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 interpretation of continuing declines in US Treasury yields is a benign one. We see little evidence of diminishing economic growth prospects, believe Central Bank policy is generally credible and do not see an immediate threat from deflation. The more pertinent consideration is one of valuation: the broad case for owning equities over credit at current levels seems clear. Our preference is for Europe, where we see the highly supportive conditions, but other regions also have their merits.

Asset allocation:

Equities: Despite many equity markets making new nominal highs, there appear to be few signs of investor euphoria. Growth and earnings expectations now seem to be set at more realistic levels than at the start of the year, while prospects have improved and valuations in most regions remain relatively undemanding. Our preference is for Europe and Japan, but we also see an improving case for emerging markets. Globally, bottom-up, alpha-focused managers should also continue to prosper in this current environment, which remains characterised by high dispersion levels.
Credit: If prospects really are improving (or at the least, look less negative than some months ago), then it seems reasonable to ask how much further yields can compress. The carry that can be earned on credit (sub-10 basis points on two-year German debt, for example) looks increasingly unattractive. Our approach remains one of selective allocations within the space, particularly towards managers with flexible mandates and differentiated approaches.
Alternative Asset Managers: There remains no change to our thesis for and hence allocation towards event-driven managers. Over $1.7trillion of M&A has been announced so far in 2014, and given little change in broad equity market valuations year-to-date, high corporate cash balances, improving lending conditions and growing CEO confidence levels, we expect the trend of deal-making to prevail for some time longer.

Arguably the biggest question on investors’ minds is why the yield on the US 10-Year Treasury continues to fall, having descended from 3.0% at the start of this year to around 2.5% at present. Or, put another way, given that equity markets continue to grind higher, making new nominal highs, surely yields should be more elevated? There are two possible interpretations to this conundrum. The benign view would suggest that investors believe that a world of low interest rates and accommodative monetary policy is sustainable for the foreseeable future. The more concerning one centres on worries about the outlook for economic growth, the threat of deflation and the potential for geopolitical dislocation.

Our survey of the evidence (discussed in more detail below) would suggest that the former of these two views constitutes the more persuasive one. Beyond this debate, however, the more important consideration is how to position portfolios most appropriately. While it clearly behoves us to protect investors’ capital, generating returns also clearly matters. It therefore seems highly appropriate to wonder how much further Treasury yields can plausibly fall, particularly given the evidence with which we are presented. We find it, for example, hard to make a compelling case for owning two-year German government debt with a yield of 6 basis points when European equities (the Euro-Stoxx 600) offer a 3.5% dividend yield. Furthermore, the gap between the US 10-Year yield and the S&P’s forward earnings yield is its widest in six months.

Indeed, we feel that a clear set of data points currently present themselves allowing us to form a generally constructive view on equities. Although global equity performance has been relatively lacklustre year-to-date (most developed market indices have barely gained 5%), expectations – for both GDP and corporate earnings growth – now certainly feel more realistic and less elevated than they did at the start of 2014. Moreover, notwithstanding the ebullient IPO market and over $1.7bn of M&A activity announced in the last five months, there remains a notable absence of the sort of investor euphoria (this time it’s different, bubble-mentality) that typifies equity market tops. Many investors with whom we speak and commentaries we read seem to profess profound caution and scepticism about the current investing environment. Fund Manager surveys point to cash levels being at their highest in almost two years.

Our relative optimism is based on a combination of observations. We are certainly not of the view that the lack of economic growth can explain the current level of Treasury yields. Recent US economic data (new business activity at its highest since February 2008, three consecutive months of growth in durable goods orders, initial jobless claims at their lowest in seven years, and so on) already make the first quarter’s print of -1.0% GDP growth look like a partially weather-induced anomaly. Meanwhile in Europe, there is a similarly robust picture, with most manufacturing surveys pointing to the strongest performance in three years and consumer confidence at its highest in almost seven.

