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: our key conviction for owning equities and investing in active global strategies remains firmly intact. January’s correction in markets creates an opportunity. Equity market drawdowns were always likely and will remain so throughout 2014. We are encouraged by positive evidence of improving levels of corporate capex, accelerating earnings momentum and an increase in deal-making, all conducive to the further performance of equities.

Asset allocation:

Equities: Correlations between stocks in major markets are at seven-year lows and evidence of dispersion has been strong so far this year. This reinforces the logic of favouring high-conviction global managers with a strong approach towards bottom-up stock-picking. Even given the current challenges facing emerging markets, there exist clear stock opportunities in these regions. Japan remains our current favoured geographic allocation, followed by Europe.
Credit: Similar to equities, we see significant scope for alpha-focused credit managers to outperform, in particular those that have flexible mandates and are able to avoid duration risk. In broad terms, we do not believe credit is yet attractive relative to equities in terms of valuation.
Alternative Asset Managers: With over $100bn of deals already announced year-to-date, there is good reason to believe that event-driven managers in particular are well-positioned to outperform. Corporates are sitting on record cash balances and will likely start spending, seeking to acquire other businesses and enhance their own.

2014 has begun as few expected, with equities experiencing their worst month in over a year and the yield on the US 10-Year falling by over 30 basis points. Context, as ever, is important. It should not be forgotten that market progression is rarely linear, expectations going into this year had perhaps become too elevated, even complacent, and corrections are often healthy, creating opportunities. Moreover, our key convictions, if anything, have strengthened. More notable to us than the downward pressure equities have experienced year-to-date is the level of dispersion evident both across and within markets, playing to our contention that the coming months will quite explicitly favour active, stock-picking equity managers.

The move by the Federal Reserve to taper has been well-discussed previously and was entirely necessary, indicative of the improving health of the US economy. Although the Fed’s balance sheet is still expanding, albeit at a slower pace than previously, the emphasis now is increasingly on forward guidance. As logical as this may be, it is also necessary to recognise that such a strategy is, fundamentally, a less explicit way of managing the yield curve than quantitative easing and so inherently more risky. It also implies the increased interpretation of every data point, potentially exacerbating the scope for misunderstanding and hence over-reaction by market participants. The ramifications of the Fed’s policy have also clearly been felt beyond the United States, most particularly in emerging markets.

Our approach has always been one of considering the direction of travel more than individual data points. In this respect, it is clear to us that GDP growth globally is beginning to accelerate and this should stimulate at least three encouraging trends: a pick-up in corporate capital expenditure, an improvement in earnings and a swathe of deal-making. All should be supportive to equity markets and continue to play out favourably over the remainder of the year.

However, by their very nature, these factors will not benefit all companies equally. In other words, the importance of stock-picking is only reinforced by the manifestation of these above trends and so correlations between equities ought to continue to diminish. Indeed, according to a recent report by Barclays, the relationships between the top fifty stocks in both Europe and the US over a rolling three-month period are currently at their lowest since 2007. The logic of this argument also applies to emerging markets. It would be incorrect to assert that all emerging economies currently face the same structural challenges and there are hence many opportunities at both a country and a corporate level. Nonetheless, investors should not forget that as strong as the broad direction of travel may be and despite January’s market correction, there has only been one drawdown of more than 5% in global equities over the last two years. The possibility, therefore, of at least another during the course of this year remains significant.

On the positive side, corporate capital expenditure, earnings upgrades and M&A all tend to lag industrial production data by around six to eight quarters implying that the point of inflection ought to start occurring around the middle of this year. Taking capex first, there is substantial evidence that companies globally, but particularly in Europe have been under-spending. In some ways, this is only logical given the cautiousness felt over the macro environment in recent years. With corporates holding at least $2 trillion of cash on their balance sheets at the end of 2013, double levels of ten years ago, there is a persuasive logic attached to start spending some of it, particularly if the outlook is now beginning to look somewhat brighter. Morgan Stanley estimates that the current average capex/ sales ratio globally stands at 9.4% and at just 6.7% in the Eurozone. These figures are around one percentage point below long-term average levels and compare against previous cycle peaks of 13.0% and 9.7% respectively.

