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: expectations going into 2019 are set very low. The scope for upside surprise is, correspondingly, much higher. Risk-reward looks more attractive than it did a year ago and so now is the time to be constructive, contrarian and opportunistic. The coming year will see a decisive shift from quantitative easing to quantitative tightening and, with it, likely slower growth and higher inflation. This implies that it will be hard for investors to generate returns. Volatility is certainly here to stay, but we believe investors may currently be overestimating the risks and underestimating the potential returns that are achievable. Our strategy is to focus on increased diversification and allocations to uncorrelated asset classes wherever possible. For the longer-term investor, we see growing opportunities in emerging markets, particularly relative to the developed world.

Asset Allocation:

• Equities: After the worst year for global equities since 2008, there are clear opportunities to be found. Global equities are now cheap relative to history (at a ~10% discount versus their average earnings multiple over the last 30 years, per JP Morgan), but the importance of high-conviction, careful stock selection has never been greater. Our general preference is for value over growth and we see emerging markets (EM) as particularly attractive, especially for the long- term. EM equities could outperform simply by demonstrating that things are not as bad as previously feared.
• Fixed Income: Similar to equities, credit also witnessed its worst year in performance terms for a decade. Traditional safe havens such as government bonds were not able to offer any form of portfolio protection, given that correlations with equities only increased. This trend will likely persist. We also have concerns over corporate credit (Investment Grade and High Yield) given how well they prospered in a low-rate environment. This regime is now changing, just as credit quality is deteriorating. We have limited fixed income allocations, but note some pockets of EM debt are now interesting.
• FX: We have no active views at present. Nonetheless, consistent with our thesis on equities and credit, selected emerging market currencies should benefit from the likely rebalancing of capital flows away from the US Dollar going forward.
• Alternative Assets: 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 (private) 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: In the current uncertain environment, cash may act not just as a source of defence and form of diversifier, but also as an asset that is now beginning to offer some marginal yield.

Regime change part 2 (or, how much do we know?)
The lesson of 2018, put simply, was that the expected did not occur. Few foresaw at the start of last year the extent of gyrations across all asset classes, and the compounding impact of their correlations. Whenever things appeared to become more difficult, there were very limited places to hide. We have increasingly come to recognise that markets are complex entities that involve many participants with different objectives and constraints. Therefore, inferring causality from specific news events, or trying to ‘predict’ their specific impact, can be unhelpful at best and dangerous at worst.

What does all this mean for 2019? As stated, we are not in the business of prediction, but after the underperformance of almost all asset classes and investment styles in 2018, it is certainly fair to say that expectations going into 2019 are low. The scope for upside surprise, is correspondingly, much higher. Risk-reward looks more attractive than it did a year ago, particularly since current risk-appetite/ conviction levels are very low. Our caveat to the above would, however, be that just because expectation levels appear a lot lower than a year prior, this does not mean that finding assets capable of generating attractive returns is going to be any easier. We can be constructive on risk while accepting that volatility is here to stay. Now, more than ever, is arguably a time for contrarian thinking.

How close are we to the end of the cycle?
All good things do, inevitably, come to an end. The harder question, of course, is knowing exactly when. Cycles generally end not because of old age, but more when investors overestimate returns and underestimate risks. This certainly does not seem the case at present. On the contrary, most investors we speak to seem much more cautious, while the latest Fund Manager survey from Bank of America Merrill Lynch shows that respondents have the lowest expectations for economic growth and corporate profits over the next 12 months than they have had since 2008.

We believe it is a lot harder to tell where we are in the current cycle owing to the slow and shallow nature of recovery and also given the extent to which Central Banks have deployed unconventional monetary policies over the last decade. Trying to extrapolate conclusions from the shape of the yield curve has significant limitations, in our view, given the multi-faceted nature of the market’s participants, in our view. If we know anything, then its shape tells us less about the imminence of recession and more about the nature of regime change. 2019 will be the year when quantitative easing decisively shifts to quantitative tightening, as all three main Central Banks in the developed world start to shrink their balance sheets.

