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: despite all major asset classes delivering absolute gains in the first-half of 2014, investor sentiment appears far from euphoric. Concerns remain over growth prospects and Central Bank policy in particular. Investors would like – but may not get – a policy environment which is neither too simulative nor restrictive. The inevitability of eventual rises in interest rates combined with the current search for yield lead us to reiterate our preference for equities relative to credit. We continue to favour European markets in particular.

Asset allocation:

Equities: Earnings estimates have normalised in all regions and prospects look encouraging, driven by (relative) valuation, reasonable expectations and the additional positive drivers of M&A, share buybacks and increased dividends, all currently at record levels. Our preference for Europe and Japan (and also emerging markets for longer-term investors) is informed both by valuation considerations and the direction of Central Bank policy, which is likely to remain favourable in both these regions. Globally, bottom-up, alpha-focused managers should also continue to prosper in this current environment, which remains characterised by high dispersion levels.
Credit: With the spread between equity market free cashflow yields and junk bond yields being at its highest in 15 years and the gap between 10-year US Treasury yields and S&P earnings yields being at its widest in 12 months, it seems reasonable to ask how much further yields can compress. 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 $2.1trillion of global M&A has been announced so far in 2014, and activity in the US has already surpassed the record levels set in 2000. We expect this trend of deal-making to prevail for some time longer especially given high corporate cash balances, improving lending conditions and growing CEO confidence levels.

A relatively rare phenomenon occurred in the first six months of 2014: bonds (Sovereign and High Yield), equities (developed and emerging markets) and gold all increased in absolute terms. The last time this occurred was 2003. Meanwhile, the VIX index of volatility has continued to trend lower, reaching levels last seen almost a decade ago. However, not only have many investors struggled to make money so far this year, but there also seems to be a relatively limited sense of euphoria.

With regard to the former, many of the equity strategies that worked well in 2013 (particularly momentum) seem to have recently reversed, and while investors in peripheral Europe have seen local bourses rise around 10% on average, Japanese markets have declined and the UK’s FTSE is virtually unchanged. Mixed performance may partly explain investor attitudes, but other factors also matter. While it is easy to argue that much bad news – America’s Q1 deep freeze, the threat of Eurozone deflation, the impact of Japan’s consumption tax and the possibility of a Chinese credit crunch – is now behind us, or being dealt with – many uncertainties also remain.

There appear to be significant question marks over two major and interlinked issues at present: the sustainability of better economic news and the potentially confused messaging from Central Banks, particularly the Federal Reserve and the Bank of England (BoE). Other concerns remain over geopolitical instability in Iraq and its impact on the price of oil, whether lending will accelerate sufficiently in the Eurozone to offset the potential threat of deflation, and the relative extent to which China’s policy experiment of managing economic slowdown successfully will succeed.

The issue of Central Bank policy and its impact on growth is the most complex and inevitably exacerbated by the somewhat schizophrenic attitude on the part of many investors, namely, that they want growth, but not so much of it that interest rates would be forced to rise abruptly. As Bill Gross of Pimco writes, the ‘new normal’ for Central Banks is to operate a ‘new neutral’ policy, where the monetary environment is neither too restrictive nor too simulative. Managing such an act successfully is clearly not a simple process and it was notable, for example, that while Janet Yellen appeared to present a sanguine outlook for the US economy, she also used the word “uncertainty” on eight occasions during her last Fed press conference. Meanwhile, although Mark Carney stated that rate rises by the Bank of England “could happen earlier than investors expect”, he also added the caveat that the Monetary Policy Committee has “no pre-set course.”

The commentary from Janet Yellen and Mark Carney may partly be an exercise in expectations’ management, but the reality is that however accommodative monetary policy may remain for now, yields will eventually need to rebound in anticipation of higher policy rates. Even if the ‘new neutral’ means that real policy rates end up being lower than in previous decades, the prospect of more elevated rates does have clear implications for asset allocation strategies. Investors need to accept the reality that, at some stage, bond yields will have to normalise or, at least, transition towards normalisation. Against a backdrop of current Central Bank policy and close to zero returns from holding cash, the search for yield is evident. It is notable that the spread between the free cashflow yield of both US and Eurozone equities relative to their respective junk bond markets is at its higher in 15 years, according to data from Credit Suisse. Moreover, the gap between the yield on the US 10-year Treasury and that of the S&P 500 is also wider now than it has been at any other stage in the previous 12 months.

