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: The genie is definitively out of the bottle and will be very hard to put back in. Events from the past month may be indicative of what is to come. The deterioration in relations between the US and China is going to take time to repair and has significant investment implications. Global economic growth is slowing at the same time as we are moving into a new phase of wealth (re)distribution – across both regions and demographic cohorts. At the same time, the power of Central Bank policy may be lessening. Despite the above, we still very much see an environment in which investors can prosper. Valuation has never mattered more. Our strategy remains one centred around investing in uncorrelated assets and with truly active and differentiated managers.

Asset Allocation:

• Equities: Market movements in May have not changed our thesis of preferring equities over fixed income. If anything, shrinking bond yields reinforce the relative valuation case for equities, particularly when the health of most corporates remains relatively good, as evidenced in the recent reporting season. Nonetheless, there has never been a more important time to prioritise active managers over passive ones. Style-wise, value should prosper relative to growth. While, emerging markets may remain under pressure in the near-term – owing to trade tensions – we still see an attractive long-term case.
• Fixed Income: Lower government bond yields (10-year US Treasuries are at their weakest in two years) can be seen as a reflection of current risk aversion on the part of investors. Yields can also shrink further, particularly if the rate hiking cycle looks to be over. However, it is important to consider how attractive low/ negative yielding debt is for long-term portfolios. Within (developed world) corporate credit, there are also some worrying signs of excess at present. We have limited exposure – other than tactical – to the fixed income asset class.
• Alternative Assets: 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 and see continued scope for high-quality assets with decent cashflows to outperform.
• Cash: We see merits in holding some cash, as a source of defence (a role gold canal so partially fulfil). It seems logical to consider increasing cash levels should the environment merit such a move. Look to raise cash on market bounces.
• FX: We have no active stances, but note that on almost all long-term measures, the US Dollar currently looks overvalued.

Hope is not a strategy

We’ve seen it before and we’ll see it again; how, in the space of a month, near-term euphoria can turn to a sense of despair. Given the melt-up witnessed prior to May on over-exuberance, it should be of no surprise that there has now been a relapse. For too long, many investors have been threading a delicate needle, promoting economic growth and stock prices without abandoning the delicate issue of trade. The prevailing mindset seems to be focused more on managing the day’s headlines and appears much less about finding good assets/ businesses in which to invest. Nonetheless, the tit-for-tat escalation between the US and China has resulted in a gradual yet significant repricing of all asset classes: equities, bonds, currencies and commodities.

Our focus remains very much on the longer-term and the bigger picture. Over the past month we have been forced on several occasions to wonder whether we can talk about anything other than tariffs and trade wars. Amidst the headlines, it is important to consider what can we know for sure? We would point to two crucial things.

• The atmosphere of mistrust and uncertainty between the US and China is likely to remain for some years, especially given that the differences between the two nations seem to be widening. The deterioration in the relationship between the countries has been wilfully ignored for some time and will be hard to repair given the mutual distrust. The overarching consideration can be framed as the ‘Thucydides Trap’ – namely when one great power (China) threatens to displace another (the US), war – in some format – is almost always the result. It can clearly be avoided, but if anything, investors are under-estimating how long it will take to repair relations between the two countries.
• It is dangerous to start a trade war (and what some have described as a new cold war) when the world is on the cusp of a decline in economic growth. Economists, almost universally, are of the view that increased tariffs are detrimental to global GDP. Assuming the tariffs currently proposed by the US are fully implemented, this would take the weighted average trade tariff on US exports to 8%, well in excess of the 6% level that occurred when the Smoot- Hawley Tariff Act was implemented in 1930 (per 13D Research). This Act, which imposed tariffs on European agricultural products coming into the US, helped tip the world into the 1930s Great Depression. Even if history does not repeat itself, it still rhymes.

0. Given the above, it is crucial for investors to consider the implications. We suggest that these are threefold.
   • First, valuation matters. Of course, it always has done, but will do even more so in an environment where a risk-off mentality prevails. Investors should perhaps not be surprised by how many of the marque IPOs of this year have struggled. Uber and Lyft remain poster-children for current sentiment. With 320 new listings planned over 2019 (per Bloomberg), the rhyming parallels with 1999 are there.
   • Second, asset allocation decisions need to reflect that we are in a new era of wealth distribution. This is a complex topic encompassing both geopolitics and demographics. In brief, and as noted previously, there is a power shift away from the US and towards China. More broadly, the structural shift can be characterised as one between developed and developing economies. Even within the US (and other mature economies), there is a significant generational dynamic. Not only will the Millennial/Generation-Z cohort become the largest in many nations (as measured by headcount), but also the most powerful, with the wealth of passing Baby Boomers transferring to them. These younger generations also view the world in a different fashion; with a greater emphasis on equality and environmental considerations than previous ones.
   • Finally, amidst general uncertainty, we should accept that the current rate hike cycle is almost over. Federal Fund Futures are now pricing the likelihood of a 90% cut in US interest rates before the year-end and a 40% chance of two cuts. This is a quite remarkable volte-face given that only six months ago, the market was pricing three rate increases for 2019! Sure, the global growth outlook has become more uncertain, while an atmosphere of growing geopolitical distrust implies a risk of less-coordinated monetary policy, but the wider consideration needs to be one of developed

Given the above, it is crucial for investors to consider the implications. We suggest that these are threefold.

