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: we retain our positive stance on equities relative to other asset classes, even as the prospect of higher interest rates in the US moves closer. Rallies are rarely linear and it has been many months since markets have experienced a notable drawdown, but when we assess fundamentals, we see support provided by valuation levels and an improvement in the business cycle, while we believe geopolitical tensions should have only a temporary impact. Europe, Japan and emerging markets are our favoured equity regions.
Equities: With corporates across the world generally exceeding expectations in recently reported results, valuation levels are receiving support from earnings upgrades rather than being driven just by multiple expansion. The improving outlook highlighted by many businesses should also see this trend sustained. We currently see greatest scope for upgrades in Europe, Japan and emerging markets, and this is reflected in our preference for these regions. The direction of Central Bank policy is also likely to remain especially favourable in these two former regions. Global, bottom-up, alpha-focused managers should continue to prosper in this current environment.
Credit: The search for yield continues to dominate investors’ approach to credit, and it remains reasonable to question the extent of further compression, particularly when the German 10-year is, for example, offering just 1.2%. Even if the US 10-year has moved slightly upwards from its lows, we see a limited investment case until levels of at least 3.0%are approached. Our broader approach within credit remains one of selective allocations, particularly towards managers with flexible mandates and differentiated strategies.
Alternative Asset Managers: There remains no change to our thesis for and hence allocation towards event-driven managers. Over $2.5trillion 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.
Many developed world equity markets (including the Dow Jones) are now in negative territory for the year. A plethora of concerns are cited for this trend including the risk of imminently higher US interest rates, demanding valuation levels, uncertain economic trends and geopolitical tensions. Although it would certainly be fair observe that the current investing environment remains characterised by an under-current of pessimism and also that the most recent phase of the equity bull market that began in 2009 has been a grinding affair, one of short sell-offs followed by renewed highs, our contention remains that for broad asset allocators, equities remain the best place to be, for now.
In our view, we believe that the following three observations can be made, and these influence our investment strategy. First, it is inevitable that US interest rates will rise, and almost certainly within the next year. However, not only is such a scenario typically initially better for equity than credit investors, but also monetary policy will continue to ease in many other regions (particularly Europe and Japan). Next, while the prospect of higher rates may lead to a partial contraction in equity valuation multiples, the current robustness in earnings – across all regions – is encouraging. We have argued for some time that earnings growth rather than multiple expansion will provide the necessary support for equity markets. Finally, we find little evidence to suggest that geopolitics act as an undermining factor for equities. Rather, the business cycle matters much more. With global industrial output at close to three-year highs (and trade volumes at all-time record levels), both corporates and consumers across the world seem notably more confident than in the recent past, a view perhaps not embraced by many more sceptical investors. Each of these points merit more detailed consideration.
It is perhaps impossible to believe that the transition to a new monetary regime of higher rates in the US can be managed seamlessly. Indeed, the unprecedented nature of the Fed’s recent monetary experiment suggests that there is a greater chance of policy error as the move towards normalisation occurs. Such a view is perhaps only reinforced by the level of dissent that seems to exist among members of the Fed’s Board, as evidenced in recent speeches and minutes. Nonetheless, the prospect of higher rates at some stage in 2015 has been very well-flagged and so the reality of rises, when they happen, may come as little surprise to investors, perhaps in a manner not dissimilar to what happened when tapering was first introduced. This prospect of even gradual rates rises combined with the current strength of the US economy, implies directionally higher Treasury yields, and also a stronger Dollar.
The situation in America contrasts very strongly with that in other regions. Although credit conditions for corporates in the Eurozone improved for the first time since 2007 according to the European Central Bank’s most recent lending survey, the region’s growth is still somewhat lacklustre and remains characterised by a notable absence of inflation. At 0.4%, the rate has not been this low since 2009. This compares to a current 1.9% rate in the US. Admittedly the ECB has yet to implement its next round of de facto easing, but perhaps as with Japan, the longer Europe goes without much-needed monetary stimulus the greater will be the size of the programme and its subsequent impact when the event ultimately occurs. Recent comments from the Bank of Japan also pave the way for more quantitative easing this autumn.
