks as being weighted to the downside, particularly should investors discount further inflationary pressures in the near-term. The deteriorating quality of some High Yield credit is another concerning factor to monitor. We suggest only selective allocations.
• FX: Large and growing fiscal/government deficits tend to be correlated to weaker currencies. Given current US debt levels, we can see a case for why the Dollar should weaken over time, even if there may be periodic bouts of mean reversion along the way. Emerging market currencies may benefit, especially in countries with relative fiscal strength.
• Gold: The 10%+ fall in the price of gold over the last six months creates a potentially attractive entry point in our view. We continue to see gold as not only a very good portfolio diversifier, but also a low-cost portfolio hedge against unforeseen risks. A weaker Dollar and/or rising nominal yields would both be positive for the gold price, in our view.
• 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.

“Go big” was the message US Treasury Secretary Janet Yellen urged when she spoke at the latest G7 gathering in February. She was highlighting the logic for significant stimulus sums to spur a post-pandemic recovery. Investors, however, seem to have taken Ms Yellen at her word. Consider any of the following – inflows into equity markets, new stock market listings, or Bitcoin fervour – as supportive evidence. This party may well continue and while no guest ever wants to be accused of leaving early, the aphorism discretion is the better part of valour does spring to mind. A course of prudence over courageousness has its undoubted merits currently.

What we do know is that recoveries are rarely linear and that sell-offs will create opportunities. We don’t have a crystal ball, but do note that there have been five equity market corrections of at least 10% since the start of 2015 (the most recent being March 2020). The likelihood of another only grows in tandem with increasing investor exuberance. At a more general portfolio level, we urge balance – between growth and value, cyclical and quality – as well as diversification into more idiosyncratic strategies.

First the good news. There is significant evidence of a mounting recovery. JP Morgan’s Global composite PMI indicator of economic activity exhibited a reading of 52.3 in February, the third consecutive month of expansion. Just as much of the world entered a synchronised downturn at the start of pandemic-enforced lockdowns, so recovery is occurring globally, evidenced by gradual re-openings and growing consumer optimism. Data from Mastercard anecdotally point to a growth in discretionary spending across regions. This is evidenced elsewhere. In the US, where the consumer comprises c70% of GDP, retail sales are currently growing at a pace of over 5% month-on-month per latest Commerce Board data.

The recovery also remains buttressed by supportive Central Bank policies – ultra-easy money in the form of low rates and continued quantitative easing. There is the expectation of further stimulus too. If Treasury Secretary Yellen and President Biden are indeed allowed to “go big”, then $1.9tr of fiscal stimulus will flood the US economy in the coming months. Add into the equation the fact that Americans have apparently accumulated $1.4tr in unspent income over the past year (per Citigroup). This set-up argues for an acceleration in economic growth in the second half of 2021. A similar pattern – albeit to not quite such an extent – will likely play out in much of the rest of the world.

Investors seem clearly to believe in this scenario, although whether as a function of conviction or through perceived fear of missing out remains unclear to us. Equity markets globally continue to flirt with new highs, helped by record monthly inflows for two consecutive months (per EPFR data). Risk-on seems to be the name of the game. Consider that there have been over 150 initial public offerings so far this year, which comprises two-thirds of 2020’s total. At the current rate, 1200 flotations might take place in 2021, easily surpassing the record year of 1996. Note that over 80% of this year’s listings have been SPACs (special-purpose acquisition – or shell – companies), raising $45bn alone – a worrying sign if ever there were one, in our view. It’s not just the equity market though. Digital currencies (such as Bitcoin) have cumulatively added over $1tr in value year-to-date, while there has been above $150bn of high yield issuance (all data courtesy of Bloomberg).

The flipside of equity market fervour has been the worst start to the year for the Barclays Global Aggregate Bond Index since 2013. The yield on 10-year US Treasurys stands at around to 1.4% versus less than 0.5% six months, while the yield on 30-year US debt is now around 80 basis points higher than last summer. Rising bond yields are not just a US phenomenon either. The yield on 30-year German debt is currently at a two-and-a-half year high. So what’s going on: are investors making a one-way bet on growth, and then a conceptual leap from better growth to more inflation?

There are certainly some good arguments for emerging inflationary trends.Take the data. US inflation is currently running at 1.5% and Eurozone levels at 0.9%, its highest in five years. Several factors are also supportive of further upward pressure on prices: shipping container costs are up over 100% year-on-year; there are major shortages in the semiconductor supply chain; and oil is rising owing to the Texas freeze. Correspondingly, the prices paid by US manufacturers are showing their greatest upward pressure in a decade (per ISM business data). At the same time, the United Nations reports global food prices at six-year highs. Correspondingly, five-year break-even inflation expectations in the US currently stand at 2.0%.

It’s hard to ignore the reflation trade, even if it’s easy to remain sceptical. One of the biggest challenges for all investors is simply that because inflation has been absent for so long, it is difficult to conceive of what it may do to portfolios. Most market participants have little experience of it and no valid playbook to resort to, particularly given the distortions that over a decade of financial repression have introduced to the system. We should also consider two other important factors. First, there is no guarantee of higher inflation. Indeed, strong arguments can be made for further deflation given not just negative demographics, but also the growing significance of technology in the economy. If the pandemic has brought forward three-to-five years of digital adoption – now the consensus view – then this has clear deflationary ramifications. Next, there is no guarantee of sustained recovery. The transition from pandemic to no pandemic will not be binary, but rather gradual; partial lockdowns and endemic diseases may well endure. Significant output gaps and ample labour market slack will also likely keep inflation under control for now.  

The problem, perhaps, then is complacency or, at the least, highly polarised and consensual positioning. Sentiment on global growth is at an all-time high, cash levels are at an eight-year low and 92% of Fund Managers expect higher inflation over the next 12 months, per the latest Bank of America Merrill Lynch investor survey released in mid-February. The role of Central Banks also needs due consideration. The messaging seems to be one of risks weighted to the downside. Such a stance is supportive of rates remaining lower for longer and no risk of tapering (scaling back quantitative easing) for now. Investors seem to have bought into such a view in the sense that yields at the short-end of the curve have remained well anchored, even if the higher-end has steepened. Sure, the Fed et al have said they are happy to tolerate some inflation in the system, but it will be interesting to see how Central Banks deal with scenarios of potentially more rampant inflation. Similar to investors, they have no ‘obvious’ playbook on which to fall back. At the same time, over a decade of benign monetary accommodation has introduced massive moral hazard into the financial system, allowing many structurally challenged businesses to endure. These may be tested if rates have to start rising.

To say we are not in a bubble is not the same thing as saying that one isn’t building. When we hear suggestions – as we have done – that this time is different (for any number of reasons), then there is ample cause to be worried. It will be important not just to monitor investor sentiment but also to observe the extent to which financial leverage and other imbalances build in the system. What we do know is that the high valuation starting point coming out of last year (15x trough earnings on the S&P 500 Index versus 10x in 2009, for example) combined with higher debt burdens than after the Great Financial Crisis mean that future returns will be lower than those enjoyed in the past. Further, markets don’t always do well when recessions end and recoveries begin – it depends on how much is priced in. Fundamentals will reassert themselves at some stage. Our counsel is to strike a balance and to continue diversifying across asset allocation strategies.

Alex Gunz, Fund Manager, Heptagon Capital