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.

In the light of the recent geopolitical events and market volatility I would like to update you on our thinking and Heptagon’s portfolio positioning.

Despite a pull-back in recent days, the MSCI Global Index hit a 52-week high on 27 January and has risen 2.1% year-to-date. Confidence levels and attitudes towards risk have improved in the last few months, and it seems likely to us that the ‘risk trade’, especially towards equities, is set to remain in place for a while, implying potentially attractive returns for investors. Although the global economy still faces some major structural issues (particularly with regard to unsustainable debt and the ongoing painful process of deleveraging), which could imply a painful hard-landing over time, we can see several key reasons why riskier assets may continue to outperform in the near-term:

• Context: recent events in the Middle East will have very little impact on the near term profitability level of corporate America.
• Monetary policy favourable: in the US especially, reality (low inflation) and rhetoric (signalling from the Fed that it will do all it can to support the economy, especially in year-three of the US electoral cycle) imply that monetary policy should stay ‘market-friendly’ for a while longer. This will not only help spur consumer and corporate sentiment, but also favour equities.
• Low interest rates also mean more cash for investors in equities: record corporate cash balances imply the potential for significant and sustainable cash distributions to shareholders via share buybacks, dividends and increased M&A situations.
• The cost of capital is low too: for those large companies needing to raise capital in the corporate debt market, it is currently possible to do so at very attractive rates.
• Fiscal policy also benign for now: the extension of the Bush tax cuts helped remove a major uncertainty about which investors had been concerned. Moreover, the Obama administration now seems to be considering a reduction in the corporate tax rate.
• Valuation: equities continue to look too cheap, especially relative to fixed income markets: Currently, the return on cash is essentially zero, 10-year Treasury-note yields are 3.4%, investment- grade-bond yields are 5.5%. In comparison, for the S&P 500, the earnings yield is currently 7.5%, the free-cash-flow yield is 6.5%, the dividend yield is 2.0%, and trend growth in earnings and dividends is 5%-7%. In the light of the above, it seems to us that equities should be the allocation of choice for the few quarters to come. (please note that HY bonds are yielding 7.9% but offer little scope for further significant compression in yields).
• And, context again – play the Presidential cycle: historically, there have been very strong equity returns (albeit with significant volatility) in the third year of the presidential cycle ( 18.3% average annual return for the past 60 years).

On the negative side, we would not deny that substantial risks do exist and we will continue to monitor how these play out and when they may influence our decision to take a somewhat more cautious equity stance:

• Inflation is a problem in EM, especially China. EM equity valuations also look demanding to us.
• There is an above-average likelihood of a further deterioration in EU sovereign debt risks.
• Global current account and currency imbalances suggest that there may be a rise in protectionist sentiment / capital controls, especially in EM countries.
• And, if inflation does materialise in US, then base rates may need to rise, potentially much more quickly than sentiment is currently willing to discount.

Conclusion: risk trade on for now, but do not forget that risks remain.

With best regards, Arnaud Gandon, Chief Investment Officer; Alex Gunz, Fund Manager.