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: We have no crystal ball. We are not, therefore, going to try and forecast either where markets may stand this time next year, or the outcome of many of the crucial political events set to characterise the coming months. Rather, we advocate a more common-sense approach. History shows that valuation acts as the strongest predictor of future returns. Logically, given how high current starting points stand for most mainstream asset classes, future returns are likely to be lower than those historically achieved. Against a backdrop of escalating social, environmental, political and economic challenges, the case for increasing portfolio diversification continues to grow. Our broad advice for 2020 is to back out-of-favour and/or uncorrelated assets.

Asset Allocation

• Equities: We continue to advocate equities over fixed income when it comes to considering the potential returns available from investing in mainstream assets. Equities can offer a combination of both growth and yield that is hard to replicate elsewhere. Not all segments of the stock market are in bubble territory and the generally weak earnings growth that has characterised 2019 should at least make comparatives markedly easier in 2020. The scope for the rest of the world to catch up with the US in performance terms looks potentially strong, given political uncertainty in America and relative valuation levels elsewhere. Our approach remains firmly fixed on managers pursuing truly active, differentiated strategies.
• Fixed Income: Bond yields have continued to compress throughout 2019 with over $12tr of sovereign debt now offering a negative yield (per Bloomberg). We do not see the logic of paying for the privilege to borrow government debt, particularly should nations seek to monetise their debt through more inflationary strategies at some stage. Even if such an outcome is looking increasingly more likely, it may not stop further capital flowing into perceived safe-haven assets in the near-term. Meanwhile, in the corporate space, we note that many indicators are pointing to credit quality deterioration. Now is not the time to be seeking yield by increasing credit risk.

• Alternative Assets: The attraction of illiquid alternative asset classes only continues to grow, in our view. In a low-rate environment, there is an increasingly compelling case for owning longer-duration assets. We consider allocations to uncorrelated assets such as infrastructure, real estate and niche private equity to be particularly attractive and see continued scope for high-quality assets with meaningful cashflows to outperform.
• Gold: We see a logic for owning gold. It acts as a natural diversifier. Furthermore, relative to its history, it is one of the few asset classes that remains clearly undervalued. Listed gold miners represent another way of gaining exposure to the asset class.

No crystal ball, just common sense

2019 has been, for most investors, a good year. Global equities stand at all-time nominal highs and bond yields are at almost their lowest levels ever recorded. Both these events have also occurred against a backdrop of the longest US economic expansion on record. Looking forward, it is only reasonable to wonder whether we are at the peak, or if there is more still to come. Arguments supportive to both these scenarios have regularly been discussed in View From The Top over the course of the past year. Our impression, peering ahead into 2020 is that positioning is becoming polarised at both extremes. Some of the ongoing outperformance continues, we believe, simply to be driven by a perceived fear of missing out. At the other end of the spectrum, it has remained quite remarkable just how many ‘walls of worry’ markets have seemingly been able to climb. If nothing else, investor sentiment remains far from euphoric; sceptics abound in many quarters.

We have no crystal ball. To go back in time briefly, consider just how formative a year was 2016. It was dominated by the seismic votes in favour of both Brexit and the election of Donald Trump as US President. British and American citizens as well as those in the rest of the world are still suffering the (unintended) consequences of both events more than three years on. Crucially, we learned the danger not only of trying to forecast outcomes, but also to infer causality. Just because event ‘A’ happens does not automatically mean that it will have a given impact on asset class ‘B.’ Readers will therefore find no attempts in this document to predict the outcome of the pending UK Election, the resolution of the Brexit debate, the potential impeachment of Donald Trump, or who will be in the White House at the end of 2020. Forecasting the impact of such outcomes on different asset classes is an even harder – and potentially more foolish – task.

To the extent that history does provide a meaningful playbook for the future, then we are simply content in asserting that ‘shocks’ to the financial system are most likely to come from where investors are looking least. The black swan swims supreme. Furthermore, given that most markets are trading at elevated levels, it is very fair to say that optimism can change to pessimism very quickly.

Against this background, our approach is to adopt a resort to common sense. We also recognise that the start of a new year represents a somewhat arbitrary date, even if it does matter for many. The world is not suddenly on 1 January 2020 going to be markedly different to how it looks today. Logic would therefore support the following observation: a high starting point for most asset classes inevitably implies lower returns going forward. On the back of a boom in almost everything, people inevitably should be somewhat nervous, and an absence of recession implies a much higher likelihood of one occurring.

