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: It is hard to resist the currently positive narrative of rising equities and plummeting bond yields. Central Banks are continuing to do whatever it takes to underwrite the broader economy and investing environment, even if this may result in bigger problems somewhere down the line. The unconventional has now become conventional, which has fuelled the ongoing addition of risk to investor portfolios. While it would be easy to continue embracing this approach in the near-term, we highlight the importance of remaining disciplined. It’s the long-term that ultimately matters. Buying assets that are out of favour makes intuitive sense. We also caution against complacency after a strong first half of 2019; the second may be more challenging.
- Equities: Many markets have recorded new 52-week highs with the S&P 500 having enjoyed its best six-month start to the year since 1997. Equities are where it is at, particularly relative to fixed income. Valuations are not expensive (a 19x multiple for the S&P compares to a ten-year average of 18x and a recent peak of 24x, per Bloomberg) yet we would nuance our enthusiasm with the following observations. First, there may be better value in markets outside the US, with many other indices still languishing over 20% below their 2007 highs. Next, the upcoming Q2 earnings season may be challenging. Finally, as the cycle matures, the logic for investing in truly active equity managers only grows.
- Fixed Income: Sovereign debt, Investment Grade and High Yield have all enjoyed strong year-to-date performance, helped by benign Central Bank policies and tight credit spreads. Even if equities are also recording gains, capital is clearly flowing into safer assets. A record of $13tr of sovereign debt now has a negative yield (per Bloomberg). Yields can also go lower still, particularly if the rate hiking cycle looks to be over. However, it is important to consider how (un)attractive low/ negative yielding debt is for long-term portfolios. We have limited exposure to the fixed income asset class.
- FX: We have no active stances but observe the current race-to-the-bottom. Central Bank policy globally seems to favour ongoing accommodation, yet currency is not a zero-sum game. The US Dollar looks overvalued on many metrics.
- Gold: Currently at a 6-year high, gold has continued to show strength. Its gains are perhaps indicative of lower interest rates combined with concerns over potential deflationary fears. Gold could make further gains from here.
- 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, direct lending, niche private equity and real estate to be particularly attractive and see continued scope for high-quality assets with decent cashflows to outperform.
The S&P 500 Index at a record nominal level and global equities touching 52-week highs sit on one side of the equation; US 10-year Treasury bond yields at their lowest since 2016 and German Bunds of a similar maturity yielding less than zero on the other. Are we living in a world of cognitive dissonance? For those unaware, the term is one most commonly deployed in the field of psychology and relates to the ability to hold two (or more) contradictory values or beliefs simultaneously.
How might we square the circle of gains for both bonds and equities? Well, it’s simple (and we could – arguably – have written this line in almost any of our monthly commentaries for almost the last decade): don’t fight the Central Banks. Even if we can clearly point to multiple headwinds facing the broader investing environment, it is hard to resist the currently positive near-term narrative. Put another way, the view of many seems to be, why worry about the long-term when there is a melt-up/ last hurrah for investors to be enjoyed at present?
This is why staying disciplined matters. We’ve said it before and we’ll say it again: the short-term is just noise; it’s the long-term that matters. Countless academic studies point to the importance of long-term investing. As a reminder, a recent useful piece of analysis (courtesy of Goldman Sachs) considered rolling time periods for the S&P 500 Index with positive returns over the 50-year timespan through to 2018. 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. It’s all about the long-term.
Perhaps this explains why despite the pronounced moves in both equities and fixed income, cash holdings among institutional investors have jumped their most in June since 2011, per Bank of America Merrill Lynch’s monthly fund manager survey. Meanwhile, investors also recorded their second largest month-on-month drop in equity allocations ever in June. Capital is pouring into safer assets. Interestingly, the main reason cited for this change in behaviour was “monetary policy impotence.” We have wondered this regularly: when does the unconventional become conventional? Maybe even Jerome Powell, Chair of the Federal Reserve, recognises this, noting in a speech on 6 June that “perhaps it is time to retire the term ‘unconventional’ when referring to tools used in the crisis.” Sure, there has been a 120-month expansion in the US economy (a new record; the longest since 1854), but the hallmark of this cycle has arguably been its underperformance. Because economic growth has, for the most part, remained below average historic levels, throughout the cycle the Fed has persistently held off raising rates. The rest of the world is even further behind. We must be forced to consider how healthy an economy (i.e. the US) really is if it can’t handle interest rates above 2.5%.
