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: Cyclicality and mean reversion are not terms investors have been much accustomed to hearing recently. However, they haven’t gone away, despite whatever policymakers may have us believe. The problem is that we have become conditioned to abnormality. Equities continue to move higher while bond yields compress lower, yet ongoing unconventional Central Bank intervention is almost certainly creating a set of unintended consequences that have by no means fully played out. Their effects might only be seen when a recession and/or market correction does come. Our approach remains less centred on the avoidance of short- term volatility and more focused on preserving capital for the medium-term. Continue to diversify intelligently.

Asset Allocation:

• fEquities: The upward movement of most global stock market indices continues. Relative to much of the fixed income asset class bucket, equities naturally continue to look attractive. By owning equities on a selective basis, investors can logically benefit from a compelling combination of both yield and growth that is not available elsewhere at present. While there has been some rotation towards more value-based sectors of the market in recent weeks, the sustainability of this move will be partly contingent on the future direction of Central Bank policy. The upcoming reporting season will also likely provide investors with potential opportunities in many spaces. Our expectation is for more volatility, both within the market and across sectors. Against this background, we naturally favour truly active over passive strategies.
• Fixed Income: It is hard to ignore the fact that a third of all government bonds globally offer a negative yield, while the same can also be said of over $1tr of investment grade bonds (per Goldman Sachs). Although we find it hard to justify owning negative yielding debt, the sustained push into negative yield territory may endure. Longer-term inflation expectations continue to decline, while there simply remains a scarcity of other perceived safe assets for many investors. Our preference within this segment is for selected allocations to high-quality and flexible credit plays.
• 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. Relatively more defensive currencies may continue to outperform.
• 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.

Conditioned to abnormality

How do we reconcile a US (and global) stock market at close to record highs with the possibility that the economy might be in recession before the next Presidential election occurs? The simple answer is that we have become conditioned toabnormality. What we mean is that a large majority of investors seem to be of the view that someone – the Heads of the world’s major Central Banks for want of a better alternative – is in charge. The famous ‘Fed put’ remains alive and kicking. Central Banks will be there to do what it takes, seemingly regardless of the cost.

By cost, what we have spent an increasing amount of recent time thinking about are the unintended consequences of ongoing unconventional Central Bank intervention. Where to begin? Well, the suppression of interest rates has misdirected capital (hence the relentless rise in equities and decline in bond yields). How can it be ‘normal’ for creditors to have to accept a negative yield for the privilege of lending money? This has never occurred in history before. Next, by intervening and seeking to ‘manage’ the business cycle, many companies that should perhaps have failed instead have been allowed to endure. This is only storing up problems for the future. And, perhaps most glaringly, intervention has become an addiction: Central Banks have arguably gone so far that it is hard for them now to consider stopping; markets may not allow it.

What then to do? One strategy would be to adopt the Chuck Prince approach. For those unaware, the former Chairman of Citigroup notoriously said in 2007 that for “as long as the music is playing, you’ve got to get up and dance.” Put another way, there remains for many a significant opportunity cost attached to not participating in the market at present. FOMO (fear of missing out) and career risk may perhaps be informing investment decisions more than fundamentals.

While such an approach may have some (short-term) merits, it does of course ignore several crucial factors. History may not, as Mark Twain famously said, repeat itself, but it does certainly rhyme. Consider that the tech IPO train may already have left the station for this cycle. The decision of the We Company (WeWork to most of us) to pull its planned listing may have marked the top. The earlier flotations of Lyft and Uber – both trading at least 30% below their flotation prices – may equally have been an early warning sign. Moving to a different segment of financial markets, we cannot help but observe the growing levels of leveraged loan losses and distressed situations that are emerging. The ratio of high yield debt trading at least at a 1000-point premium to US Treasuries is currently at its highest since 2016, per S&P. Meanwhile, credit card debt in the US currently matches its 2008 peak, per Bloomberg.

