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: global equities continue to move in a broad upward direction despite over five years of improvement, but government bond yields (in either nominal or real terms) are also making all-time lows. While there is a natural tendency to find reasons why such an outcome might not be sustained, from a simple relative valuation perspective, we continue to favour equities. Still loose global monetary policy and positive earnings revisions support the case. US interest rate rises remain some way off and will put a generally greater emphasis on corporate fundamentals, but reinforce our preference for European and Japanese equities. We also continue to expect the Euro and Yen to weaken further relative to the Dollar.

Asset Allocation:

Equities: Global earnings momentum recently turned positive for the first time since 2011 and has the potential to be sustainable. In Europe and Japan in particular, weaker currencies, below-average margins and stimulus (monetary and broader economic) should help. Fewer of these drivers are available in the US, where valuation levels are also more demanding. In emerging markets, the opportunity-set remains significant, particularly over the medium-term. Such an environment should favour active managers, and despite 2014 being so far characterised by high dispersion levels between outperformers and underperformers, we continue to advocate global bottom-up investment strategies.
Credit: Our argument has been consistent with regard to credit for some time, namely, that even if yields do compress still further, the relative attractiveness of this asset class seems limited. We find it difficult, for example, to make the case for 10-year German debt yielding less than 1%, when European equities offer an average dividend of more than 3.5%. Participating in the enthusiasm for credit also means running the risk of participating in the correction. As a consequence, our approach remains one of highly selective allocations, favouring managers with flexible mandates and differentiated strategies.
Alternative Asset Managers: We have made the case for event-driven managers for around a year now and they have delivered clear returns in this period. Our conviction remains as M&A continues unabated. 2014 is set to be the best year for deal-making since 2007 with $3.2trillion of announced deals so far, and further activity seems likely given corporate cash balances and CEO confidence levels.

When assessing monthly movements in equity markets, investors perhaps have a tendency to overlook the fact that the MSCI World has risen substantially since its March 2009 low. Such a performance is impressive on any account and against this background, minor setbacks should logically be expected and are, arguably, even necessary too. It seems that the concerns voiced to us by many in recent weeks – relating to the direction of US monetary policy, growth prospects in both Europe and China as well as ongoing geopolitical uncertainty – are nothing new. More importantly, the broader narrative has not changed. In other words, although growth and monetary dynamics remain highly unsynchronised across the world, several things seem evident: global monetary policy continues to be loose and visible; positive earnings revisions are rising; and, most importantly, the choice of where to invest is clear to us.

Any simple analysis demonstrates that the yields on ten-year government debt are at record lows across almost all geographies. In other words, investors exposed to this asset class earn almost nothing in exchange for notional risk-free exposure. However, even if the US equity market may be close to an all-time nominal high, there are many other regions (particularly Europe and Japan) where equities remain highly compelling, given recent performance and hence corresponding valuation. Moreover, in clear contrast to conventional credit, equity investments continue to offer meaningful yield: more than 60% of European stocks currently have a dividend yield ahead of the yield on domestic government debt (according to Goldman Sachs), while the headline 3.7% dividend yield of the Euro Stoxx contrasts with a sub-1.0% yield on 10-year German debt.

The key debate in our minds, therefore, centres on how to position within equities. A second issue, which we will also discuss below, is what could most undermine the near-term case for this asset class relative to others. In terms of equities, it is worth highlighting again (as we have done in several previous commentaries), the divergence between Europe and the US. Data courtesy of Barclays Capital puts the argument very succinctly: US earnings are at peak levels; European earnings are roughly 30% below peak. Meanwhile, Europe is set to enjoy forward 12-month earnings growth of more than 12%, well ahead of the global average and also of US levels. Given the relative underperformance of Europe year-to-date (German equities are even in negative territory since the start of 2014, creating a potentially notable opportunity), the argument is all the more persuasive.