Central Banks seem to have adopted the belief that continuous quantitative easing (and/or a rhetoric supportive to this notion) can generate permanent prosperity. We are not so sure. As with many things, the economist John Maynard Keynes may have been right when he wrote in 1931 about the dangers of “sub-normal prosperity” in a world characterised by low growth and low inflation. Consider that long-term (10-year) expectations for inflation in both the US and the Eurozone are at record low levels: 2.2% and 1.2% respectively, per the University of Michigan and the European Central Bank.
Perhaps a recognition of this dynamic is pushing many towards the notion of more stimulus, hence the gradual embracing of modern monetary theory. We would note, however, large budget and/or fiscal deficits will become problematic at some stage; they cannot be ignored in perpetuity. More importantly, recessions are not to be feared. A Darwinian process is healthy for the economy. We are of the view that quantitative easing has kept many businesses afloat that should have gone bankrupt.
Despite this, Central Banks remain unrelenting. When Mario Draghi said in July 2012 that the ECB “will do whatever it takes” this proved catalysing in stemming the tide of the Eurozone crisis. Almost seven years on, admittedly after a prior poor month for global equities (in May) and some pressure from President Trump, Jerome Powell uttered almost the same: the Fed “will act as appropriate to sustain the current expansion.” A case of the boy (Central Bank) crying wolf? Everyone else has joined the party. Consider the following quotes, respectively from the Heads of the Central Banks in Europe, Japan and China: the former institution is “determined to act in case of adverse circumstances;” the next says it “can deliver more stimulus if needed” and the final that there is “tremendous” monetary and fiscal policy space. Even with 28 years of unbroken economic prosperity, the Governor of the Royal Bank of Australia is getting in on the act, saying it is “more likely than not” to cut rates.
We cannot help but wondering, if rates are near zero and/or at the lower bound already when the slowdown is just beginning, how effective will Central Banks be in providing incremental accommodation the market should things get worse? Put another way, Central Banks may be easing, but their monetary toolkit globally is significantly depleted versus pre-crisis levels. It is fair to acknowledge that economic data has been weakening for some time. Note that US business conditions are at their lowest level since 2008 (per a recent Morgan Stanley survey), while industrial manufacturing PMI data is at its lowest since 2009. Some 48% of American Finance Directors interviewed by Duke University see their economy in recession within the next 12 months. Meanwhile, manufacturing output data in Europe and Japan is already pointing to a contraction in both regions. For how long can Central Banks maintain an aura of calm, particularly when there seems to be such a belief that their power is a panacea, a cure for all ills?
There is additional bigger-picture consideration. We recognise that recessions are typically the result of excesses or exogenous events, so let’s be generous and give Central Banks the benefit of the doubt; they can help to prolong the rally a bit longer. Furthermore, let’s assume that Trump and Xi reach some sort of compromise before the 2020 US Presidential Election. Against this background, equities and bonds could mark further gains. However, the excesses (particularly in areas such as leveraged lending) will continue to build. Meanwhile, the relationship between the US and China cannot be easily repaired through a couple of handshakes and some bland rhetoric. The bigger picture dynamic which investors do need to incorporate when considering longer-term asset allocation decisions is that at some stage, the Chinese economy is going to overtake the US in terms of global importance.
The very explicit suppression of interest rates by Central Banks has made valuable information about the investing environment unavailable to investors and has lowered the opportunity cost of holding investments. This is why fundamentals matter. The current valuation starting point for some asset classes reinforces the logic of investing in assets when they are out of favour. Put another way, we advocate the avoidance of trend-chasing, particularly when many seem to be favouring momentum and growth. A fear of missing out – often a hallmark of late-cycle investing – seems to be driving much current investor behaviour. It is therefore important to stay disciplined. The second half of 2019 may well be a lot more challenging for investors than the first half.
Alex Gunz, Fund Manager, Heptagon Capital
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