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 thaView from the very top: Investors are starting 2020 with most asset classes not only looking more expensive than a year ago, but also with expectations markedly higher. After the outsized returns of the last year/decade, the scope for such an outcome to be repeated over the coming period looks markedly lower. Widening inequalities and increased deglobalisation are problems that not only refuse to go away but also can’t be fixed easily. At some stage, the cycle will turn, and with it, policymakers will need to pursue different and more radical options. Our strategy is to remain nimble, continue diversifying and increase focus on uncorrelated asset classes.

Asset Allocation:

• Equities remain the only mainstream game in town, especially in the absence of any major cyclical and/or policy risks developing. The reality is that even after the recent rally, the forward price-to-earnings multiple for the MSCI World Index remains close to its historic average (per Bloomberg), whereas bonds continue to look very unattractive relative to history. Within the equity world, our preference is more nuanced. At some stage, value will work relative to growth (even if this may not be the case in 2020), but it remains clear to us that some sectors of the market (US, mega-cap, tech) look markedly more expensive than others. Our preference remains for high-conviction, truly differentiated managers.

• Fixed Income: As bond yields continue to fall, their risk-return profile becomes increasingly asymmetric. Put another way, the cushioning that bonds provide against equity marked drawdowns gets thinner as yields decline. Investors perhaps need to rethink the concept of government bonds as safe havens, despite capital continuing to flow into the space. 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: The attraction of illiquid alternative asset classes only continues to grow, in our view. In a low-rate environment, there is an increasingly compelling case for owning longer-duration assets. We consider allocations to uncorrelated assets such as infrastructure, real estate and niche private equity to be particularly attractive and see continued scope for high-quality assets with meaningful cashflows to outperform.
• Gold: We see a logic for owning gold. It acts as a natural diversifier. Furthermore, relative to its history, it is one of the few asset classes that remains clearly undervalued. Listed gold miners represent another way of gaining exposure to the asset class.

New decade, same story (at least for now)

Starting points matter. A decade ago, the world was beginning only very slowly to emerge from the worst financial crisis since the Great Depression. Investing, therefore, in almost any asset class at the beginning of 2010 would have resulted in positive returns over the ensuing 10 years. Global equities (led by the US) reached all-time nominal highs, while Government bond yields in much of the developed world reached levels not seen in over 400 years. In some ways 2019 marked the epitome of this dynamic, the year being characterised for most investors as being one where it would have been very hard not to have made money. Over the past 12 months, equities enjoyed their best year since 2013, investment grade debt the best since 2009 and high yield the best since 2016. Gold and oil also delivered positive returns. Looking forward, while we are reluctant to make any formal ‘predictions’, some things do appear much more obvious to us than others…

1: The outlook for returns

The 2010s marked the first decade in modern times without a bear market – i.e. a 20% drop from any peak. Sure, there were 6 separate 10% corrections (per Bloomberg), but none of these was enough to kill the bull. Against this background, after the high returns of the past decade, returns for the next decade from conventional asset classes will likely be lower.

For 2020 specifically, it seems likely to be a more ‘normal’ year. 2019, with hindsight, was always likely to have been a good year for investors given that the prior one (2018) saw very few asset classes delivering positive returns. Indeed, for equities, 2018 was the worst year in returns terms since 2008. The only problem, however, is that expectations are now a lot higher than they were this time last year. Maybe the melt-up continues but mean-reversion as an alternative outcome can also not be ruled out. At the least, we see limited evidence of late-cycle behaviour. Sentiment does not seem excessively bullish – if anything, the contrary may be more accurate – and indicators such as merger and acquisitions activity remain markedly below previous cycle-highs. If we were to proffer counsel, then it might simply be to make hay while the sun shines.

2: Recession risk

Beyond being a decade with no bear market, the 2010s were remarkable for the fact that the last decade saw no global recession – the first time that such an outcome has been achieved in modern history. Indeed, per Jerome Powell, the Chair of the Federal Reserve, “I see the glass as much more than half full.” Perhaps Powell’s confidence comes from the fact that a US recession has never started when the unemployment rate has been falling – which it continues to do. Furthermore, recent American industrial production reports have exceeded expectations, while homebuilder confidence stands at a 20- year high.

