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: All mainstream asset classes are higher than where they began the year and could trade higher still. Markets tend to peak when optimism peaks and we do not seem close to this point at present. However, the abnormality conditioning behind the current cycle has helped paper over a lot of cracks. Some combination of defaults, credit downgrades and/or corporate austerity could be on the horizon. It is hard to see how any of these outcomes would be unambiguously good either for equities or credit. Investors need to prepare. Lower returns and wider dispersion seem inevitable going forward. Our counsel is to think beyond the conventional and to make the most of opportunities arising from any market dislocations that may occur.
- Equities:Itishardnottofavourequitiesoverfixedincome.Theassetclassoffersabroadcombinationofbothgrowth and yield. The recent earnings season has seen businesses generally surpass (albeit low) expectations, helping to support current valuation levels. On ~18x forward earnings, the MSCI World does not look overly expensive, trading in-line with its 10-year average multiple. Furthermore, the average dividend yield for the global market is 2.5%, highly attractive versus the yields offered by government debt (all data per Bloomberg). Our strategy, however, remains one of pragmatic allocation, favouring truly active and differentiated strategies.
- Fixed Income: Although it has been said before, the adage that bonds now offer return-free risk rather than risk-free return seems a highly pertinent one. Yields continue to compress and although we find it hard to justify owning negative yielding debt, further downward momentum seems possible. 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. Now is not the time to be seeking yield by increasing credit risk, in our view.
- 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 close to a 6-year high, gold could see further strength. 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.
- 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.
Have we ever had it this good?
Consider this: global equities are up almost 20% year-to-date, bond yields have continued to compress and both gold and oil have generated double-digit returns. It has been hard not to make money this year, even if it hasn’t always felt this way. Investors, seemingly, have been able to navigate through concerns as multifarious as trade war fears, a potential manufacturing recession, the inversion of the yield curve, Central Bank dissent and the social upheaval wrought by populist governments.
How then to explain the above? We’ve certainly had a few attempts during the year. July’s monthly publication was entitled “cognitive dissonance” and discussed how it can be possible to manifest two contradictory positions (a bull market in equities and in fixed income) simultaneously. Meanwhile, last month’s View From The Top developed the ideas of how investors had seemingly become “conditioned to abnormality”, namely, the ongoing support offered by Central Banks. We also offered the refrain of Chuck Prince, Citi’s former Chairman, that we might continue dancing (investing) for “as long as the music is playing.”
The remainder of this piece seeks to take a different approach, somewhat reframing the debate by seeking to look forward.
Common sense and that terribly old-fashioned idea of mean reversion would suggest that the current situation cannot endure forever. Even if calling when the dancing may stop is a lot harder, we remain convinced that, at some stage, something will have to give. Be vigilant and be prepared.
Many commentators (ourselves included) seem to recognise that the direction of travel for interest rates is likely to be lower rather than higher in the immediate future. While it is easy to sleep metaphorically well in the knowledge that Central Banks seem prepared to “do what it takes” to prop things up, we believe the more intelligent consideration might be to ask what benefit (or cost) low rates may be having on both investors and the economy.
We should not forget the importance of signalling mechanisms, or even just basic psychology. Lower rates may no longer be supportive for either credit creation or equity valuations. Rather, they could be sending a signal about prospects for both growth and profitability. Why invest (buy a new pair of shoes, build a factory) if the cost of being able to do so may be cheaper tomorrow? Trade wars magnify the problem: similarly, why invest if there is a risk of your supply chain unravelling? Sure, lower rates do imply lower discount rates when valuing risk assets, but clearly with profit margins (to say nothing of valuation levels relative to history) at record levels in many areas, the scope for disappointment is high.
It may also be hard to break out of this potentially vicious circle, not just because of the conditioning to abnormality that we discussed earlier, but also because political dysfunction is preventing governments from pursuing more creative policies. We are not advocates of modern monetary theory – far from it – but few governments in the western world have been able to implement pro-growth (fiscal) strategies. Within the next 12 months, the US, the UK, Germany and Spain (among others) will all likely see Elections. Even if new political leaders emerge, consensus building in an era of populism has become increasingly hard.
Governments, however, will almost certainly have to work harder to come up with more intelligent solutions going forward, as much as anything because the abnormality conditioning behind the current cycle has helped paper over a lot of cracks. Consider that the IMF reduced its forecast for global GDP growth for the fifth consecutive quarter in October. The agency now assumes a 3.0% expansion for 2019, the slowest rate of growth since 2009. For context, prior to the current trade war downgrade cycle, the IMF was assuming a 3.9% increase in output for the year. The IMF’s growing gloom is corroborated by the World Trade Organisation’s latest outlook, which now assumes 1.2% trade growth for 2019. By contrast, six months ago, its forecast was 2.6%. Jerome Powell recognises that “growth around much of the world has weakened” (per the most recent FOMC Minutes), while Mario Draghi noted “weaker growth momentum” and “risks on the downside” in his valedictory press conference at the European Central Bank.
Put another way, it doesn’t take much for an economy growing only at stall speed to tip into recession. Growth requires confidence and stability in the financial outlook. Against this background, solving the burden of debt with more debt inevitably leads to a debacle. Investors should not forget credit as a weak link for the economy. Current corporate leverage (defined as net debt/EBITDA) in the US, at 2.2x, is worse than it was at the time of the credit crisis and stands at its highest since at least 2004, the earliest date to which JP Morgan’s data series extends back. Over $410bn of debt has been issued by S&P 500 companies year-to-date, driven as much as anything, by investors’ lust for yield. At the same time, cash balances at non-financial businesses within the S&P 500 have witnessed their biggest decline in percentage terms over the last 12 months since 1980 (data per Goldman Sachs).
Where might it all end? Well, despite a potential near-term détente in the US-China trade war, Global CEO business confidence levels are apparently lower now than in 2008 (per the OECD). Against this background, some combination of defaults, credit downgrades and/ or increased corporate austerity could be on the horizon. Logically, companies spend less when uncertainty is elevated. Similarly, 2019 is set to mark the smallest year for share buybacks in the US since 2009 (per Goldman Sachs). It is hard to see how any of these outcomes would be unambiguously good either for equities or credit.
At the very least, investors need to prepare themselves for an era of potentially lower returns and almost certainly of wider dispersion. As we have written on many previous occasions, the notion of a 60:40 equity-bond portfolio is gone. The relationship between the mainstream asset classes appears to have changed, at least in the short-term; bonds might now be the new equities. Ongoing financial repression and the conditioning to abnormality means that many investors now seemingly own equities for income and bonds for price. The more conventional rationale has been inverted. Put another way, the popularity of bonds has forced investors to take on more risk to achieve the same yield. There are now 1,100+ stocks globally that pay a dividend yield above the average yield for global government bonds, per Bank of America Merrill Lynch research.
Positioning has therefore inevitably become crowded. This is generally not a good sign. However, what gives us cause for comfort is that markets tend to peak when optimism peaks (think about 2000 and 2007). We certainly do not seem close to this point at present. Rather, the upward momentum in mainstream assets has been more a source of consternation and celebration. It is also important, in our view, not to conflate corrections with the beginning of the end, or a more protracted downturn. While recessions are arguably avoidable – through intelligent policy pre-emption and management – drawdowns are not. Indeed, global equities have experienced five intra-month downward moves of more than 5% since the start of 2018 alone. Our counsel then is to avoid crowded positioning and to make the most of market dislocations when they come along, which more surely will.
Alex Gunz, Fund Manager, Heptagon Capital
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