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: We’re still dancing, for now. Headlines (coronavirus, Middle Eastern conflict etc.) scream uncertainty, but most investors seem to expect that both equities can still rise reluctantly and that bond yields will fall further. What matters most is simply that the stance of the world’s major Central Banks stays loose. As long as easing policies remain, a support is provided both for economic growth and for risk assets. Extremes, therefore, can get more extreme. Our stance, however, is not driven by a perceived fear of missing out. Rather, we see a case for being constructive: keep powder dry for the dislocations that will occur; invest intelligently into less popular areas within the mainstream asset classes; and, continue to grow diversification, particularly to private assets.

Asset Allocation:

• Equities: remain a more attractive option than fixed income for those investors seeking exposure to liquid assets. Even if some segments of the market (particularly popular US mega caps) are expensive relative to history, passive fund flows and share buybacks may continue to drive valuations higher. Our approach is to be selective, focusing on truly active global managers able to identify market dislocations. Other regions (Europe, and emerging markets for the very long- term) offer more attractive relative value opportunities than the US. The case for owning equities backed by income paying meaningful dividends is also compelling, given the ongoing search for yield.
• Fixed Income: For as long as monetary policy remains loose – and we do not anticipate any change in this respect – bond yields can continue to compress further. Capital certainly continues to flow into the space. However, as bond yields decline, their risk-return profile does become increasingly asymmetric. Meanwhile, in the corporate segment of the debt market, we note that many indicators are pointing to credit quality deterioration. Now is not the time to be seeking yield by increasing credit risk.
• Alternative Assets: Low yields strengthen the case for owning assets in private markets. An illiquidity premium makes sense in a low-rate environment. Now is the time to own real assets such as infrastructure, real estate and niche private equity.
• Gold: We see a logic for owning gold. It is defensive, carries neither credit nor political risks and acts as a natural diversifier. Relative to its history, it is one of the few asset classes that remains clearly undervalued. Listed gold miners (which are cash-generative) represent another way of gaining exposure to the asset class.
• FX: We have no active views but note the logic for ‘safe haven’ currencies such as the Japanese Yen and Swiss Franc in market conditions which may grow increasingly uncertain.

For how long will we continue to dance?

No one ever said it was going to be easy. After a year such as 2019, when exposure to almost any asset class would have generated positive returns, the story for 2020 was always likely to be much less linear. January has already given us a potential window of things to come. Markets have had to deal both with a military flare-up in Iran and the emergence of a hither to unknown and possibly very deadly global virus. Even if bond yields have compressed yet further, while equities have attempted to move higher (the MSCI World was in positive territory until the last day of January), it remains our view that current positioning leaves very little room for complacency. Such moves in both asset classes speak most abundantly of the persistent need not to miss out. To the extent that there is a rhyming with previous eras, we find ourselves inevitably drawn to the now-notorious observation of Chuck Prince, the former Citi CEO: “as long as the music is playing, you’ve got to get up and dance.” For now, we’re still dancing.

Extremes can get more extreme. However, the higher markets go, the more nervous investors are naturally entitled to become. From what we see/hear, more and more seem to be seeking ‘justifications’ or ‘catalysts’ for the perpetuation of current circumstances. Hope should never be a strategy, but the expectation for further new (equity) highs seems to be justified on an improvement in the global economy and/or growth in corporate earnings. Of course, there is no guarantee that either happens. Even prior to the emergence of the coronavirus, both the World Bank and the IMF were downgrading their economic outlook estimates. For sure, in the absence of either of the above positive scenarios coming to pass, there is a clear risk that valuations will become increasingly detached from reality.

Why have equities been going up? We believe two main factors are at work. The first is simply ETF (i.e. passive) money flows. Despite a palpable absence of investor euphoria, a fear of missing out – whether actual or perceived – continues to dictate behaviour. Next, consider the impact of share buybacks, whose impact continues only to expand. While consumer debt has fallen since the Financial Crisis, corporate leverage is at its highest in 65 years (per the Federal Reserve). High stock prices are coming at the expense of public companies becoming more levered, a phenomenon most pronounced in the US. It will end badly, in our view. The analogy of the elastic band is a valid one – the string can keep stretching until it doesn’t; the band will snap, eventually. We note the following statistics of concern:

• the size of the S&P 500 Index relative to the GDP of the US economy – at 200% – is at an all-time high;
• the current (2020E) earnings multiple for the S&P of ~22x is the highest it has been since 2002; in 1999 it peaked at ~23x;
• the S&P’s cyclically adjusted earnings multiple is currently in the 90th percentile relative to its history;
• the PEG ratio (of earnings relative to growth prospects) is the highest it has ever been; and,
• the top decile of S&P stocks (by market capitalisation) now trade at their most expensive since 2000 (statistics courtesy of Goldman Sachs for the first three, Bank of America and KKR).

