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: sentiment can change very quickly. February’s price action in all asset classes has shown clearly that the impact of the coronavirus has extended well beyond China’s borders. Investors, understandably, dislike uncertainty. That said, recent events will likely force policymakers into action once again. With unconventional monetary approaches reaching their limits of potency, fiscal solutions may take up the slack. Each new crisis generally means more extreme policy actions and a swathe of unintended consequences. We stress the importance of seeking to think differently and the need for more of a focus on the longer- rather than the shorter- term. From a practical perspective this means pursuing an ongoing process of portfolio diversification, avoiding the conventional and favouring the truly differentiated.

Asset Allocation:

• Equities: The move in global equities from an all-time nominal high (on 12 February) to correction territory of at least a 10% drop by month-end has been as rapid as it has been concerning. Sure, the until-recent upward rise in markets has been achieved against a backdrop of low volatility and its return should not be surprising. Bears would additionally point to the coronavirus-inspired uncertainty over near-term estimates and rich valuations relative to history, but these arguments need to be nuanced. Equities (in general terms) continue to look more attractive than fixed income from a valuation perspective. Our approach is to be highly selective, focusing on truly active global managers able to identify market dislocations. Regionally we prefer Europe (and emerging markets for the long-term) over the US.
• Fixed Income: The herd mentality remains strong as evidenced by record net new inflows into fixed in come funds globally over the past month (per Bank of America). Investors continue to flock to bonds for their perceived safe-haven status, offering steady returns as a buffer against volatility. Neither the 10-year nor the 30-year US Treasury has ever been this low in history. Nonetheless, as bond yields decline, their risk-return profile does become increasingly asymmetric and their valuation even less compelling. Elsewhere, we have concerns about deteriorating corporate credit quality in certain segments. Now is not the time to be seeking yield by increasing credit risk.
• Alternative Assets: Low yields only 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 continued logic for owning gold, even with its price at its highest in almost eight years. 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.

Focus on the bigger picture

Being conditioned to abnormality is all well and good, but it is also an act of denial. Markets rarely move in a linear and non-volatile fashion. Perhaps hindsight may show that the conditions that characterised 2019 – where it was almost impossible not to make money – were the exception rather than the rule. This year was never likely to be one of plain sailing for investors and indeed its first eight weeks perhaps provide a foretaste of what is to come.

If the prospect of entrenched trade wars were the major concern of investors last year, then the potential for the coronavirus to develop into a global epidemic is even more pronounced. While an increased severity of trade barriers would clearly have been deleterious both to economic growth prospects and corporate earnings, coronavirus may have an even more adverse effect. There have been countless column inches of speculation around the topic and we see limited point in trying to add more. The full facts surrounding the virus are still unclear, but it is hard to disagree with the statement of the World Health Organisation that the outbreak is “very worrisome.”

Investors are understandably nervous, especially given the low levels of visibility. Not panicking may be one thing, but to suggest that the virus won’t have an impact is quite another. Bear in mind that we are currently sitting in a late-cycle market with slowing economic growth around the world and a stock market that has been bouncing not far below its all-time highs. Sure, corrections do happen (as indeed we are witnessing) and we are believers in mean reversion, but it is equally fair to wonder when (and how) a routine decline might metastasise into more climactic selling.

Consider the data. In 2003 – when the world’s attention was grabbed by the SARS epidemic – China generated 4% of global GDP; last year, it was 16% (per Bloomberg). Put another way, a slowdown in domestic consumption and production does not stop at China’s borders. Businesses as diverse as Apple, Coca Cola and MasterCard (among others) have all revised down their financial guidance since the start of the year based on the potential impact of the virus. The IMF, perhaps unsurprisingly, warns that the coronavirus could “put the global economy at risk.” Manufacturing indices in both Europe and Japan are already in decline, with industrial production in Germany at its weakest in four years. The US economy continues to hold up for now but note that recently reported fourth quarter GDP was its slowest in three years.

How worried should we be? Well, even if there is a clear slump in economic growth globally this quarter, there may be an equally strong rebound at some stage later in the year. Although many international organisations have warned of increased uncertainty, few have revised down their growth forecasts so far. Similarly, corporates tend to set conservative guidance at the start of the year (and all the more so currently), potentially paving the way for upside surprises later.

