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: after a decade of extremes, normalisation was never going to be easy. Even if growth is slowing and investors have already begun to demand a higher recession-risk premium, we are encouraged by the fact that assumptions and sentiment seem conservatively set. Many asset classes have now repriced a weaker growth outlook and look attractive from a long-term valuation perspective. Challenges clearly remain, most notably the ever-growing burden of debt and the emerging conflicts over how best to deploy monetary and fiscal policies in tandem. We counsel a course of diversification, favouring quality and complexity. For the longer-term investor, we see growing opportunities in emerging markets, particularly relative to the developed world.

Asset Allocation:

• Equities: Despite January’s rally in stock markets globally, many equities remain cheap, even if global earnings revisions are falling at their fastest pace in a decade (per Citi). Given last year’s correction, US, Eurozone and Emerging Market (EM) equites are all now trading at close to the midpoint of the valuation ranges they have commanded for the last 30 years (per JP Morgan, as measured on one-year forward earnings). However, amidst uncertainty, 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: We have been sceptical about the case for conventional fixed income for quite some time and after the significant breadth of underperformance in 2018, it looks increasingly clear that long-term bonds can no longer serve as shock absorbers for multi-asset portfolios. Furthermore, currently falling bond yields (the 10-year US Treasury has moved from ~3.2% to ~2.6% in the last three months) are generally supportive to equities. 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 no wat 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: 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 (in Dollar terms).

Blink, and you may have missed it

Spot the difference: January 2019 was the best month for global equities since March 2016; December 2018 was the worst month for global equities since May 2012. Bond yields have also gyrated wildly over this period. Sure, we can point to mean reversion or late-cycle volatility as potential explanatory factors. Macro indicators and reports from corporates have, meanwhile, remained mixed. So, what’s going on? Our headline above provides a clue: Fed Chairman Jerome Powell’s utterance on 4 January (which was reiterated on 30 January) that the US Central Bank would “be patient” may have been important for investors as Mario Draghi’s “whatever it takes” speech of July 2012. It is indicative of a clear shift in policy. Investors may still wish to believe that Central Banks have the ability to abolish the business cycle. We remain unconvinced. 2019 could be as volatile as 2018. We continue to stress the importance of diversification.

The importance of being data-dependent

We are reminded by the famous line from John Maynard Keynes, “when the facts change, I change my mind.” What has become more evident in recent months is that no country (and particularly not the US) can claim immunity from the weakening growth that has spread throughout the rest of the world. Perhaps we should not be surprised, since the US is still enjoying its longest period of interrupted growth (as measured by consecutive quarters of GDP expansion) since 1854. Nonetheless, it is hard to deny the data points that have emerged since the start of 2019: the US index of purchasing managers (a good proxy for industrial expansion) reported its biggest monthly fall in December since the Global Financial Crisis. China, Taiwan, Malaysia and South Korea are all recording economic contraction based on similar surveys, while the Eurozone economy is at its weakest since 2014, with German manufacturing also formally in contraction.

A slowdown in growth is, of course, not an economic disaster. We have also seen other periods of weaker economic performance during the current cycle, most notably around the Eurozone crisis of 2012-13 and the emerging markets/ commodities meltdown of 2015-16. Furthermore, investors should not forget that even if global growth may be past its peak, the IMF continues to forecast a 3.5% GDP expansion for 2019, while UBS notes in a recent report that worldwide unemployment is currently at its lowest since 1980.

However, given the spectre of slowing growth globally, investors have already begun to demand a higher recession- risk premium, even if no recession occurs in 2019. This is evidenced through higher credit spreads and a growing scrutiny of corporates’ balance sheets. It is possible that both businesses and consumers have already begun to alter their behaviour, taking a more prudent approach and spending less. Prophecies can be(come) self-fulfilling.

The key challenges
As we have written in previous commentaries, the past decade of quantitative easing has distorted both behaviour and perspectives. Over this period, the four largest Central Banks in the developed world have purchased some $16trillion of assets (per Morgan Stanley). Now comes normalisation after a decade of extremes. Policymakers must grapple with three challenges: how to engineer a soft landing, unwind monetary policy and pay for fiscal expansion. The latter need comes at a time when most economies already have too much government debt, even if it seems likely that more fiscal stimulus will be applied. Such an approach might logically be sought by Governments since not only does it drive more tangible growth than unconventional monetary approaches, but it can also help mend socio-economic divides.

Do not forget, however, that the policymakers responsible for delivering on these objectives are multiple in nature, and their aims may be in direct conflict. Note, the tensions that have already emerged in the US between President Trump and Federal Reserve Chair Jerome Powell. Meanwhile, Mario Draghi – who has done much to ensure the stability of the Eurozone in recent years – will leave his post at the ECB in October. It is not yet clear who his successor will be.

All the important policy actors must also operate in an environment where debt levels are markedly higher than a decade ago. The US total credit market expanded by 132% between 2008 and 2018, during which underwriting standards almost certainly deteriorated. Over this period, Investment Grade credit expanded by 156%, US loans by 90% and High Yield by 69% (all data per Bank of America Merrill Lynch). Thought of another way, US total debt at 6% of GDP is unprecedented for a peace-time economy at full-employment.

The reality is that debt has been behind almost every financial crisis in recent history. Correspondingly, the key risk tomonitoristhequalityofcredit–itmaybeinworseshapethanmanythink.WeareremindedofHymanMinsky’sobservation that easy-lending brings about foolish investments. It is not difficult to imagine a vicious circle where widening credit spreads result in tighter financial conditions. In turn, this implies growing economic headwinds and more volatile asset prices. The economy then slows, which could cause an increased risk of expected credit defaults, hence downgrades to credit ratings and ever-wider credit spreads.

Against this background, it is worth considering how proposed fiscal stimulus (an idea that has already been mooted in the US, China and Japan, with others set to follow) will be funded. Take the US. Republican tax cuts were passed with much fanfare last year, but the corollary was that federal tax revenues fell by 5.4% in real terms during 2018. At the same time, the Federal budget needs a 28% year-on-year increase to provide funding for pensions and increased Medicare contributions (all data per the Federal Reserve). 2019 marks the peak year that America’s baby boomers turn 65. Demographics are deteriorating in most mature economies – the future has already happened when it comes to tax and expenditure budgeting. We wonder what happens to funding (and tax revenues) were these economies to tip into recession.

Where to go from here
Unlike the past 8-10 years, liquidity has now peaked. However, while liquidity is leaving the financial system, there is still a lot of it around in absolute terms. Based on the current pace of contraction, the Federal Reserve’s balance sheet may end 2019 $1.4trillion lower than it was at the beginning, but its size will still be over three times its level at the end of 2009 (per Goldman Sachs). Investors should remember that quantitative tightening is reversible. In a scenario where economic data and financial markets deteriorated markedly, non-traditional monetary policy (QE4, anyone?) may even be back on the table.

History will only tell whether this current period proves to be a late cycle dip or the start of something profound. In our view, it is a good thing that assumptions and sentiment seem encouragingly conservative. Many asset classes have already begun to reprice a weaker growth outlook and look attractive from a long-term valuation perspective. In an era where data-dependence matters more than ever, we counsel a course of diversification, favouring quality and complexity. The days of low-volatility are behind us and it pays to prepare now for a more uncertain future.

AlexGunz, Fund Manager, Heptagon Capital