What the above implies is that future growth is being pulled forward – i.e. already discounted in valuation multiples. At the same time, current valuations weigh on the odds of higher future returns. Particularly for ‘winners’, it will be increasingly difficult to keep compounding in the future at the same rate as achieved in the past. The one caveat attached to this prognosis is the consideration that while S&P earnings have expanded by over 80% since their pre-crisis peak, all other major regions – Asia, Japan and Europe – have achieved less than 20% earnings expansion over the same period (again, per Goldman Sachs). Opportunities exist, but investors need to be selective. Even if equities are increasingly detached from reality, what about fixed income? We repeat the observation made many times previously/elsewhere: potential owners of developed world government bonds are earning the lowest yields in over 500 years. If this were not evidence enough, then consider that over 90% of corporates in US/Europe now have a dividend yield greater than their country’s corporate bond yield (per Goldman Sachs). Of course, for as long as interest rates remain structurally low, the case for further yield compression cannot be ruled out. Listening to the leaders of the world’s Central Banks at the AGM of the American Economics Association in early January, it would be easy to believe this is the case. If anything, the illuminati present suggested that demographics and weak productivity trends would support a case for even lower rates.

Investors can relax in the knowledge that ongoing financial easing ought to be a net positive both for economic growth and risk assets in the near-term. If we may be bolder, it is hard to escape the notion that what matters most to markets most of the time is the Federal Reserve. To follow this argument through to its logical conclusion, equity (S&P) multiples can remain elevated because monetary policy is so easy, and investors have become more comfortable with the idea that medium-term interest rates will rise only slowly. On this logic, ‘value’ as investing style would remain cheap, given its seeming negative correlation with interest rates. Also do not forget that inflationary pressures remain generally muted. Despite US unemployment at a 50-year low, headline CPI is just 2.3% (and wage growth 2.9%). In Europe, CPI is currently running even lower, at just 1.4%. Don’t ask about Japan.

The above, however, does not suggest that investors should bask in the sun. Those who ignore the growing debt burden do so at their peril. We made reference earlier to how consumer debt had effectively been shifted to the corporate sector. The bald reality is that total global debt as a percentage of GDP has risen by over 50 percentage points in the last decade, to reach a ratio of 230% (per the World Bank). While much of this increase has, admittedly, been a function of the rapid expansion of China’s economy, the Bank’s report does highlight that the current wave of debt accumulation is “the largest, fastest and most broad-based increase” since the 1970s. Further, it notes that low interest rates provide “precarious protection.”

Closer to home, we note the growth in both junk debt and leveraged loans as being factors of potential concern worth monitoring carefully. Begin with the former, and current issuance of non-Investment Grade bonds, loans and related instruments (i.e. junk) currently stands at a record high of $1.2tr in the US (per Moody’s), while European issuance stands at its highest since 2013 (per Bloomberg). On the leveraged loans side, we note credit downgrades are outpacing upgrades at present by a factor of three to one (per S&P). Meanwhile, new leveraged loans are being issued with a worryingly high average net debt to EBITDA ratio of over five times, higher than historic levels (per UBS). Looking forward, we would expect to see further deterioration in areas of the credit market where there have been most excesses (e.g. unsecured consumer credit, subprime etc.). Like the grain of sand analogy, which single grain knocks over the whole pile remains unknown for now.

What to do then? Rather than worry about potentially missing out on the very near-term, we favour planning for the longer-term. As we said earlier, 2020 is unlikely to see a linear progression for any asset class. The logic, therefore, of keeping some powder dry for inevitable dislocations is compelling. There will be opportunities, especially in less ‘popular’ or more misunderstood areas. At the same, we think it important to reiterate the message on which we have been consistent for some time: continue diversifying.

Alex Gunz, Fund Manager, Heptagon Capital