More importantly, when we look at the factors helping drive these trends, it is clear from the most recent Senior Loan Officer Survey in the US and ECB Lending Survey, that credit conditions are easing notably. In particular, within the Eurozone, lending conditions have begun to ease for the first time since 2011, with growth being reported in all categories across both households and corporates. These trends have particularly important implications for investment allocations. As we have written in the past, the correlation between GDP growth and equity market returns is limited; it is important to think of GDP more as a necessary, rather than a sufficient factor behind investment decisions. Rather, for us, the debate centres on a combination of valuation, liquidity and risk factors. Our composite model comprising these elements for the Eurozone is currently showing a highly positive reading – the most encouraging for some time – hence our positive stance on equities in this region.

Given prospects in Europe, it is worth considering whether the European Central Bank needs to implement further monetary loosening later this week. Expectations for action (whether a further cut to interest rates or some form of more accommodative policy) seem to have risen. The outcome may be anti-climactic. The more important debate, however, on both sides of the Atlantic relates to the credibility of Central Bankers and their actions. The messaging from the Federal Reserve remains clear and consistent: rates can stay low for as long as inflation does. Mark Carney, Governor of the Bank of England – the country that may be first in line in the developed world to raise rates – also made the observation at the last Bank press conference (on 21 May) that rate rises should be considered as “the last line of defence against financial stability risk.” Investors should be able to draw some reassurance from comments such as these; low rates may prevail for some time longer.

With regard to inflation, trends are somewhat divergent in the developed world, but to suggest that there are clear deflationary pressures at work simply seems inaccurate at present. US and UK inflation are both running at over 1% (indeed in the latter, it has averaged 3.1% in the last three years). Wage growth in the US is also currently at 1.9% suggesting that this trend may feed into inflation figures over time, particularly as the output gap in the US – the difference between actual and potential GDP – narrows. The picture in Europe is somewhat different, with reported inflation at below 1% for the last seven months. Some of this, however, can be explained by the internal devaluations witnessed, particularly in the periphery. As growth returns to these areas (Greek GDP in Q1 shrank by the smallest amount since the third quarter of 2008), and lending trends also improve, so should inflation pick up once again, albeit gradually.

China represents perhaps the biggest current source of nervousness for the global investor, and its actions will also have an inevitable impact on any assessment over prospects for inflation. It is well-understood (and so arguably discounted) that the country faces a potential credit crunch and is going through a period of economic contraction. Industrial production has been negative for the last five months, retail sales are growing at their slowest pace in five years and housing market activity is decelerating. How the Chinese authorities manage this process is not clear, but faced with the choice of internal devaluation (recession, Eurozone-style) or external devaluation (currency depreciation), the latter would seem preferable. Such a strategy would have the consequence effectively of exporting deflation to the developed world.

Whether this trend would be strong enough to offset other, somewhat more positive developments at work in the west, is not clear. Moreover, any policy action in China will most likely be gradual: reform does not happen overnight and reining in shadow banking too forcefully may have the adverse effect of precipitating a run on such institutions. Perhaps a policy of moving slowly and even allowing some selective defaults therefore maybe makes more sense.

Even if China does constitute something of a concern, this should not preclude investing in emerging markets. As China-led growth and its era of cheap credit comes to an end, emerging markets will increasingly need to be judged on their own merits. Political change in a number of key countries (India especially) may provide an additional catalyst. That emerging equity markets have outperformed developed ones in the last three months is indicative both of increasing investor risk appetite and the compelling valuation argument (which we have advocated for some time) with regard to these assets.

Any discussion about equities and valuation should also clearly include consideration of Japan. The 8% year-to-date decline in the TOPIX needs to be seen in the context of a 50%+ rise in the index over 2013. The main Japanese market remains the strongest globally for earnings momentum, having delivered six consecutive quarters of beats relative to expectations. Meanwhile, share buybacks have accelerated, up over 50% year-on-year, according to Morgan Stanley. If these were not reasons enough to invest in the region, then the scope for more monetary easing, possible economic reform and domestic pension fund buying of equities should be additionally supportive. The picture in Japan is similar to elsewhere: there is a markedly stronger case for equities than for credit at present, given both valuation and prospects.

Alexander Gunz, Fund Manager, Heptagon Capital