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: equity markets continue to struggle for direction in the absence of earnings upgrades and the presence of uncertainties. A possible Chinese credit crunch and Russian geopolitical ambitions top this latter list. Developed world deflation is an additional concern, which would only mount should China seek to devalue further its currency. This is therefore an environment for selective equity and credit allocations, a focus on alpha-strategies, lower-beta approaches and the retention of cash for opportunistic moves.

Asset Allocation:

Equities: Despite the major US equity indices trading at close to nominal highs, global markets have witnessed their weakest start to the year since 2009 as earnings momentum has fallen and investors have been reluctant to apply higher multiples in the absence of positive catalysts. Nonetheless, dispersion across and within markets has been significant (its highest in seven years), suggesting that there remains a compelling argument for continuing to favour 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 2.65% so far in 2014. This trend may continue for some time, particularly since 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: With over $1trillion of M&A already announced so far this year (a 70% increase over the last twelve months), event-driven managers have delivered clear outperformance. We first allocated to such managers around six months ago and continue to see a strong case, particularly against a backdrop of plentiful corporate cash balances and low debt levels. Such managers also offer relatively low correlations relative to the equity markets.

It wasn’t supposed to be like this: with the global economy seemingly at its strongest position for some time, equities were poised to continue last year’s outperformance into 2014. However, it has been credit that has outpaced equity year-to-date and the returns posted by both the MSCI World and the S&P in the first four months of the year (1.6% and 2.5% respectively) constitute the weakest start since 2009. Nonetheless, it has been possible to make money, not just from balanced portfolios containing equities and credit, but also within equities. Dispersion both across and within markets has been notable and deal-making has been pervasive, at its highest since 2007. These trends continue to benefit both active equity managers and also event-driven funds, to which we have had exposure for some time.

Against this background, three logical and pertinent questions arise: what factors help explain the relatively lacklustre performance of equity markets so far this year; should we expect these trends to persist over the coming months; and, how should investors position appropriately? With regard to the first, the simplest explanation seems to be one of a reluctance for investors to rerate stocks higher given not only a broad absence of earnings growth but also the emergence of an expanding list of global uncertainties, namely, over the direction of Fed policy, a Chinese credit crisis and escalating Russian military aggressiveness to highlight the principal ones.

Earnings forecasts have fallen in all regions with the exception of Japan so far this year, by an average of 1.0-1.5%, according to calculations by Morgan Stanley. Even if 68% of US companies have beaten consensus estimates so far in the current reporting season, a seemingly healthy outcome in the context of a 20-year average figure of 63%, investors should be mindful that expectations were significantly lowered (partly on weather-related concerns) going into the quarter. That equity markets have struggled to make meaningful new highs in spite of earnings beats and merger activity is telling in itself, suggestive either of the fact that valuations are too stretched, or investors are concerned about the bigger picture, or both.

We certainly concur with the valuation argument, having highlighted in previous notes that US equities in particular are trading at extended multiples on most historic metrics. However, of greater concern perhaps is the absence of positive catalysts. Our sense remains that investors are potentially too complacent about the ability for the Chinese authorities to manage a situation that has many of the hallmarks of a credit crisis. Meanwhile trying to gauge the intentions of Vladimir Putin is close to impossible. Moreover, even if much of the macro data are suggestive of a stabilising/ improving outlook in the US and Europe (particularly the latter), the threat of deflation remains notable in both regions. Inflation in the US has run below 2% for the last two years, while the Eurozone’s last print of 0.7% marks its lowest level in almost five. Should China seek actively to devalue further its currency (a possible scenario), then this would only likely exacerbate deflationary pressures. Credit could continue to outperform equity in an environment characterised by deflation.

It is certainly notable that a growing chorus of commentators whose views we respect highly (Michael Cembalest, Russell Napier and Crispin Odey among others) are highlighting the possible approach of ‘Minsky moment’ for China; namely, the risk of a sudden collapse in asset values ensuing after a period of speculation-driven prosperity largely funded with borrowed money. We have highlighted in previous notes the high and arguably unsustainable levels of debt (both private and public) relative to GDP. Recent data are also somewhat concerning. Industrial production is falling, the housing market is dropping and the rate at which money supply is contracting (down 19% in March) is accelerating.