There are clear investment implications from this regional divergence. The most effective investment strategy for some time has been to follow Central Bank balance sheet expansion, and we see little reason for this to change. Moreover, should the ECB and BOJ continue with their current strategies, this implies notably weaker currencies in these regions too. With regard to the Euro in particular, it has already fallen from €1.39 relative to the Dollar to €1.34 in the last three months. Should the ECB’s targeted long-term refinancing operation be taken up in full, then the Central Bank’s balance sheet would return to its peak-level of mid-2012. At this time, the Euro traded at €1.20.
A weaker Euro is inevitably supportive for exporters and also for corporates earnings. As such, it should strengthen the already encouraging trend witnessed in the most recent results season. To-date, there have been 6% more beats than misses by Eurozone companies, the best quarter since the beginning of 2012 (according to Morgan Stanley). Furthermore, guidance has been notably less negative than in previous quarters, admittedly helped by the currency outlook. This trend of better results has also been replicated elsewhere, with 77% of US companies having exceeded consensus expectations this quarter by an average of 1% at the top-line and 5% at the earnings level. Annualised earnings growth should reach 9-10% in the US in 2014, consistent with the forecast outlook at the start of the year, but a notable improvement relative to where they stood at the start of the previous quarter. A similar trend has been witnessed in Japan.
Even if there exists debate about how to position within equities, the case for equities relative to other asset classes should be clear. Earnings momentum is inevitably supportive for valuations. Faced, for example, with a choice of a 1.2% yield on a 10-year German government bond (the lowest it has been in almost 200 years) or a 3.5% dividend yield for the Euro Stoxx 600, most investors should have little trouble deliberating. The same argument also holds in the US, although somewhat less persuasively. The case for owning credit over equity in the US probably only becomes a subject of debate when the US 10-year Treasury moves above 3.0%, against its current 2.5% rate. Moreover, Janet Yellen’s comment regarding valuation metrics in some sectors appearing “substantially stretched” should be seen in context: the NASDAQ market currently trades on 19x earnings, a long way below both its long-term average of 27x and its 2000 peak of 72x.
Might geopolitical dislocation have an impact on equities and pressure valuations? There are clear areas of tension in both the Middle East and Russia-Ukraine at present, but these warn-torn nations together account for just 3.0% of global GDP, 2.6% of world trade and 0.8% of corporate profits (according to analysis by JP Morgan). Furthermore, history shows that while such conflicts can have a near-term impact on sentiment, with the exception of the Israeli-Arab war of 1973 (when a Saudi oil embargo against the US led to a quadrupling of oil prices), these confrontations rarely have a long-lasting effect on equities or their earnings potential.
Beyond valuation, which we have already considered, the other notably important factor for equities remains the business cycle. In this respect, we are also encouraged. In the US, annualised GDP during the second quarter expanded at 4.0%, indicative of a strong recovery. Looking ahead, inventory levels are low, durable goods orders are rising (up in four of the last six months) and corporate spending intentions are at a 10-year high. M&A activity is also indicative of corporate optimism. Such a backdrop is also consistent with an upward path for Treasury yields and the Dollar, as discussed earlier. Furthermore, in Europe, additional easing of lending standards, a weakening of the currency and the practical implementation of monetary stimulus should pave the way for an acceleration in the business cycle here.
Emerging markets provide a further bright spot. Beyond recent equity market performance (six consecutive months of positive returns), the outlook appears to have stabilised. After substantial currency declines, industrial output is now improving, while political change in India and Indonesia (potentially Brazil too, later this year) is also helpful for longer-term prospects. China’s GDP has also accelerated and it appears that state-led rebalancing is having a positive impact. While some of this equity market performance has inevitably been helped by falling US Treasury yields, a reversal of this trend may not be overly negative and indeed current emerging market equity multiples are lower relative to comparable developed market levels than was the case before the US began its first quantitative easing programme. This suggests that opportunities clearly remain for equity investors globally, even as US rates begin their inevitable rise upwards.
Alexander Gunz, Fund Manager, Heptagon Capital
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