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: stay disciplined. This is our key message for the months ahead. All mainstream asset classes have begun the year strongly on the back of a markedly more dovish Central Bank pivot. However powerful their influence, the problem remains that they still cannot abolish the business cycle. We note slowing macro trends and deteriorating credit indicators. Most importantly, looking forward, the scope for outsized returns from investing in conventional asset classes is more constrained now than in the past given the relative maturity of the current cycle. Even if further accommodative Central Bank action is pending, our investment strategy is premised on proactive diversification. We favour complexity over simplicity and see a strong case for uncorrelated assets.
- Equities: Markets globally have moved strongly higher in 2019. Some of the gains, however, have simply been a function of increased risk appetite rather than a more fundamental re-assessment of prospects. We note that corporates in the US S&P 500 Index have recorded their lowest level of quarterly beats since 2014, while forward guidance from 80% of these businesses has been negative (per Bernstein). Against this background, we believe the importance of high-conviction, careful stock selection has never been greater. Our general preference is for value over growth and we see EM equities as particularly attractive, especially for the long-term.
- Fixed Income: Government Bond yields in the developed world have contracted rapidly on the back of the more dovish policy stance adopted by Central Banks. While there is scope for some further yield compression, falling bond yields serve, in our view, to reinforce the relative attractiveness of equities. Furthermore, 2018 demonstrated clearly that long- term bonds can no longer serve as shock absorbers for multi-asset portfolios. Elsewhere, we have concerns over corporate credit (Investment Grade and High Yield) given how well they prospered in a low-rate environment. Our fixed income allocations are limited but note some pockets of EM debt are now interesting.
- FX: We have no active stances at present. 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 going forward.
- Alternative Assets: High-quality assets with decent cash flows are back in vogue, with quantitative easing now at an end. This is the time to be constructive on illiquidity premiums. Uncorrelated assets have the potential to outperform equities and bonds, particularly should inflation become more pronounced. We consider allocations to infrastructure assets, direct lending, niche private equity and real estate to be attractive.
- Cash:Weseemeritsinpreservingsomecashinordertobeproactivelyopportunistic.Theassetclassnowalsooffers some marginal yield (in Dollar terms).
The case of the shrinking porridge bowl
So is everything OK then? 2019 has seen the best tart to equities globally since 1987, memories of ten-year US Treasuries yielding over 3% seem long-distant (the yield is currently 2.7%) and volatility as measured by the VIX Index is less than half the level witnessed at the end of last year. The swiftness of the recovery in assets broadly mirrors the abruptness of the decline. Moreover, we all know the reason for this sharp volte-face in markets in recent months: put simply, there has been a clear pivot on the part of Central Banks across the developed world, a shift to a more dovish tone and a reinforcement of the notion that they will do whatever is needed to support markets. The bulls seem firmly in control for now, and at least as far as equities are concerned, a fear of missing out is continuing to drive markets higher.
Seen from a different perspective, investors clearly seem to be of the view that Goldilocks is back. A reprise of the familiar story for those less familiar: once in the house of the three bears, the cheeky lead character liked her porridge neither too hot nor too cold. To apply this metaphor to the global macro backdrop/ investing environment, we are currently in a period where there is ‘just the right amount’ of growth and inflation for investors to remain sanguine.
2017 marked the apogee of the Goldilocks era, where both bonds and equities delivered positive returns for investors, and cross-asset volatility was low. The rolling five-year average risk-adjusted return (or Sharpe ratio) from investing in a 60:40 bond-equity portfolio that year was ~2.0 – an almost unprecedented outcome, given that a more typical ratio would be closer to ~1.0 (per Bloomberg). By contrast, last year constituted an inevitable test and reset to this thesis. Looking forward, the appropriate question, therefore, to ask, is given not only on recent Central Bank actions, but also the current macro backdrop, where do we stand?
Sure, we see little risk of either severe Central Bank tightening or rampant inflation in the near-term, but to continue the Goldilocks metaphor, the porridge bowl is now undoubtedly smaller than it was, say, two years ago. Put another way, the scope for outsized returns from investing in conventional asset classes is now more constrained given where we are in the business cycle. The days of synchronised economic growth are behind us, especially in the context of ongoing trade war concerns. Meanwhile, the rate of corporate earnings growth is also slowing (particularly in the US, with tax cuts now in the rear-view mirror).
