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 are living in unchartered territory. It is not just the record amount of negative yielding government debt that is notable, but the fact that global cooperation is reaching new nadirs. These two factors are inescapably interlinked. Trade wars are unambiguously negative. Against this background, the risk of a global slowdown metastasising into something more significant is high. The economy may be fine for now and monetary policy is highly accommodative but consider that any recession – when it comes – may not be a bad thing, creating opportunities for investors. A complicated world implies a need for flexible strategies. We continue to advocate diversification, particularly into uncorrelated assets.

Asset Allocation:

• Equities: We favour equities over fixed income by default, particularly since the fall in government bond yields is supportive to equity valuations. Consider that the dividend yield on the US S&P 500 Index is now higher than that offered by the US 30-year government bond – for the first time since the financial crisis. We see some growth ahead for equities but remain pragmatic in our allocations. Global financial conditions are certainly looser than a year ago, but investors should prepare themselves for more volatility. It is important to stay disciplined. We favour active over passive strategies, especially those with high-conviction strategies. EM equities would be likely to suffer first in the event of any economic slowdown and we note that earnings revisions in this region are currently worse than elsewhere (per IBES).
• Fixed Income: Capital continues to pour into safer assets pushing bond yields globally further in to negative territory on an almost daily basis. We believe that yields can go lower still, given the economic backdrop and current stance of Central Banks. Nonetheless, at this stage of the cycle, now is not the time to be seeking yield by increasing credit risk; rather, we see a logic of keeping duration low and credit quality high.
• FX: The race to the bottom in currencies remains in full force, particularly given the pressure on Central Banks to continue with dovish policy accommodation. We believe there is scope for relatively more ‘defensive’ currencies, and particularly the Japanese Yen to continue outperforming.
• Gold: Currently at a 6- year high, we expect gold to show further strength. Relative to its history, it is one of the few asset classes that remains undervalued. Listed gold miners represent another way of gaining exposure to the asset class.
• Alternative Assets: We remain constructive on illiquidity premiums. In a low-rate environment, the case for owning longer-duration assets only continues to grow. Against this background, we consider allocations to uncorrelated assets such as infrastructure, niche private equity and real estate to be particularly attractive and see continued scope for high- quality assets with decent cashflows to outperform.

How low can you go?

So much for the quiet summer that many had hoped for. Sure, the sun shone (even in the UK), but back in the real world of investing, the VIX Index of volatility reached its most elevated levels of 2019, global equities have fallen for four of the last five weeks, and the total sum of negative yielding government debt globally surpassed $16tr for the first time ever.

Interestingly, Chief Executives and their ilk must clearly think something is amiss, for the past month was also characterised by the highest level of corporate insider selling of stock since August 2007 (per data from TrimTabs, a research provider).

The backdrop is, of course, challenging. Global cooperation is the lowest in living memory; there is little trust left between nations and globalisation – as we know it – has materially changed. The genie is out of the bottle and the global competitive landscape has shifted permanently. The new paradigm inverts previous logic and favours national champions and local sourcing above all else. A more extreme interpretation of recent developments even posits that we are at the start of a new Cold War, based largely around technological prowess, with the digital divide between the US and China widening daily.

Although we would hardly be the first commentator to observe this, the US is being led by a President who, at the most generous, could be described as erratic. Markets are, unsurprisingly, in flux given how highly uncertain the next utterance from the President may be. We also believe that it is a somewhat complacent assumption to think Trump will do whatever it takes to get re-elected. Put another way, not just is it hard to put that genie back into its bottle, but – crucially – Central Banks cannot come close to ameliorating the economic fall-out from Trump’s trade activities. Fed Chair Powell doing what is best for the US economy is not the same as what is best for the incumbent President. If the realisation has not dawned yet, it should: it is not possible for the US (or any economy) to have a cheap currency, win a trade conflict and enjoy a thriving economy.

