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: focus on the bigger picture. What we do know is that returns from investing in conventional asset classes will likely be lower in the future than they have been in the recent past, given the historically high starting point. This serves to reinforce the logic of diversifying portfolios. Our ability to predict the short-term is challenged by market noise and exacerbated by Central Bank policies which seem focused on keeping markets afloat whatever the longer-term consequences. Current market participation therefore appears based more on a potential fear of missing out than on robust fundamentals. Our strategy is simply to buy good (different and uncorrelated) assets at reasonable prices. Then, it is a matter of discipline: invest for the long-term.

Asset Allocation:

• Equities: In a debate about whether to own equities or fixed income, the former gets our vote, given the risk-return outlook. Such a conviction comes despite equities across the world having generally enjoyed an exceptionally strong start to the year. Importantly, the current earnings season seems to be delivering results better than the low expectations that preceded it. Even with a potentially improving outlook, our conviction in equities is nuanced: we clearly prefer high- conviction active strategies over passive ones, particularly at this stage of the cycle. Additionally, our general preference remains for value over growth and emerging markets over developed ones.
• Fixed Income: Government bond yields are likely to stay depressed for as long as Central Banks remain dovish in their policy outlook. Moreover, as bond yields fall, this only increases the relative attractions of owning equities. Looking beyond this dynamic, we see little case for owning negative yielding debt for the long-term and have limited exposure to fixed income beyond select tactical allocations. On the positive side, some pockets of EM debt do appear interesting.
• FX: We have no active stances at present. The Dollar has remained remarkably strong and may continue to do so in the near-term, particularly relative to the Euro. Nonetheless, consistent with our thesis on equities and credit, some emerging market currencies should benefit from the likely rebalancing of capital flows away from the US Dollar over time.
• Alternative Assets: We see continued scope for high-quality assets with decent cash flows to out perform. Now is the time to be 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, direct lending, niche private equity and real estate to be particularly attractive.

Nothing but noise

Equities continue their relentless march higher. Meanwhile bond yields are notably lower than a year ago. Unsurprisingly, there are countless commentaries that we have seen which seek to ‘predict’ or ‘chart’ the direction of markets from here. We generally try and steer clear of this approach. Consider the column inches of concern posited over the possible inversion of the US yield curve barely more than a month ago. Now compare this with the best quarterly returns just delivered for the S&P 500 Index in 20 years. The debate seems less of one ‘this time it’s [the yield curve] different’ and more one of ‘this time it’s irrelevant.’ For us, to the extent that it’s important, the shape of the yield curve is more a symptom of the macro environment rather than either a driver of financial conditions or returns.

Probably the most interesting set of data we came across in the last month was the following: an analysis of rolling time periods for the S&P 500 Index with positive returns over the 50-year timespan through to 2018 (courtesy of Goldman Sachs). On a 1-month view, positive returns occurred 62% of the time; on a 1-year view, positive returns occurred 79% of the time, but on a 15-year view, positive returns occurred 100% of the time. What to conclude from all of this? Despite so much focus on the short-term, it’s the long-term that really matters.

Against this background, it seems an opportune moment to reiterate the message we have advocated consistently for some time: it is important to diversify and also to stay disciplined. Our ability to predict the timing of major market falls and then to know how this translates into individual asset class movements as well as how to position appropriately in terms of entering and exiting any given trade accurately is close to impossible. It’s not that the cycle has somehow been miraculously abolished by Central Banks and their financial wizardry as some assert; it’s more that we can’t time cycles at all perfectly. Very simply, then, there is a high logic in buying good assets, making sure that you are not overpaying for them and, after that, just doing nothing. Patience (and discipline) will pay off in the long-term.

Our preference is to focus on what we do know. The most important lesson, we feel, is to recognise that returns from investing in conventional asset classes will likely be lower in the future than they have been in the past given the historically high starting point. Viewed from a different perspective, all savers (be they individuals, institutions, pension authorities or insurance companies) will be hard-pressed to find the levels of income that they need to cover their liabilities through the ownership of long-term traditional sovereign debt instruments. This implies either the need to accept structurally lower future returns or – more pragmatically – a recognition of the need to diversify.

