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: similar to many, we favour equities relative to credit. Nonetheless this is partly owing to the absence of more compelling alternative options; and even within the equity space, careful consideration of allocations is required. Despite February proving to be a better month for equity investors than January, general market complacency levels seem high to us. The two key questions, therefore, to ask are: what factors may most challenge the pro-equities view (perhaps emerging market dislocation more than anything else) and where is Heptagon most differentiated in its own investment strategy? With regard to the latter, it is in terms of currently favouring Japanese equities and event-driven managers.

Asset allocation:

Equities: Active management approaches should outperform passive ones, particularly with correlation levels at their lowest since 2007, and would notably if market volatility increases. Against this background, our preference is for alpha-focused global equity managers with a strong emphasis on bottom-up stock-picking. Japan remains our current favoured geographic allocation, followed by Europe.
Credit: Similar to equities, we see significant scope for credit managers with a high-conviction and differentiated approach to deliver outperformance, particularly those with flexible mandates and the ability 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: Event-driven managers have outperformed year-to-date against a background of over$500bn of deal-making announced so far in 2014. Such activity has been well-spread both by sector and geographically and there are good reasons to believe that this trend will continue for now.

To recognise that there will always be limitations to consensual thinking is crucial. Indeed, when consensus is most polarised, risks tend to be at their highest – one only need recall prevailing investor mentality in 2007 prior to the ensuing credit crisis. At the start of this year, opinion was strongly aligned in favour of equities and against credit. Even if February provided notable comfort to equity market bulls after January’s unexpected start to the year, more challenges lie ahead. Events in Russia and Ukraine are inevitably headline-grabbing at present, but it is arguably more important to consider what factors may most likely threaten the outlook for investors over the remainder of the year. The second, related, topic of importance is to identify where the best investment opportunities may lie: even if equities constitute the most attractive asset class in which to participate, particularly in the absence of more compelling alternative options, there is still significant scope to adopt a differentiated stance.

The term ‘black swan’ has become a popularised, but nonetheless useful metaphor for describing an event that comes as a surprise, has a major impact, and is often inappropriately rationalised with the benefit of hindsight. By definition, such events are almost impossible to identify. Nonetheless, it is possible to make two clear observations with confidence: first, there currently exists a high degree of investor complacency; and, second, geopolitical and social instability globally is notably higher than it was either five or ten years ago. Together, these make an unfortunate and high-risk combination. In general terms, investors continue to place faith in the restorative ability of Central Bankers’ policymaking and their tacit ability to talk markets up, witness the hope that the US taper may be ‘tapered’ if American economic prospects worsen and the growing reliance/ dependence on forward guidance. It was ever thus that while monetary policy can buy time, it can’t make structural adjustments.

The situation in many emerging markets around the world is of particular interest at present. Their interconnectedness not only to each other, but also to the developed world is a factor many investors seem (or maybe have chosen) to discount. Whether one likes it or not, investors do tend to move en masse – hence the dangers of consensual thinking – and a recent report from the World Bank shows this starkly: more than 60% of inflows into emerging world financial markets since 2009 can either directly or indirectly be attributed to quantitative easing (even if there have been notable increases in foreign direct investment in these same economies over this period). As the US and other developed economies move towards ‘normalisation’, the reversal of this financial trend is compounding a series of other troublesome factors. There are undeniable contrasts across the emerging world and while several economies (such as Mexico, South Korea and the Philippines) have made notable progress in recent years, a number of others (Thailand, Turkey and South Africa to name but a few) remain characterised by situations of increasing indebtedness. High current account deficits (at least comparable to pre-Asian crisis 1996 levels), elevated fiscal deficits (notably S&P reports that negative credit outlooks currently outnumber positive ones by a factor of two-to-one) and rising inflation are all problems in themselves but they intensify economic pain and social unrest, creating a potentially vicious circle.