A reminder of what we mean by regime change

We first deployed this expression in our December 2018 commentary. Put simply, Central Bank policy has so utterly distorted relative assets prices that normalisation was always going to be difficult. The rising tide that was quantitative easing and so lifted all boats is now reversing. Investors, we believe, continue to have unreasonably complacent expectations about the future path of monetary policy; that Central Banks will look to repress financial volatility at the first sign of market vulnerabilities. The reality is a world of tighter (or increasingly tight) liquidity. Relative to 2018, the year ahead should be one of slower growth, higher inflation and tighter policy.

What worries us?
In summary, a litany of factors that could be summarised as concerns about growth, debt, policy error, politics and more. Begin with growth, and many macro indicators (such as purchasing manager surveys, consumer confidence and so on) appear to be deteriorating. Financial conditions have clearly already begun to tighten in recent months, and combined with trade tensions, it is perhaps not surprising that these elements have begun to weigh on both confidence and investment.

The greater worry, of course, is when a reappraisal of economic growth causes investors to take a second look at money- losing enterprises. A decade’s worth of interest rate suppression has led to an outpouring of new credit, much of which may have been mispriced at inception, given the artificially low borrowing costs in place at the time. As a result, significant imbalances may well have arisen in certain segments of the debt market. We note that net debt to EBITDA ratios for both investment grade and high yield rated corporates in the US and Europe are higher now than they have been at the peaks of both the two previous cycles (per JP Morgan). Meanwhile, the leveraged loan market in the US has doubled in the last decade (per S&P) while junk-rated debt is now three times higher than it was in 2008 (per Bloomberg). Debt has been behind almost every financial crisis in recent history, and so remains crucial to monitor.

Concerns over debt are naturally compounded by the perceived risk of policy error on the part of Central Banks, particularly since many investors have become conditioned to expect Central Bank dovishness. Liquidity is tightening just as growth is slowing. We are less concerned about possible error and more about how to reconcile the current disconnect which we believe is becoming increasingly evident. Investors seem to be moving to discount a recession in a far more extreme way than anything in the data currently supports. However, the Federal Reserve (and other Central Banks) seem not to have judged accurately the extent to which regime change is inducing anxiety and altering behaviour. Liquidity is tightening and a recession may become self-fulfilling simply if businesses and investors start to discount it ahead of it actually happening. When the fourth-quarter earnings season begins in late January, Finance Directors have little incentive to set bullish 2019 guidance at present and may indeed even use the present gloom to reset expectations lower.

Where lie the opportunities?

Current anxieties around the cycle, growth and earnings are all very legitimate. Economic activity is slowing, financial conditions have become tighter and estimates are at risk. However, investors may now have priced a much more adverse outcome than is likely to come to pass. Put another way, expectations are set very low. History has also shown us that the best time to invest in any asset class is when it is most out-of-favour.

Our mantra in recent commentaries has been one of diversification. This view remains unchanged. Beyond such an approach, we believe that as some investors begin to question the rationale for paying still-elevated multiples for assets in the developed world when (earnings) growth is decelerating, emerging market assets could outperform simply by demonstrating that things are not as bad as previously feared. The bear market in emerging markets happened earlier than in many other asset classes and so may now be nearing the end of its downturn. When we look further ahead, we cannot help but observe the widening growth differential between emerging and developed markets. Average real GDP growth for emerging markets over the next 20 years is forecast to be more than double developed market levels (5.5% vs 2.0%) as is real income per capita growth (7.2% vs 3.2% – all data per Goldman Sachs). Demographics are markedly more favourably in the emerging world.

Now is a time for sober thinking: be long-term, be diversified, be opportunistic and seek uncorrelated assets.

Alex Gunz, Fund Manager, Heptagon Capital