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: even with the S&P at an all-time nominal high, the investing environment continues to be characterised by profound uncertainties. Despite notable swings during the past month, government bond yields continue to trend lower as equities move reluctantly higher. Our conviction remains one of continuing to favour equities relative to bonds, but the more interesting debate relates to what moves in the bond market mean for the broader investing environment. If the bond market is perhaps right and there is a risk either of potential global recession or Central Bank policy error, then there are clear ramifications. The conclusion is to focus on which investments make most sense: a stronger Dollar and the relative case for certain equities.

Asset Allocation:

Currencies: The Dollar has strengthened more during the last quarter than at any stage in the last six years and should rise further. This is a function of deflationary tendencies globally, particularly in Europe and Japan, which are seeing correspondingly weaker currencies. Dollar-exposure has been increased in Euro-denominated portfolios.
Equities: We continue to favour this asset class on a relative basis. From a valuation perspective, the strongest case can be made for European and Japanese equities at present. However, Europe (and emerging markets) potentially face a more challenging near-term outlook than other regions, even if the scope for medium-term turnaround is substantial. US equities typically tend to benefit from a stronger Dollar and may also be seen as a comparatively less risky asset should uncertainties persist. Although active equity managers have generally struggled this year, we also believe that the environment remains conducive to alpha-capture.
Credit: Global government bond yields have declined further during the past month, only strengthening our view about the relative unattractiveness for this asset class, even if yields do compress still further. 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 strategies for around a year now and although many managers have been exhibited notable volatility during the last month, we retain our conviction. M&A activity remains significant despite a number of recent high-profile deal failures, and corporate cash balances combined with current CEO confidence levels reinforce the case.

If it is possible to highlight one dominant trend from the first ten months of investing this year, then it has been that global equity and bond markets have consistently confounded investor expectations. Amidst this background, it is hardly surprising that not only is sentiment somewhat fatigued but also that it actually takes very little to unsettle investors at present. Indeed, in October alone equity markets saw both their worst one-day fall in the last three years and their biggest single-day rise since the start of 2014.

Substantial uncertainties remain in four key areas: economic growth, corporate earnings, Central Bank policy and geopolitics. This is nothing new per se, but it is important to recognise a subtle nuancing of the thesis in each of these key areas. It would be fair to characterise the current environment as being one where global GDP growth is not markedly slowing, even if it is not improving; current quarterly earnings have generally exceeded expectations even if they have not been stellar; Central Banks are not going anywhere anytime soon, even if quantitative easing (QE) has now ended in the US; and, geopolitical noise is somewhat lower than in the recent past, even if it has not gone fully away.

Underlying these observations remains the issue of valuation and while the story of 2014 so far has been one of reluctant upward gains for most equity markets, moves in the bond market have been more startling. As has been well-documented, the yield on the US 10-year has plummeted from 3.0% at the beginning of the year to just 2.3% at present, having touched an intra-month low 2.1%. Yields on European government debt have also declined markedly. While it is therefore easy to make the case for equities relative to bonds, as we have done throughout the past year, the additional important consideration relates to what may the move in bonds mean for the broader investing environment? Put another way, what is the bond market telling us that perhaps equity investors might otherwise be missing?

We believe there are two plausible explanations. First, with some signs of global recessionary pressures building, yields may be falling in recognition of their safe haven status. Alternatively, the decline in yields may be in light of investor concerns over a possible policy mistake by Central Banks, in particular the Fed with regard to its interest rate policy. Neither is mutually exclusive. And, under either scenario, it is possible to reach the conclusion that monetary policy alone cannot resolve underlying economic issues. If this is true, then it only reinforces the importance of focusing on fundamentals.

It would clearly be premature and potentially inaccurate to talk of global recession as a threat, but it is nonetheless important to recognise a combination of concerning factors. The US Dollar has strengthened notably, commodity prices have fallen substantially (exacerbated by Dollar strength) and growth is slowing in several regions. These factors are all necessarily interlinked. Chinese GDP growth for the third quarter of 2014, for example, was at its slowest since early 2009. While it is clear that China is transitioning from more of a producer to a consumer nation, this does have ramifications in other regions. Moreover, the risk of policy error in China cannot be totally discounted, especially with total debt at 200% of GDP and credit growth running at three times the rate of GDP. Slower growth in emerging markets inevitably impacts other regions and particularly the Eurozone, its largest trading partner.