However compelling all the above may be, the reality remains that over the last decade, sustained growth has been scarce, and the recovery has been fragile. At the same time, inequalities have spread and many parts of the economy (or broader society) have moved further out of sync. The reason why: the problem of (excess) debt that brought about the last major downturn has been ‘solved’ only by more debt. Even if debt is cheap, it can be tough to escape once the load gets too heavy.

Consider that the world currently carries record debt; some $120tr, when the sums owing of governments, corporates and households are aggregated. This equates to three times the level of global GDP, or $32,500 for every person alive on the planet (per the International Institute of Finance). If this burden seems too abstract, then maybe it is simpler to wonder for how long, say, the consumer can continue to hold up the US economy. Consumer debt in the US stands at $14tr, or 19% of GDP, up from the 17.5% peak seen at the time of the credit crisis (per Deutsche Bank).

If not the consumer, then how about corporate debt as being the weakest link? The last quarter of 2019 saw the highest level of corporate debt downgrades relative to upgrades ex-financials in the US since 2015, while debt to EBITDA levels for the same cohort of American businesses stands at an all-time high (data per Bloomberg and JP Morgan respectively).

3: Trade outlook

Could trade – rather than debt – be the straw that metaphorically breaks the camel’s back. At the least, deglobalisation represents a structural challenge for asset allocators. Think of it like this, trade wars are disruptive not only to demand patterns (which negatively impact GDP), but also weaken supply chains and drive input costs higher. Both these factors are typically considered as inflationary, at least over the medium-term.

In the near-term, the current détente between the US and China should most likely be seen as a temporary reprieve. Both the US and China will benefit from a boost to GDP, especially with an election year occurring in the former country and economic growth having tumbled to 6% (versus a 20-year average of 9%) in the latter. However, consider that not only has Donald Trump continued to tighten tariffs elsewhere in the world (on steel in Brazil and Argentina; on luxury goods in France etc.), but also that some Democrat Presidential candidates appear to have any even more hawkish view on trade. From an investor’s perspective, if anything, we see sentiment as being too sanguine. Most bullish market scenarios would take a hit were either the US or China to step back from the current accord. Meanwhile, from a bigger picture perspective – as we have argued elsewhere – when it comes to trade, the genie is firmly out of the bottle. It will be very hard to return any time soon to a world-view which incorporates global cooperation.

4: Where does it all end?

Calling an end to the current cycle – the longest in modern history – is to bet against the secular trends that got us here. Central Banks have flooded the market with liquidity and interest rates are at historic lows. There remains an ongoing confidence (or dare we suggest, complacency) in the notion of the Central Bank ‘put’. Sure, nearly 60% of the world’s Central Banks are currently easing policy, the largest level since the Financial Crisis (per Bloomberg), but there remains an ongoing and persistent view that low interest rates are here to stay. We tell ourselves myths to keep the delusion alive.

Quantitative easing may have saved the economy from potential depression, but also introduced a number of side-effects – most notably, inequality and anaemic growth. If history shows us anything, then it is that cycles do exist and that periods of wealth redistribution typically follow those of accumulation. Put another way, excesses tend to cause backlashes.

Governments therefore need to think creatively. Our sense is that the era of monetary dominance is coming to an end. Do not forget that despite over $12tr of financial repurchases globally, there has still been no sustained inflation. Look to Japan for an example of ‘quantitative failure’ or perhaps a sign of things to come; monetary impotence against a backdrop of deteriorating demographics.

What next then? Governments may look to run fiscal deficits to spend their way out of potential ‘Japanification.’ Indeed, consider Japan’s $120bn fiscal stimulus package perhaps as a sign of things to come. In crisis, expect more radical variants – modern monetary theory springs to mind. Sure, new policies will also have unintended consequences. We leave readers with the thought that at the least, very few asset classes (or indeed investors) seem currently to be discounting scenarios of higher inflation. In such an environment, equities will prosper (relatively) at the expense of fixed income, but real assets are the place to be.

Alex Gunz, Fund Manager, Heptagon Capital