Furthermore, we cannot help but be aware that attention to asset class valuation levels seem to ‘matter’ less when markets are going up. Nonetheless, history shows valuation as the strongest predictor of future returns. At present (almost) everyone seems to be chasing the same thing. High valuations can go higher, but not indefinitely. Mean reversion can be a very powerful force. The case for investing in out of favour asset classes looks highly compelling. At the least, investors should consider increasing diversification levels within their portfolios. Returns from conventional fixed income and equity portfolios will, in all likelihood, be markedly lower going forward than they have been historically.

Our conviction in such an approach is only increased given our assessment of the bigger picture. Whether we like it or not, the world’s social, environmental, political and economic systems are facing escalating challenges. It is perhaps of no surprise that populism and its uglier sibling nationalism are regrettably gaining ground. Asset-class inflation may be all well and good for investors, but there appears to be a growing shift away from policies that support wealth accumulation to those favouring wealth redistribution. Inequalities in wealth, income and healthcare (particularly in the US) are only likely to come more to the fore in 2020. This we feel fairly confident in asserting, even in the absence of a crystal ball. How administrations around the world deal with ageing populations will be a defining issue for years to come. Policy divergence (rather than convergence) may well become the norm, particularly as the battle for economic and technological supremacy will continue to rage between the US and China.

What then can we expect? Central Banks are likely to continue to play an active role in shaping the direction of the economy and financial markets, even if their policy tools are looking increasingly exhausted. That Federal Reserve Chairman Jerome Powell has observed that it might be “time to retire the term unconventional” speaks volumes about the challenges facing Central Banks. In general, the absence of inflationary growth has only led to more intervention as a prop for the market.

The sustainability of such an approach, however, remains to be seen. Consider the test-lab of Japan as a potential sign of things to come elsewhere. In the seven years since Abenomics (i.e. the ‘three arrows’ policy approach pursued by Prime Minister Shinzo Abe), inflation has averaged just 0.8%, against the country’s stated target of 2.0%. Meanwhile annualised GDP growth is currently running at just 0.2%. To achieve such an outcome has seen the Bank of Japan’s balance sheet expand to 104% of nominal GDP, versus just 40% pre-Abenomics (all data per Bloomberg). If the world is caught in a potential liquidity trap with persistently low interest rates and a glut of savings, then fiscal stimulus may be one solution. At the least, governments need to play a bigger role. Some, admittedly, appear to have begun to recognise this.

The above call to arms is all the more pertinent given that the macro environment remains challenging. Most market participants continue to look through the fact that economic growth forecasts continue to be downgraded around the world. Both the OECD and the European Commission have trimmed their 2020 estimates in recent weeks. This is perhaps of no surprise given that global industrial output indices have now contracted for four consecutive months (per JP Morgan). Purchasing managers’ indices are signalling contraction (i.e. readings below 50) in the US, Europe and Japan. If you were wondering whether a trade war was deleterious to growth prospects, then consider that Chinese industrial production is running at its lowest rate since 1998, while US non-farm productivity has not touched such current lows since 2015. Consumers may not have been spooked by trade wars (yet), but many businesses certainly seem to have been.

Debt remains the elephant in the room. Record low interest rates around the world mean that global non-financial debt climbed by $7.5tr in the first half of 2019 to reach a record level of $251tr, per the International Monetary Fund (IMF). More worryingly, the IMF warns that in the event of a global economic downturn, 40% of corporate debt would be at the risk of default. Many of the dashboard indicators we monitor (such as leverage, spreads or financial conditions) look markedly weaker than they did a year ago. There have been significant erosions in both capital structures and credit quality.

Where does it all end? One extreme outcome could be the complete monetisation of all debt; in other words, the deployment of truly unconventional monetary policies to inflate away the current debt burden. Notwithstanding its faults, modern monetary theory (in various guises) seems to be gaining increasing credence. Optimists would more generally assert that humankind’s capacity to reinvent itself continually in the face of new and unforeseen challenges is relentless. We would like to concur, but to be safe, we also strongly counsel the case for ongoing asset class diversification.

Alex Gunz, Fund Manager, Heptagon Capital