It would be naïve to believe that the world has now – somehow – miraculously arrived at a level (or maybe even a plateau) of permanently high and stable growth, where loss-making businesses can gain access to public capital easily or investors are happy to own huge swathes of covenant-lite loans. As old-fashioned as it may sound, cyclicality remains inherent in the financial system and with this, the scope for mean reversion. Let’s see what happens when – choose your expression – a recession/ controversial political election/ equity bear market/ exogenous shock occurs.

How seriously should we take the threat of potential recession? Well, the data certainly don’t look compelling at present. The OECD (and other similar bodies) continue to revise down their estimates for global GDP growth in both 2019 and 2020. This is perhaps not surprising given that JP Morgan’s index of global PMI industrial activity is now highlighting contraction with a sub-50 reading. A figure of 49.3 compares to the 54.4 recorded at the start of 2018. Elsewhere, Chinese industrial production figures are at their lowest in 17 years, German factory activity is shrinking at its fastest pace in a decade and Japanese machine orders are their weakest since 2012.

Even if some recent data from the US (such as existing home sales, retail figures and jobless claims) continue to look solid, at the least, there is no pattern of uniform global growth. As we have written before, the US economy cannot operate in a vacuum in perpetuity, regardless of what its President may believe. Rhetoric such as a trade deal is coming “sooner than you think” (a Trump tweet from 25 September) provides just a near-term sugar-high. Putting the genie back into the bottle can’t be done easily. Repairing America’s relationship with China may take years. Similarly, with each round of resurrected trade talks (and we’re currently on the 13th iteration), the stakes get proportionately higher.

To return to our earlier line of thought, if we are not to ‘keep dancing,’ then it behoves us to think of other alternatives. Part of the answer to this question requires a consideration of how much confidence ought to be placed in Central Banks. Furthermore, if trust in these institutions is deteriorating, it is necessary to think how else the current economic (and related investment) conundrums may be resolved.

It was notable to us that at the time of both the Federal Reserve’s and the ECB’s most recent policy announcements that the Boards of the two Central Banks showed a markedly higher level of dissension than in recent history. The split among votes cast on whether to cut interest rates at the most recent Open Market Committee of the Federal Reserve was the highest recorded since 2014. Turning to Europe, perhaps we should not be surprised about the controversy surrounding Mario Draghi’s decision to return to the policy of quantitative easing (QE). Similar to Einstein’s definition of insanity, just as QE has not worked in the past in stimulating sustained growth, why should we assume it will do so this time? Disagreement, of course, breeds uncertainty, which is never healthy. Perhaps there is just a basic reality at work, that not all are yet willing to recognise: Central Banks have reached the limits of what they can effectively achieve with the policy tools available to them. Such an impasse may be just the opportunity that some populists (Trump, anyone?) have been looking for; to curtail the independence of such organisations and bring them back under state control.

Another approach may be for fiscal policy to play a more active role. Even if the US currently has a fiscal budget deficit of $1.2tr (the first time since 1945 that the deficit has not shrunk over the course of the recovery, per Bloomberg), low interest rates may make it easier for governments to sanction increased fiscal spending. Even the traditionally conservative Germans do not appear to have ruled out this option. It should also not be forgotten that state spending on schools, hospitals, roads etc is inherently populist, an easy win for politicians targeting disgruntled voters. We may not even be so far away from Milton Friedman’s (thankfully still theoretical) idea of helicopter money; a last resort where expansionary fiscal policy is financed by an increase in an economy’s money supply. Proponents of modern monetary theory have reformulated this idea, perhaps ignoring the fact that it may create as many problems (such as potentially uncontrolled inflation) as it solves.

We can say with a degree of certainty that ‘the music’ will not continue to play forever and that the relative ‘normality’ of the cycle and all that follows (i.e. recession at some stage) will eventually return. For longer-term and more fundamental investors, it is important now to start positioning appropriately. We believe the debate is less about avoiding short-term market volatility and more about preserving the value of portfolios from being impaired in the medium-term. We continue, therefore, to stress the merits of proactive portfolio diversification.

Alex Gunz, Fund Manager, Heptagon Capital