And, of course, Central Banks may come to the rescue – again. The injection of liquidity into the financial system has worked in the past (over $15tr of assets have been added to the balance sheets of the leading Central Banks since 2007, per Bloomberg) and may continue to do so in the future. China has already cut interest rates and injected $30bn into its financial system, while globally, financial easing is currently at its highest since 2010 (per data cited in 13D Research). However, each round of accommodative monetary policy has become less effective than the previous one. Central Banks have helped extend the economic cycle (and certainly helped avoid a more profound crisis after the financial bubble burst), but this has never been a ‘normal’ cycle; more an elongated one, characterised by slow and shallow growth.

The end of globalisation and social polarisation have now complicated things (for Central Banks, and indeed investors). The potential coronavirus pandemic further raises the stakes. Where all this appears to be heading is towards a pressing needfor a ‘growth’ solution. Monetary policy may have helped ‘tune’ the economic cycle, but fiscal policy represents a much more extreme measure. Comments out of Beijing suggest that China may soon launch a large fiscal stimulus package; Fed Chairman Jerome Powell said recently in a Congress testimony that there was a “need” for fiscal stimulus; and even some potential candidates for the next German President have hinted at the possibility of the country abandoning its fiscal rectitude. We have seen that populist policies (‘for the people’) can win votes. Many get excited about the benefits – even if they fail to understand the costs – of Modern Monetary Theory; debt is now OK if it helps finance growth and does not drive inflation. Only history will tell.

Our biggest concern is that each new crisis sees more extreme policy action, creating fresh credit and asset bubbles and encouraging further debt and fragility. The extreme (monetary, quantitative easing-inspired) distortions of the last decade have brought about the ‘everything bubble’, where both equities have gone up and bond yields have declined. Global growth, albeit slower than that to which we have historically been accustomed, has helped to paper over the cracks. Conventional asset classes are richly valued on the assumption that interest rates, inflation and volatility can remain low. Extremes, as we have seen, can get more extreme. Fiscal stimulus – in whatever guise it may take – could expose the financial system to a swathe of (new) unintended consequences, particularly the potential return of inflation. We are likely some way off from this moment, but when it does come, it may further undermine participants’ trust in the financial system.

Now, more than ever, is a time to think differently. What do we mean by this? We need to try to rid ourselves of biases or heuristics (crude ‘rules of thumb’). It is human nature to be attracted to stories in general and headlines in particular. Incremental change, slow progress, or the direction of travel simply do not grab peoples’ attention quite so much. Sure, the coronavirus is deeply unsettling, but maybe it’s more important to consider that childhood mortality rates are declining globally, more people are moving out of extreme poverty and gaining a basic level of education each year. It is important that we should not confuse the short-term with the long-term. Even if there is a perceived need to be seen to be ‘active’ in front of clients, there is a strong logic in slowing down (or at least using your ‘slow’ brain more). Things that are often considered as unsustainable can last for longer than anticipated, but we remain believers in the concept of mean reversion.

At present, it seems that many market participants are focused on the most ‘obvious’ things. By this, we would call out the notion of continued liquidity within the financial system. We consider this a dangerous assumption. As and when investors do seek to de-risk their portfolios, such a process will likely be concentrated on the most liquid segments. This is partly the (unintended) consequence of accommodative monetary policy; since this has encouraged those with longer investment horizons into more illiquid assets, implying that when selling does occur, the most liquid bits will go first. Now consider that in these segments of the market, machines (or computer algorithms) dominate trading. As a next step, let’s assume that such programmes decide to start withdrawing liquidity in a stressed market – which seems reasonable – and then, what happens to liquid markets? They drop, potentially sharply and rapidly. Perceived safety is exposed as dysfunctionality.

The above is just example; think of it either as a modern-day parable or as a possible warning of what could come to pass. Regardless, the message remains the same – think differently. We have argued the case for portfolio diversification and eschewing the conventional for some time. As the cycle progress, our conviction in these respects only grows.

Alex Gunz, Fund Manager, Heptagon Capital