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 reasoned assessment of the current landscape leads us to conclude that there is a lack of visible and positive catalysts for risky assets. A deteriorating outlook in China and directionally tighter monetary policy in the US top our list of concerns. For equities, an absence of earnings growth is also worrying. As a result, we have chosen to be prudent and reduce directional equity exposure, reallocating towards lower-beta strategies and cash. This approach leaves us well-positioned in the event of any major drawdown.

Asset allocation:

Equities: Some markets (particularly the US) look overvalued to us, while all regions (excluding Japan) are currently suffering negative earnings revisions. These stand at a one-year low. While emerging markets have recently outperformed on a relative basis, they continue to face challenges and may only be appropriate for the longer-term investor. We believe it is hence appropriate to reduce exposure to this asset class and our preferred allocations within equities remain towards alpha-focused global equity managers focused on bottom-up stock-picking.
Credit: The absence of inflation and still lacklustre GDP growth help explain why the yield on the US 10-year has fallen from 3.00% to 2.75% so far in 2014. Credit still offers some (albeit limited) carry in an uncertain world, a relative safe haven amidst potentially growing geopolitical instability. Our approach is focused on managers with high-conviction and differentiated approaches, particularly those with flexible mandates.
Alternative Asset Managers: One of the few areas that have delivered clear outperformance so far in 2014 has been event-driven managers. We have recently increased allocations in this area. Such managers offer relatively low correlations relative to the equity markets and are benefiting from an environment that has seen over $780bn of deals announced so far in 2014 (growth of 35% year-on-year). Further activity seems likely.

2014 was always going to be a harder year for investors after the rally enjoyed over the previous twelve months. Equity markets have generally lacked direction year-to-date, while credit has outperformed. These trends may endure for some time further and it should remain a sobering reminder that equities have only experienced one monthly drawdown of more than 5% in the last two years. The risk of another such event in the coming months cannot at all be ruled out and several factors perturb us. We have concerns over valuation levels in some equity markets (particularly the US, which has outperformed year-to-date), accompanied by an increasingly uncertain global macro environment – compounded by investor complacency. As a consequence, a reduction in exposure to more risky assets seems a logical strategy.

Two issues – a possible Chinese credit crunch and directionally tighter US monetary policy – concern us in particular. Without wishing to state the obvious, these factors matter for investors not just in their own right, but given the implications that the outcomes of these two events can have in other areas too. In other words, global interconnectedness is a fact: either a crisis in China (which most still seem to dismiss as a possibility) or a faster-than-anticipated rise in US rates would likely intensify the current challenges facing many emerging economies, while any developing market deterioration would have notably negative ramifications for the world’s more advanced economies too.

To start with China, we believe that the economy may be fast appointing a tipping point in terms of a credit crunch. Put simply, excess investment has helped drive recent economic growth; this growth is now slowing, just as the costs of funding it – through debt – are rising. The figures speak for themselves: total (public and private) debt will exceed 200% of GDP this year, according to Morgan Stanley, while the rate at which private sector debt has increased in the last five years has only been surpassed by two other countries over any similar given time period in recent history. The two were Spain and Ireland, and the salutary lessons from these geographies ought to be clear. Meanwhile, Chinese industrial production stands at its lowest since July 2011, export growth is slowing (down 18% year-on-year in March) and domestic retail sales are also weak.

Against this background, a series of selected corporate defaults has occurred, bank lending rates have risen and the local currency has fallen. None of this ought not to be surprising. However, we continue to be taken aback by the prevailing view of confidence in the seeming ability of the Chinese authorities to manage a situation that has all the hallmarks of a potential credit crisis. A few select interventions and bail-outs may only be delaying the inevitable and history clearly slows that such events are, by their very nature, unpredictable. Even if there is no full-blown crisis, a hypothetical scenario of Chinese GDP slowing from a consensus 7.5% rate of growth in 2014 to a – perhaps more realistic 4.0-5.0% outcome – is something that is both not discounted and would have major implications for global investors.