At present, both the US and China continue to ratchet up pressure in the trade war, with no visible sign of a truce coming. Regardless of what either leader may think, no country operates in a vacuum. Think of it this way: global trade has grown historically at ~8% a year (since the start of the century), roughly double the rate of GDP. However, the World Trade Organisation is predicting just 2.6% growth in global trade for 2019. Go figure what this means for the economy. Now consider the data: the OECD’s leading indicator of economic activity is at its weakest in a decade, having fallen for the last 17 consecutive months.

With trade wars as the new status quo, there is a growing risk of a coordinated global slowdown. Trade wars, unsurprisingly, are likely to lead to businesses materially curtailing corporate spending. The corollary of this is often lower corporate hiring. It is easy then to see how a negative prophecy can quickly become self-fulfilling. We can already see evidence building. Take US industrial output, currently highlighting contraction for the first time since 2009, with manufacturing new orders and exports also both at their lowest in a decade. Similarly, German industrial output stands at its worst in ten years, while Chinese industrial output has not been this weak since 2002. The consumer is holding up for now, but let’s see what happens when tariffs start to be applied to consumer products for the first time, beginning in September.

Against this background, it is easy to see how an increased risk-off mentality may precipitate recession. The longer the slowdown goes on, the more investors are entitled to worry. With interest rates having been cut in the US at the end of July, we wonder what this says about the need for stimulus in other economies, who are arguably in a worse state. In the past month, countries around the world (as diverse as Egypt, India, New Zealand and Thailand) have continued to cut rates. Nonetheless, it remains hard for Central Banks to engineer a ‘soft landing’ given external factors at work. Trade wars are unambiguously negative.

We also think it is important to recognise that cutting interest rates may not help. Consider that we are at the lower bounds of monetary policy anyway. More importantly, Japan has tried – and failed – with this policy for over three decades. Recall, the term ‘secular stagnation’ was first applied to this economy. Globally, we believe, there is a changed mindset: people no longer have to be bribed with a high interest rate in order to save rather than consume; consumption in the future, is now valued as much or more than consumption in the present. Circumstances have changed. Sure, life expectancy has increased (impacting how people consume), but the Millennial generation came of age at the nadir of the last crisis, implying a much more cautious approach in expectations, and to expenditure, for this cohort.

The world is now in a very precarious place. Beyond reversing the deterioration in relations between the US and China, the growing risk of more widespread stagnation implies a major rethink of Central Bank policy at the least. Notably, governments across the world have begun to talk increasingly vociferously about the need for fiscal stimulus, even if there is nothing close to a consensus yet on this topic (think, for example, how divided experts are on the merits or otherwise of modern monetary theory). Optimistic scenarios point to a pro-growth convergence of monetary and fiscal policy.

Whether such an outcome occurs and whether it happens quickly enough to stave off recession remains unclear. However,

although recessions are never convenient, they do two things: provide a necessary purge and create opportunities for investors. The biggest challenge, as we currently see it, is how to position and where to invest. The dilemma lies in having to prepare for a downturn while continuing to seek returns through the ongoing, remaining expansion.

The problem is compounded by the fact that over 30% of total global debt now attracts a negative yield (per Bloomberg). Government bond yields have sub-zero yields out to 15 years of maturity in Japan, France and Belgium, while in Denmark the figure is 20 years, reaching 30 years in Germany and the Netherlands and a remarkable 50 years in Switzerland. Even if the US remains something of an outlier, with its 30-year yield still in positive territory, these bonds have now fallen below 2% for the first time ever. We are in unchartered territory. Prior to this cycle, nominal negative yields of even long-dated sovereign debt were almost unheard of in over 400 years of modern financial history. Never have yields been this low and duration so high.

The answer to the question of why yields are so low is that there are few other safe places for risk-averse investors. Nonetheless, an addiction to low or negative rates may be hard to reverse. Sure, the world is increasingly complicated – even if the economy is still expanding for now, monetary conditions remains exceptionally loose and commercial banks look much healthier than a decade ago – but the conclusion we draw from this is simple: complication implies a need for flexibility. Put another way, investors should seek to look beyond the traditional. We have long advocated a diversification of portfolios into uncorrelated (and often private) assets. Let’s see what the remainder of the year brings.

Alex Gunz, Fund Manager, Heptagon Capital