Even if China is not obviously exposed to all of the above trends, there are also significant current risks attached to the world’s second largest economy, which would inevitably have global ramifications. A notable slowdown in Chinese GDP growth is a scenario not currently accepted by many, but remains plausible to consider. Beyond the more ‘obvious’ concerning indicators such as the disappointing trend in industrial production (weaker than any other global region at present), and slowing electricity output or railway cargo stock levels (often accurate precursors to economic weakness), Chinese debt levels look particularly worrying. Credit Suisse estimates that total Chinese debt comprises 230% of GDP, with private sector debt making up just over 40% of this figure, having risen at a faster pace over the last five years than in any other country globally. Moreover, if similar work by Morgan Stanley is correct, then almost 50% of this debt will need to be refinanced within the next 12 months. Clearly any tightening in Chinese rates could have major negative consequences, while current currency (Renminbi) weakness may exacerbate matters.

Against this background, it would clearly be incorrect to view emerging market developments as discrete events; rather, they are already and will continue to impact the broader global economy. Another important medium-term issue to consider is that of inflation. The current (perhaps complacent) view held by investors and policymakers in the western world is that inflation – at just 1.1% in the US and 0.8% in the Eurozone – should not be considered as a threat; more, it is the possibility of deflation that is concerning. Nonetheless, much of the global food and energy supply chain is located precisely in emerging markets and particularly those that are being challenged currently by political and social disruption. Both Ukraine and Kazakhstan are profuse in natural mineral resources, while South Africa remains a major commodity producer. Furthermore, Indonesia is the globe’s leading producer of coal for electricity production and Thailand the major world producer of natural rubber. Meanwhile Brazil’s worst droughts in more than 80 years are pressuring coffee, fruit juice and sugar prices. At some stage, upward pressure on pricing may come to the fore and inflation expectations rise.

Even if inflation does not prove an immediate threat in the western world, policymakers are still struggling with economic transition (from stimulus to standalone), particularly in the United States. Only a few months ago, the popular debate was whether the American economy was growing too quickly such that the Fed may have to raise interest rates ahead of their documented forward guidance. Now, these concerns seem to have reversed and discussion centres on whether the economy has already reached its peak. Beyond the obvious observation that analysts almost always fail to capture turning points in economies, the following is clear: in order for the US economy to grow, there needs especially to be an improvement in corporate capex, the housing market and auto demand. The indicators in these areas are worrisome: the three-month moving average for durable goods orders has fallen for the last two months, pending home sales are down 17% from their recent May 2013 peak, mortgage applications are at their lowest since 1995 and auto sales dropped 3% year-on-year last month. Not all of this can be attributed to the weather. Clearly something needs to be done to sustain/ US macro momentum, and at the least, Governor Yellen needs to be explicit in her messaging to corporates and investors.

It is partly for the reasons cited above that we are less attracted to investing in America than other regions globally at present. In particular, we see the scope for positive surprise as being notably higher currently in Europe and Japan. Whereas the case for Europe seems to have become a relatively consensual investment view (and is helped by Eurozone GDP having seen its first annualised increase in Q4 since 2011, with the peripheral nations demonstrating notable turnaround in particular), our positive stance on Japan remains less well-accepted. Indeed, in the investor meetings we conducted around the world in February, our discussions over Japan seemed to elicit most debate.

Even if the Nikkei has underperformed its major developed world markets year-to-date, it remains the case that Japan has seen five consecutive quarters of corporate earnings exceeding expectations and constitutes the only region globally where earnings estimates have risen year-to-date. Concerns (and related underperformance) seem to have been attributed to cautious guidance – although this is typical from Japanese corporates – and the macro outlook. Nonetheless, it seems clear to us that Prime Minister Abe and Bank of Japan Governor Kuroda are committed to ‘doing what it takes,’ and last month saw a doubling of the country’s Funding-for-Lending scheme and progress being made to reduce the rate of corporation tax. Industrial new orders are currently at their highest since 2006 and many companies seem committed to raising wages in the coming months. Progress will not be linear, but we expect momentum to continue building.

Finally, despite a global economic and political outlook that is far from trouble-free at present, we note that M&A activity has been rife, a trend which we expect to continue. Since the beginning of 2014, some $560bn of deals has been announced, up more than 40% year-on-year. M&A tends to lag the stock market by around 18 months and the current low interest rate environment (combined with increasingly vocal, or activist, shareholders) is also helping. As a result, event-driven managers are enjoying good times, at least for now.

Alexander Gunz, Fund Manager, Heptagon Capital