Record corporate cash balances (combined with very low interest rates) also provide corporates with the opportunity to consider undertaking deal-making and 2014 has already seen some $100bn of announced M&A. Encouragingly, much of this has also been of a cross-border variety, indicative of a growing level of risk appetite. Deal activity tends to lag stock market returns by around 12-18 months and so more should follow. Beyond cash (which many US-listed businesses hold outside the States and cannot easily repatriate, increasing the logic of spending it on acquisitions) and confidence, it is also worth bearing in mind that there has been a recently more pronounced tendency towards shareholder activism as well as a somewhat more pragmatic stance adopted by regulators (for example, regarding the telecoms sector in Europe). These factors should also be supportive.
The combination of elevated corporate expenditure and deal-based activity should logically be conducive to driving earnings growth. Operating margins are also proving robust (they are at a five-year high in the US), helped by cost control and leverage as well as by structural trends such as automation, re-shoring and the deployment of unconventional energy sources (such as fracking). After the multiple expansion that largely drove equities last year, it is all the more important that corporates prove capable of delivering earnings upgrades over the course of 2014. A recent report by Bank of America Merrill Lynch is supportive in this respect, highlighting that global earnings revisions currently stand at their highest in three years. Furthermore, although the current reporting season is only mid-way through, margins and earnings have generally surprised positively relative to top-line developments.

The strength of these various trends (and the scope for further positive surprise) currently appears highest in Japan and Europe, hence our regional preference. After the 56% rise in the Nikkei last year, the simple strategy adopted by many was – and has been – to take profit, hence the 8.5% dip in the market in January. This creates a considerable opportunity in our view, given the many positive factors at work in the country. Beyond the fact that the IMF recently significantly raised its 2014 GDP forecast for Japan (from 1.2% to 1.7%) and that inflation expectations are currently running at three-year highs (evidence that Abenomics is working), fundamentals are more attractive here than in any other major global market. The stock market rally in 2013 was driven not just by multiple expansion, but also by earnings growth, and current revisions remain highly positive. Forecasters assume EPS growth in Japan to run at close to double the global average in 2014. The introduction of April’s consumption tax may somewhat slow momentum in Japan, but this should be offset by the ability for the BOJ to implement further accommodative monetary initiatives, combined with the likely introduction of new, more business-friendly legislation by the government.

Beyond Japan, Europe offers the greatest scope for potential equity market upside over the coming year. There is now tangible improvement across the whole region, evidenced by manufacturing output at a 31-month high and economic sentiment indicators at their most elevated in six years. The periphery nations in particular have staged a strong turnaround with, for example, Spanish industrial output at its best since mid-2007. This has been helped by the economy having the lowest wage costs within the Eurozone, a product of a major internal devaluation over the last few years. The next stage of the recovery should be an acceleration in credit growth across the region. Banks’ balance sheets have normalised and lending is beginning to increase from repressed levels; lending tends to follow recovery rather than lead it. The ECB also provides a supportive back-stop: policy will remain accommodative “for as long as necessary” and although inflation should pick up as the economy recovers, additional tools (such as a funding for lending scheme or even further rate cuts) remain on hand if required.

Although both Japan and Europe have notably underperformed the US market over the last five years, the underperformance of emerging markets relative to developed markets has been even starker. It has become more pronounced as tapering has commenced, with the corresponding strength of the US Dollar resulting in capital flight out of many countries, particularly those with balance of payment issues and unhedged debt. Political uncertainties in several countries have only exacerbated the issue. This process will take time to play out and it will be necessary for many policymakers to enforce a transition away from export-led economies to more domestically oriented ones. Nonetheless, just as we have highlighted the logic for and importance of stock-picking in developed markets, so this argument also applies for emerging markets. It is always dangerous to generalise and despite the inevitable challenges facing the latter region at present, there currently exist many attractive individual stock-based opportunities, particularly for the longer-term investor.

Alexander Gunz, Fund Manager, Heptagon Capital