The case for owning (or preferring) equities relative to other asset classes at present, therefore, seems clear. We have regularly made the point in our research that valuation matters more than any other factor when considering asset allocation decisions. It is also worth bearing in mind that after a relatively disappointing first quarter earnings season (impacted by the factors cited earlier), there is scope for a potential earnings rebound in the upcoming quarter of results. Earnings upgrades would obviously help to sustain equity market valuations. Goldman Sachs, for example, notes that the trend of downward revisions to global earnings estimates ended in May, while in a separate piece of recent research, Credit Suisse highlights that US earnings revisions have recently turned positive for the first time in two years. Furthermore, although M&A activity has attracted many headlines, it should not be forgotten that (US) share buybacks and dividends are also both currently at record levels.

The more interesting question worth considering is how to position within equities. A simple analysis of current valuation levels and earnings estimates provides a useful perspective. Using Morgan Stanley data, the US market trades on around 16x forward earnings and offers c9% earnings growth. Contrast this with European markets, trading on lower multiples (13-14x) and offering superior earnings growth (10-12%). The argument for emerging markets is potentially even more persuasive, with valuations in the range of 5-15x and 10-20% earnings growth, dependent on the specific market. The rate of earnings revisions is also currently faster in emerging markets than anywhere else globally.

These considerations are highly relevant and help to explain our current preference for European equities. Even if such a stance is now more consensual than was the case a year ago, if the region is able to deliver 40% earnings growth over the next three years (the forecast of Credit Suisse), then the case is compelling. It is also clearly notable that while the Fed and the BoE may be at the beginning of the long journey towards tightening, Mario Draghi has made it quite explicit that the European Central Bank (ECB) is far from finished with regard to the use of unconventional policy to stimulate growth. Notably, with 15 of the 24 members of the ECB’s Governing Council now coming from peripheral nations (and with the Bundesbank having also explicitly supported Draghi’s recent actions), the clear emphasis on growth and reflation is likely to remain for some time. It is encouraging to see that the most recent lending survey from the ECB already showed that credit growth is improving in the region at a faster rate than any other globally. Meanwhile, ISM (industrial activity) surveys show that growth in the periphery is now ahead of that in core Europe, the first time this has been the case since August 2007.

The other implication from Mario Draghi’s actions is that they may help legitimise Haruhiko Kuroda at the Bank of Japan (BoJ) to do more in terms of policy action. While investing in European equities may be broadly consensual, doing so in Japan is much less so. However, not only have earnings multiples compressed since the since the start of this year, but there are clear catalysts ahead, which should help reinforce the already-improving outlook for the country. First-quarter GDP growth of 6.7% annualised was the strongest in more than 15 years, helped by increased non-residential investment. That Japanese corporates have been increasing their spending on capital equipment reflects a clear improvement in confidence. Prime Minister Abe has also recently committed to reducing corporation tax and, looking ahead, the BoJ is poised to announce further monetary stimulus before the year-end. Finally, it seems likely that the country’s largest state-owned pension fund may start its programme of increased equity allocations in the coming months.

European and Japanese equities remain our highest conviction investment ideas, but longer-term investors should also consider the case for emerging market equities. The valuation/ growth attractions were highlighted previously and recent data has suggested that the Chinese economy may be stabilising. A weaker Yuan has helped drive export growth (on a three-month seasonally-adjusted basis) to its best since the start of 2011, and hence industrial production has turned positive once again. However, there remains no scope for complacency, particularly in the context of China’s well-documented credit issues. Low equity market volumes over the summer months may also exacerbate moves (on the back of either positive or negative news) in all markets. Nonetheless, we expect equities to continue their upward drift for now.

Alexander Gunz, Fund Manager, Heptagon Capital