• First, valuation matters. Of course, it always has done, but will do even more so in an environment where a risk-off mentality prevails. Investors should perhaps not be surprised by how many of the marque IPOs of this year have struggled. Uber and Lyft remain poster-children for current sentiment. With 320 new listings planned over 2019 (per Bloomberg), the rhyming parallels with 1999 are there.
• Second, asset allocation decisions need to reflect that we are in a new era of wealth distribution. This is a complex topic encompassing both geopolitics and demographics. In brief, and as noted previously, there is a power shift away from the US and towards China. More broadly, the structural shift can be characterised as one between developed and developing economies. Even within the US (and other mature economies), there is a significant generational dynamic. Not only will the Millennial/Generation-Z cohort become the largest in many nations (as measured by headcount), but also the most powerful, with the wealth of passing Baby Boomers transferring to them. These younger generations also view the world in a different fashion; with a greater emphasis on equality and environmental considerations than previous ones.
• Finally, amidst general uncertainty, we should accept that the current rate hike cycle is almost over. Federal Fund Futures are now pricing the likelihood of a 90% cut in US interest rates before the year-end and a 40% chance of two cuts. This is a quite remarkable volte-face given that only six months ago, the market was pricing three rate increases for 2019! Sure, the global growth outlook has become more uncertain, while an atmosphere of growing geopolitical distrust implies a risk of less-coordinated monetary policy, but the wider consideration needs to be one of developed world ‘Japanification.’ The combination of deteriorating demographics and advancing technology is inherently deflationary. We’re not there yet, but investors do need to consider how to position for a (developed) world of low growth and low inflation where the ammunition of Central Banks increasingly lacks potency.

Lest we get too concerned, we wholeheartedly believe it is still possible for investors to prosper in such an environment. Our strategy in recent times has been unwavering: invest in uncorrelated assets and with truly active and differentiated managers. The current environment is one where passive investing has lost some of its charm. Note that 2019 to-date has been the second-best year for active equity managers since the Financial Crisis (per Bank of America Merrill Lynch).

Moreover, the cycle is not necessarily over; rather, we are now moving into a different phase – of lower returns from more conventional asset classes. Notwithstanding the recent forecast downgrades from the World Bank and the IMF, do not forget that composite global GDP growth estimates for 2019 and 2020 are 3.3% for each year, while developed world inflation in both these years is predicted to be close to 2% (per Bloomberg). Furthermore, based on the recent earnings season, much of the corporate world remains in good health, delivering earnings growth ahead of (albeit previously lowered) expectations. Such a backdrop is hardly suggestive of impending global recession.

Whether these assumptions can endure in a world of more uncertainty, greater risk aversion and higher tariffs, of course remains unclear. To take but two indicators, manufacturing output in the US is currently the lowest it has been in over two years, while German business confidence is at its weakest in almost four. Investors should also be mindful of not complacently assuming that a Fed or Trump ‘put’ will come to the rescue. Sure, the US Presidential Election is only 18 months away, but policy action can have unintended consequences.

We regularly wonder when/how the current cycle may end. If history is any gauge, then signs of excess matter more than those of age. Against this background, what’s happening in the world of corporate credit remains a crucial area to monitor. It is hard not to note some evidence of exuberance at present. Consider that BBB-rated corporate debt issuance has grown by 400% since 2007, while covenant-lite debt now accounts for some 70% of all issuance (per Thomson Reuters and S&P respectively). Elsewhere, bear in mind that the number of non-performing consumer loans have risen for the first time since 2019, while auto loan and lease delinquencies as well as student loan delinquencies are both approaching pre-crisis highs (per the National Bureau of Economic Research). Looser monetary policy may contribute a further fuelling of excess in these areas.

What to conclude from all the above? The second-half of 2019 is likely to be considerably more challenging for investors than the first-half, based on what we know today. We are certainly not advocating the ‘sell in May’ adage; more that there is a need for investors to be pragmatic, disciplined and nimble.

Alex Gunz, Fund Manager, Heptagon Capital