Our second observation that should concern investors relates to the likely evolution of US monetary policy and the considerable ambiguity that FOMC Chair Yellen seems to have introduced. Ben Bernanke admittedly let the rate tightening genie out of the bottle last May when the word tapering was used for the first time, but the clear implication from the Fed’s last statement – and contrary to most expectations – was that rates could start rising within twelve months. Investors should also take note of comments from Charles Plosser, a voting member on the FOMC: although a noted hawk, his suggestion was that Fed Fund rates could be at 4.0% by 2016. The market is currently pricing just 2.5%.

At the very least, the direction of travel for US rates seems to be upwards. This seems highly incongruous to us, particularly in the context of both an absence of inflation and a current weakening in macro data. The core consumption deflator (the Fed’s favoured measure for inflation) dropped last month from 1.2% to 1.1%, its lowest since March 2011, and there appear to be limited signs of near-term upward pressure on wage inflation, while both China and Japan are currently exporting deflation by proxy, given their weakening currencies.

In addition, the housing market in the US (in particular) is exhibiting a number of potentially worrying signs. Although housing starts remain some 50% below their pre-crisis highs, it is somewhat unclear whether such levels may be achieved during this cycle. The 30-year US mortgage rate has already risen by around 150 basis points from trough to its current level of 4.34%, and the implication from the Fed’s commentary is that they could ascend further. However, sales of new US homes are presently at a five-month low, pending home sales have fallen 10.2% year-on-year (with the rate of decline accelerating) and the failure of the NAHB builder confidence survey to rebound in March (after its biggest ever drop in February) suggests that the weather alone cannot be blamed for deteriorating sentiment. Consumer confidence indicators are also turning downwards at present.

An alternative interpretation of the reasons behind the shift in Fed stance could simply be that their relative caution constitutes a form of ‘insurance’, a policy back-stop, should some of the more exuberant trends in the US become increasingly pronounced and therefore need to be controlled. Although the Fed’s mandate relates to the real economy rather than the equity market, it is in this latter area that there is perhaps more evidence of current excess. We have observed in previous notes that US equities look overvalued on almost all fundamental and long-term valuation metrics and, moreover, this valuation premium is currently being exacerbated by an absence of positive earnings revisions (Morgan Stanley’s estimate for S&P EPS growth in 2014 has fallen, from 10.5% at the start of the year to 9.0% currently). Meanwhile, IPO activity is at its most pronounced since the tech-bubble, with the number of businesses that are loss-making at float coming close to previous record levels.

The implications of the above are twofold. First, a slowing rate of growth in China combined with potentially tighter (at least perceived, even if not actual) US monetary policy will likely exacerbate current emerging market challenges. Combined current account and budget deficits are creating economic pressures in a number of diverse geographies. Second (and related), higher rates will probably serve to intensify the pace of broad fund flows away from emerging markets into developed markets, particularly the US. This helps partly explain the resilience of US equities (even if we are in a bubble, it may not immediately burst) and also only makes the circle more vicious for certain developing markets.

Clearly if there is any form of emerging market shock or dislocation (whether this is inspired by China, a country-specific current account/ budget deficit event, or a geopolitical crisis), then the ramifications for developed markets would undoubtedly be significant. The impact could be more pronounced than in previous crises (particularly 1997, as the most obvious comparison) for several reasons: in particular, China’s role in the world economy is now much more significant; and, developed economies have much higher exposure and interconnectedness than previously – through both exports and bank lending. In addition, the western world is starting from an economically lower base now than before; namely, the absence of strong underlying GDP growth would fail to cushion any shock.

When we review the potential options open to policymakers, there are also several challenges to consider. Proactive monetary intervention may now have reached its limits. The Federal Reserve appears already to have seen some of its hard-fought credibility undermined by Janet Yellen’s commentary. To change stance on either tapering or the likely future direction of interest rates may only induce further uncertainty. Mario Draghi may be similarly constrained in Europe. Consensus-building across the Eurozone is even harder than within the Fed and the fact that the Euro has failed to weaken suggests many investors simply do not believe that the ECB is in a position to start buying assets anytime soon. These observations lend further support to our justification for moving to a somewhat more cautious stance. Prudence, we feel, is currently an appropriate strategy.

Alexander Gunz, Fund Manager, Heptagon Capital