Next, and building on the above, do not forget the bigger picture. We have written with regularity in previous commentaries about some of the major secular shifts underway. Consider ageing demographics (a concern in both the West and in countries such as China), technological innovation (the rate of change is accelerating) and a wholescale global pivot to emerging markets (these countries will shoulder the responsibility for driving future global growth). Combined, these factors are inherently deflationary. In terms of the clear implication: expect structurally lower rates. To our mind, this only reinforces the logic for investing in longer-duration real assets.

Finally, and to bring the debate back slightly closer to what’s going on at the moment, do not forget that correlations between economic growth and market returns have always been weak. Remember that the IMF recently published its revised global outlook, cutting its forecast for world GDP growth to its lowest since 2009 and describing the current situation as a ‘delicate moment’ for the economy. Does it matter? Well, no, certainly not if you accept our view that it’s almost impossible to time anything accurately, let alone implement a successful tactical investment strategy. Furthermore, consider just where equities are today. The expression we hear consistently (whether just adage or empirical truth) is that ‘markets continue to climb a wall of worry.’ So what’s going on? It seems to us fairly simple. We are by no means at the ‘greed’ phase of this current cycle. If anything, it is worth taking note of State Street’s latest Global Institutional Investor Confidence Index, which stands at its lowest this Century. Nonetheless, it seems to us that ongoing market participation is partially being driven by a fear of missing out.

We do not seek to offer a prediction on the direction of markets from here or a view on whether the majority of 2019’s returns have already been generated in the first 4 months of the year. However, we believe that it is certainly fair to highlight that the valuation gap enjoyed by most equity markets relative to their history that existed at the start of the year has now closed. Businesses may need to deliver tangible progress (i.e. upgrades to earnings estimates) to drive equities further. This may be increasingly challenging, particularly in the US where some 58% of respondents to the National Association for Business Economics currently report rising wage costs. Moreover, even if the Fed has missed its inflation target 95% of the time in the last 10 years (per Bloomberg), the inflation spectre could return, particularly given current monetary dovishness at this stage of the cycle.

An objective look at the world shows that the data are inconsistent. In other words, the current direction of economic growth is not clear to us; and, if this remains unclear, then so is the future direction of Central Bank policy. We do, however, have to recognise that Central Banks seemingly remain under pressure (from both politicians and investors) to keep markets afloat. Given the choice, many investors might struggle with the choice of whether they would prefer dovish Central Banks or better GDP growth. Put another way, for how long can Central Banks remain dovish if growth does pick up?

We worry somewhat about potential investor complacency. Markets seem to have discounted that the next move in interest rates will be downwards. For the US in particular, with industrial production, consumer confidence, wages and jobs where they are, it would be highly unusual for the Fed now to consider cutting. We wonder when the market may have to start potentially pricing hikes again. Thus far, the Fed’s credibility does not seem to have been undermined by its dovish pivot, but this sentiment may abruptly change were a hawkish pivot suddenly to appear. More generally, the concern remains in our mind about whether Central Banks have enough flexibility/ creativity in their current mandates to manage effectively the next crisis (which will come, we just don’t know when). Modern Monetary Theory, as we discussed in our last monthly commentary, has its limitations. Despite such concerns however, such policies may end up being embraced, in desperation if not in logic. Stay disciplined.

Footnote: IPO frenzy

It is a well-documented adage that bull markets rarely die of old age and more of excess. Even if investor confidence is not generally in the ebullience phase, the number of initial public offerings (IPOs) currently underway could be seen as one proxy for potential excess. Indeed, 2019 looks set to mark the biggest year for new listings since 1999 (per Bloomberg) – and we all know how that ended. That Lyft is down over 20% from its post-IPO peak is of no surprise to us. Beyond any reasonable concerns that investors may have about corporate governance, given its dual share class structure, consider the stark fact that Lyft is not forecast to make any profit until at least 2023. This should be a salutary lesson ahead of other notable planned stock market flotations.

Alex Gunz, Fund Manager, Heptagon Capital