The IMF notably lowered its global growth forecasts during October, but highlighted specifically a 40% chance of recession within the Eurozone during the next year. For this region, there is currently a distinct lack of growth in both the economy and in lending at present. The consensus view is that ECB President, Mario Draghi, will be able to solve both. The challenge is not insignificant, however. European industrial production may still be expanding, but its pace has slowed to its weakest in 14 months. Meanwhile, the continent’s two largest economies are under pressure: German exports are suffering in light of weaker emerging market demand, with factory orders at their weakest in over five years; in France, the economy is close to technical recession. Italy (the fourth largest) is already in recession.

Admittedly, Europe may still be three years behind the US in terms of economic recovery, but the pace of its policy response and rate of reform has only been about one-third of American levels. The Asset Quality Review with regard to the region’s banks may have lifted some uncertainties about creditworthiness and could provoke an acceleration in lending. In addition, the ECB has started tentatively to expand its balance sheet. Whether this is sufficient remains unclear. While there is much expectation laid on the possibility of a European version of full-blown QE, its effectiveness may be constrained by already-low bond yields. Moreover, this potentially ignores the key challenge of implementing effective structural reform, liberalising labour markets and promoting a culture of entrepreneurship and innovation.

If there are some potential questions over the credibility and effectiveness of European Central Bank policy, then a similar charge could be levelled at the Federal Reserve. In addition to the notable decline in 10-year yield year-to-date, the spread between the 10-year and the 30-year Treasury has narrowed notably. In other words, the US yield curve is flattening. Investors with long memories may recall that the last time this occurred was back in 2007-8, just prior to the credit crisis. Is there perhaps then a risk of policy error on the part of the Fed? Such a thesis may also explain recent nervousness on the part of equity investors. Mid-cycle corrections often occur when there is a change to Fed policy, just as was the case in 1994 and 2004. The formal ending of QE may account to such a change. Clearly if the Fed were to go further and raise rates too quickly, then there would be an evident risk of choking off the burgeoning recovery currently underway.

The quarterly ‘dots’ or interest rate projections published by the Federal Open Market Committee suggest that US rates may be at 2.75% by 2016. Such an outcome would imply a rapid and regular move up in rates from their current 0.25% level and would, understandably, be concerning to investors. Nonetheless, it should not be forgotten that the Fed has a dual mandate, to manage unemployment and inflation. Unemployment may be at a rate of less than 6% at present with the Fed noting a ‘substantial improvement’ in labour market under-utilisation, but importantly there remains a palpable absence of inflation. Core US inflation is running at 1.7% and has been below the Fed’s 2.0% target for the last 28 months. Meanwhile, labour market inflation continues to track at less than 2.0%, helped by a combination of market slack, increasing automation and developing technologies. A stronger Dollar is also inherently deflationary, with Europe and Japan effectively exporting their deflation to the US. With no inflation evident, no imminent rate rises seem likely. The Fed, therefore, has to weigh up the reassurance it would gain from pushing out its dot projections, relative to the loss of credibility it may endure from shifting somewhat its stance.

Should the Fed embark on this former course of action, changing its projections, then inevitably the Dollar may weaken somewhat. However, this may take time and also does not take into account current deflationary tendencies and Central Bank strategies elsewhere, particularly in Europe and Japan. Investing is both an absolute and a relative game. With this in mind, we continue to believe in the secular Dollar story. Such a dynamic typically tends to benefit US equities on a relative basis. Furthermore, while Europe, broad emerging markets and Japan offer more current potential recovery and valuation upside potential than the US, near-term conditions in these first two regions are somewhat more challenging. Japan, at least, has announced an explicit expansion of its monetary base, is implementing structural reform and should soon see its state pension fund markedly increasing equity allocations.

Alexander Gunz, Fund Manager, Heptagon Capital