At this stage, a reference to Japan is highly valid. We were early advocates of the case for owning equities in this region (having first invested in late 2012) and have retained a positive stance since then. Often the best time to invest in any asset is when scepticism and dissension are highest. Indeed, in the 12 months subsequent to the Bank of Japan’s (BOJ’s) initial programme of quantitative easing, the Yen fell 24% and the Nikkei rose 40%. Return to Europe and we see a Euro that has weakened less than 10% from its May 2014 high, with most of this decline occurring even prior to the implementation of accommodative and unconventional monetary policy. With more than 50% of European corporate earnings deriving from outside the Eurozone (according to Credit Suisse), a weaker Euro is undoubtedly helpful. Indeed, every 10% decline in the currency, boosts earnings by around 5%, while having a broader positive effect on the Eurozone’s outlook, adding about 0.5% to GDP and 0.7% to inflation, based on the European Central Bank’s (ECB’s) own calculations.

Importantly, both Japan and Europe are still also in the early stages of their monetary experiments, a clear contrast to where the United States currently finds itself. Three points matter: first, investors should expect more from both the ECB and BOJ; next, such an outcome implies that overall global monetary policy will remain highly accommodative; and, finally, even if the US starts to raise rates in the coming months, equities still have the potential to outperform.

With regard to the ECB, Mario Draghi has consistently exhibited a high degree of pragmatism and flexibility towards policy-making, highlighting that the door is not shut on formal quantitative easing (QE). The Bank will likely monitor the success of the targeted long-term refinancing operation (TLTRO) and asset-backed security (ABS) purchases before deciding on how next to act. The precedent of the US is also meaningful: the Fed’s experiments with QE demonstrate that the policy’s potency is strongest if implemented just as the cycle is turning. In other words, European QE would likely have a more meaningful impact against a backdrop of an already weaker Euro and hence likely improving industrial production figures.

This argument also has validity in the context of Japan (and contains a further lesson for Europe too). The reason why Japanese earnings growth has been so impressive is not just a function of a weaker Yen, but also the result of structural change. Corporates across the country have actively reformed, improving governance and increasing their focus on shareholder returns, while the government has also made notable steps to reduce bureaucratic inefficiencies. As a consequence, when the BOJ announces a further round of QE – which we believe is highly likely before the year-end – the impact should be all the more potent, given that solid foundations have now been put in place. Returning to Europe, it is easy to see precisely why Spanish industrial production is at an 8-year high (and Irish output at a 16-year peak) – simply because these countries have undertaken necessary structural reform. In order for European QE (or even TLTRO/ABS purchases) to be most effective, structural reform should take place simultaneously; a clear lesson for France and Italy.

In the last 12 months, the Federal Reserve’s balance sheet has expanded by $830bn, despite tapering. Mario Draghi has already stated that he believes the ECB’s balance sheet will return to its 2012 peak of €1trillion and if we assume possible additional BOJ and/or ECB stimulus, then it seems clear that global money-printing in 2015 will be at least as notable as 2014 levels. Moreover, even assuming that (mid) 2015 marks the time that the Fed first raises rates, this may not be a negative outcome for global equities. Janet Yellen has stated consistently that the Fed’s course of action remains data-dependent. While it is notable that most US economic statistics continue mostly to surprise on the upside, pointing to an accelerating growth outlook, a number of studies suggest that the American economy is still around two years away from operating at full capacity (based on payroll growth estimates or when labour has meaningful bargaining power).

Nonetheless, in the context of the five-year bull market in equities, investors should be prepared for some volatility when the Fed does eventually start to raise rates. Geopolitical instability remains an additional, perennial, concern. Past studies discussing when equity markets peak prior to a first rate rise and the time it takes them to recover may have relatively limited application in this cycle given the unconventional nature of monetary policy since 2008. At the least, it seems reasonable to expect some market instability and potential dislocation. While such an outcome may impact equities negatively globally, it also reinforces the argument of relative preference for Europe and Japan ahead of the US.

A progression towards higher interest rates in the US has also tended to undermine the near-term case for emerging markets. However, this does not take into account the extent of reform and rebalancing that has been undertaken in many such countries. It is worth highlighting in particular that there has been a growing recent emphasis in China on investing in national infrastructure (such as railways and healthcare IT) while also improving supply-side economics. These should have clear longer-term benefits beyond the additional notable recent strength witnessed in Chinese equities.

Alexander Gunz, Fund Manager, Heptagon Capital