As we have noted in previous commentaries, however hard Central Banks try, they cannot abolish the business cycle. A ‘dream cycle’ for any economy would be one of stable but slowing growth with constrained inflation, as a path to a soft landing. However, the Fed has only once in recent history (in 1994/5) managed to stabilise growth without inducing a recession. It should not be forgotten that we are already in the second-longest cycle ever for economic expansion in the US. Per the National Bureau of Economic Research, the current expansion began in June 2009. If it continues beyond July 2019, it would be the longest ever in the US.
This time around it may, of course, be substantially harder for the Federal Reserve to bring about a soft-landing, for three main reasons. First, do not discount the impact that four interest rate rises in the US over 2018 will have wrought on growth. Most economists are of the view that it takes around six months for a rate rise to permeate into the real economy. Tighter monetary conditions would naturally serve to reduce risk appetite. Next, the US does not operate in a vacuum. Macro trends in other major global regions have weakened notably in recent months. European manufacturing indices are at their lowest in over six years, while German business expectations have not been so depressed since the Eurozone crisis at the start of the decade. Over in China, both money supply (M1) and manufacturing indices are slowing at their fastest rate since 2008.
Finally, the lingering presence of trade conflicts helps drive a vicious circle of risk aversion, reduced investment and slowing growth.
Our other major concern pertains to debt. As we have noted in previous commentaries, many investors continue to ignore the risk of a liquidity shock in general and threats from leveraged loans in particular. The quality of credit may be in worse shape than many believe. If we consider the broad US credit market, then it has expanded by 132% over the last decade, with a likely deterioration in underwriting standards over this period (2008-2018 data, per S&P).
There is no commonly-agreed upon definition for what constitutes a leveraged loan, but per a recent research paper from the Bank of England, the stock of leveraged loans at the end of 2018 may be comparable to the stock of US sub-prime mortgages in 2008. On its estimates, leveraged loans account for 11% of all US debt today versus just 2% in 2008. The growth in this segment of the market is just one of the problems where investors will have to face a reckoning in due course. Do not forget that the US fiscal deficit, at 6% of GDP (per the Federal Reserve), is unprecedented for a peace-time economy at full-employment. Against this backdrop, we are forced to wonder how GDP will perform if the cycle of credit creation that has been propelled by the Fed’s cheap liquidity (and that of other Central Banks) comes to a halt.
We all know that Goldilocks is just a fairy tale. Think about it this way: currently low cross-asset volatility may simply be indicative of limited risk appetite, and note that investors’ cash allocations are at their highest levels since January 2009 (per Bank of America’s most recent investor survey). Falling bond yields could simply imply that bond investors are already wagering that the world is moving to synchronised slowdown. It is certainly fair to wonder whether last year’s interest rate rises were too much for a still-fragile economy and that it was this that prompted the slowdown; or, whether the slowdown forced Central Banks to pivot. Were investors only able to choose one of ‘good growth’ or ‘dovish Central Banks’ it is unclear to us for which they would opt.
So how does the story end?
This is what we all want to know. We believe it is certainly incumbent on Central Banks now to be creating game plans for handling the next recession – which will certainly come along. Do not rule out the possibility of a fourth round of quantitative easing (‘QE4’). The correlation between global money supply and global equities has remained remarkably strong and consistent for the last decade: where one leads the other follows. It is hard to wean an economy (and investment community) that has become dependent on large Central Bank balance sheets. The collective memory of the Global Financial Crisis still haunts.
For investors, the one key message is to stay disciplined. Most market ‘explanations’ (for why certain asset classes are going up or down) are post-hoc rationalisations. Artificial logic and simplistic assumptions are applied to price movements, when most of the time we simply don’t know what is happening. It is therefore crucial to favour diversification and complexity. We continue to eschew many mainstream asset classes and favour increasingly those which are uncorrelated in nature.
Alex Gunz, Fund Manager, Heptagon Capital
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