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.
We asserted back at the start of June that the ensuing months would likely constitute a ‘cruel summer’ for investors across most asset classes. Events in the past weeks would seem to have reinforced this view with debt dominating the agenda on both sides of the Atlantic. Volatility has remained high and we see little reason for an alteration in our current allocation strategy, namely avoiding those assets with closest perceived proximity to sovereign risk (G7 debt, European equity in the periphery, especially within the financial sector – to name but two examples) and correspondingly favouring those furthest removed from the current crisis, namely, selective corporate and high yield short-duration bonds, equities that are defensively positioned and gold.
Our current positioning is premised on two – somewhat axiomatic, but nonetheless crucial – observations:
Economic issues are becoming (or, have become) increasingly politicised; and,
Corporate profits do not exist in a vacuum; they are affected by macroeconomic developments. The recent debates surrounding possible US default capture the above dialectic appropriately. The ultimate resolution (or, less charitably, near-term sticking plaster) confirms the view that the key issue has been much more about the willingness of American politicians to extend the debt ceiling rather than the technical ability to do so. It also ignores the bigger issue, namely that there is increasingly limited room for manoeuver in the US economy. While GDP may receive a much-needed late-2011 boost from the ability for corporates to depreciate 100% of planned capital expenditure this year (a benefit that will not be available in 2012), America’s financially straightened circumstances combined with a singularly recalcitrant Congress/Senate limit the scope for tax breaks being extended into 2012. Indeed, the opposite seems much more likely, namely, the risk of further fiscal tightening, against a backdrop of weaker output trends. Bearing in mind that US GDP has grown by only 5% since the end of the last recession (in other words, failing to recover the 5.1% it lost during the downturn), it is hard not to feel some sense of discomfort about the medium-term US growth outlook. The picture in Europe is also unappealing. The latest developments regarding Greek/Eurozone debt constitute little more than a compromise, buying more time from the inevitable. Neither the structural indebtedness of certain countries nor their lack of competitiveness has been adequately addressed. Moreover, we see there being a very limited case for greater union: it seems a poor excuse to use the inherent failures of the existing political/economic infrastructure as a reason for further expansion,
especially when public support is so low. On the contrary, recent developments suggest that a ‘two-speed’ Europe is increasingly emerging, a phenomenon that would only be reinforced were Italy and/or Spain to see their debt downgraded.
Whether Asia can come to the rescue seems open to debate. It is still unclear that inflation can be contained (and note recent rate-raising across the region). Of greater concern, especially for China, is that over-heating combined with export price inflation that has been founded on rapid labour cost growth will only serve to erode international competitiveness over time. Inflation therefore needs to come down further. We will leave other (perhaps equally significant) structural concerns such as corporate governance, protection of IP rights and the ease of transition from a manufacturing to a services economy base for debate another time. Needless to say, substantial risks exist.
Underlying all of these dynamics is the political uncertainty about which we have written and expressed concern before. America could, and China will see new national leaders next year (Presidential Elections and the appointment/ anointment of a new Chinese Premier), while Europe may also undergo wholescale change, perhaps for the worse. Periphery countries may see their leaders ousted owing to the implementation of unpopular austerity measures, while leaders in the core countries can feel no safer, with their electorates dissatisfied with the support lent to potentially failing nations.
It is against this background that we are unsurprised not only to see volatility levels remaining elevated relative to historic norms, but also correlations both between and within asset classes diminishing. While this latter point has been observed by a few commentators (for example, the strategy teams at Citigroup and Goldman Sachs), our sense is that it remains somewhat under-appreciated, creating opportunities for selective and judicious allocation, both to managers and to individual equities. Our strategy at Heptagon reflects this, and our current tactical positioning is as follows:
Avoid G7 debt: Yields do not outweigh risks in our opinion. High debt/GDP ratios, Eurozone periphery solvency and inflationary pressures combined with the increasing politicisation we highlighted earlier are factors that look set to persist for some time. For the US specifically, a debt downgrade would likely imply a steepening of the yield curve, while if the Federal Reserve were to contemplate a third round of quantitative easing, then this would also be negative for Treasuries;
Gold may outperform near-term, although looks more range-bound medium-term: the corollary of sovereign uncertainty is a flight to perceived safe havens. Low real interest rates can provide further support, but given gold’s correlation, as a rising interest rate environment becomes more discounted, recent outperformance could turn negative;
US Dollar under pressure, but with scope to rally: Just as owning gold has been a somewhat less risky and hence relatively successful strategy, so the Swiss Franc (and Singaporean Dollar) have
benefited from recent macro uncertainties. The three-month cash rate on the former is currently 18 basis points. However, it should not be forgotten that the Dollar remains the world’s de facto currency and lending vehicle. Debt resolution in the US could provide needed support; if Dollar weakness has been (partially) caused by concerns over sovereign liquidity, then the Euro ought to see more downward pressure. Similarly, at these levels, the Swiss Franc looks overvalued;
Selective allocations to corporate and high-yield short-duration bonds; also to equities and hedge funds: We seek exposure to best-in-class managers/assets, with lowest risk, particularly to the issues mentioned above. In particular, after recent underperformance a number of CTA (commodity trading adviser) and macro hedge funds are beginning to look increasingly attractive;
AvoidContinentalEurope:WenotethattheEurozoneistheonlypartoftheG7whereinterest rates have been increasing; after two rounds of rises, the risk of subsequent policy errors is disproportionately high. Lending standards continue to tighten (real M1 growth is back to 2008 levels) and consumer confidence is falling. The recent earnings season has been the most disappointing since 2008, with only 40% of corporates having surpassed consensus expectations. More fundamentally, Europe risks being trapped in a vicious circle: low growth leads to higher deficits; these lead to higher bond yields and hence more austerity; this, in turn, lowers growth...
By default/ implication, the US seems the best place to be for now: American equities have enjoyed better returns than other global markets, and have also outpaced US high yield and Treasuries year-to-date. The earnings seasons has seen 80% of companies exceed consensus with an average beat of over 7%. Tech, in particular, has been a stand-out area of strength. Current equity valuations are also undemanding and corporates have substantial scope to use their balance sheets for constructive M&A and/or enhancing buy-backs. Stocks with high international exposure have also enjoyed the benefits of a weaker Dollar.
One final word of caution, however. Since corporate profitability does not exist in a vacuum, US companies do face an unfortunate dilemma: with unemployment in the world’s largest economy still stubbornly over 9%, if American firms decide to decrease hiring, then currently stumbling economic expansion may falter further; on the other hand, if hiring were to rise from current levels, margins risk declining and earnings could fall. Enjoy the cruel summer.
Alex Gunz, Fund Manager, Heptagon Capital
The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. 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. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document.
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