The Chinese authorities would therefore seem to have two choices: when confronted with the possibility of lower growth (an internal devaluation being the consequence of a credit crunch) or a lower currency, it would appear highly logical to choose the latter. The Yuan is now at its weakest since 2012, having fallen by almost 4% against the Dollar since the start of 2014, suggesting that this course of action is being pursued. Clearly in such a scenario of currency devaluation, Chinese exports would become more competitive, but deflation would also get exported too. It may, of course, be a tall order to expect the authorities to execute a policy of seamless devaluation successfully and painlessly, while also avoiding further large-scale defaults and simultaneously implementing structural reforms.

The ramifications of such an outcome are manifold. The MSCI Emerging Markets Index may have bounced close to 10% from its early-February low, but the fate of many countries within the region is clearly heavily interlinked with that of China, particularly given trade flows. Earnings revisions also remain highly negative, having fallen for seven of the last nine quarters, according to Credit Suisse. This suggests a still-challenging outlook, where Russia represents a further complicating factor. The country saw $60bn of capital outflows in Q1 and even if President Putin’s popularity may be at a three-year high, at some stage the prospect and reality of a Russian recession may have an impact, affecting not just the country, but also its trading partners. Clearly for the longer-term investor, equity market weakness and corresponding valuation levels in China, Russia and elsewhere in the emerging world constitute a currently compelling opportunity.

Turning to the developed world, prospects in Europe arguably look better than elsewhere, with industrial production having expanded for nine consecutive months and consumer confidence at its highest since 2007. This is also a continent-wide phenomenon, with Spanish GDP now growing at its fastest pace in seven years and Portuguese/ Greek confidence at its best in the last four. Fiscal discipline and structural reform have both undoubtedly helped and it will remain important to continue along this path.

As encouraging as prospects are, there are clear challenges ahead. In the race to devalue, the Eurozone is the clear laggard and the stronger Euro is already beginning to have some impact on productivity and competitiveness. The ECB seems markedly reluctant to cut interest rates further (though the scope remains to do so), and although it appears to be inching towards quantitative easing (QE), the impact from such a policy may be muted – and may also not stave off further deflationary pressures. Expectations seem to have become more elevated, implying the inevitable risk of disappointment. Any form of QE would lack the relative drama of when it was enacted at a time of crisis in the US or of major political change in Japan, and it remains to be seen how effective it would be. Some studies suggest that even if the ECB were to purchase €1trillion of assets (in what form also remains unclear), then inflation would only rise by 0.2%.

Beyond the uncertainty and potentially elevated expectations over ECB policy, questions remain in both the US and Japan over Central Bank policy too. Janet Yellen has recently appeared to adopt a more dovish note in her speeches relating to the direction of Fed policy, but the economic data continues to be mixed: industrial production and retail spending are improving, but the housing market in particular remains lacklustre. Overall GDP continues to run below trend. The need to keep policy loose but flexible remains a challenging one, as does the emphasis on clear and consistent messaging.

Japan constitutes a more intriguing problem. At one level, the Bank of Japan and Prime Minister Abe have succeeded, with core inflation running at 0.7% and the recent Tankan business survey pointing to a 1.7% inflation rate three years out. Abe’s popularity also continues to run at close to 60%. However, the Japanese equity market is at six-month lows and the concern has been voiced that some government officials now believe that the ‘hard work’ has been done and so may be inclined to sit back somewhat. Against this background, it would be easy to argue that some form of clear catalyst (such as more QE or structural reform) may be required to drive equity markets up again and while we do not disagree, we also find it notable that many Japanese companies have – quietly – been increasing their focus on growing return on capital and hence also shareholder returns. Such an approach is clearly to be welcomed and certainly creates opportunities for the longer-term and more alpha-focused investor.

Alexander Gunz, Fund Manager, Heptagon Capital