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: the investing environment will remain challenging. This is the simplest (and hopefully most accurate) prediction we can make about the coming year. At some stage, something has to give. Bond yields can neither decline indefinitely nor equity markets defy gravity. Central Bankers are not omnipotent and politicians are almost always meddlesome. Against this background, our emphasis remains firmly on highly differentiated and uncorrelated investment strategies across all asset classes. Our focus is on what makes most sense, at the right price. We see a case for a stronger Dollar and for selected equities on a relative basis.

Asset Allocation:

Currencies: Central Banks globally are likely to remain in dovish mode. Even if US interest rates do rise during 2015, they are a long way from this point elsewhere. Money printing in Europe, Japan and China will see these countries’ currencies weaken in an effective race to the bottom. By default, the US Dollar should strengthen further.
Equities: US equities have outperformed almost every other global market in 2014 and look to be a broadly less risky investment than many others at present. Nonetheless, mean reversion is a powerful concept and things would not have to get much better in either Europe or Japan for these markets (which trade on notably lower multiples with better growth prospects than the US) to rerate significantly. Many emerging markets also look currently undervalued.
Credit: When we think about what has to give, our expectation would be more for credit than equity. Global government bond yields are at multi-year or record lows in almost all developed markets. Should there be further declines, this only reinforces the relative unattractiveness for this asset class. Investors need to be highly selective and concentrate their focus on managers with flexible approaches, able to invest across the credit spectrum.
Alternative Asset Managers: We continue to see a place in portfolios for event-driven strategies. Deal-based activity has risen over 60% year-on-year so far in 2014 and should remain significant given corporate cash balances and CEO confidence levels. We are also reviewing the case for other alternative strategies.

Most investor letters at this time of the year contain forecasts or expectations for the following twelve months ahead. We all like to feel reassured that the world is probably going to be better in the future than it is in the present and make our decisions around such an assessment. Yet the art of prediction is precisely that; something highly subjective and intangible and very often wrong – although, of course, we only know this with the benefit of hindsight. The events of 2014, characterised in investment terms by a market in which both equities gained and credit yields contracted, certainly confounded most expectations. It seems likely that 2015 will be little different.

While there will be some inevitable assumptions or predictions made on our part in the commentary below, our starting point is to focus on the realities of the current investing environment. Although the following may not be a typical message of seasonal cheer, our simple assessment is that it will become increasingly more challenging to generate returns, or at least the returns to which investors have become accustomed. Put another way, investors should consider that yields on government bonds are at multi-year or record lows in almost all major developed economies while the equity market has witnessed a broadly uninterrupted upward trend since its lows of March 2009. Something has to give at some stage. Credit yields cannot compress indefinitely and bull markets do come to an end.

It is, however, hard to know when. Even if the world remains littered by policy distortions and imbalances, Central Bankers in particular will continue on their uncharted path of monetary manipulation. While the theory remains that both investors and consumers in the real world should be incentivised to take on more risk as a result of Central Bank actions, the clear danger of such an approach is that it potentially generates excess moral hazard and therefore only creates new problems further down the line. We doubt Central Bank intervention is going to go away any time soon (indeed, it should remain highly visible during 2015), but with this added complexity in mind, it clearly behoves us as asset allocators to consider highly differentiated and uncorrelated investment strategies across all asset classes.

Where to begin? In previous commentaries, we have outlined various elements of our investment philosophy, but it seems important to highlight some core elements here. In particular, valuation is paramount. Rather than spending time worrying about GDP growth, our effort is spent on considering whether or not assets are cheap. Indeed, countless academic studies highlight that the correlation between economic growth and (stock) market returns is close to zero. It also follows from this that the best time to consider an asset is when it is most out of favour. When assessing the year ahead, it is therefore important to attempt to separate the ‘noise’ from the ‘signal’ (to paraphrase Nate Silver) and distinguish between economic, political, fundamental and technical developments.

A quick tour around the globe shows some very different trends at work in all the main regions. Beginning with the US, the economy seems to be improving with third quarter GDP growth recently revised up and unemployment at a six-year low. It is not yet clear when the Federal Reserve will raise rates, but there is certainly no evidence of wage inflation at present and when two new members join the Federal Open Market Committee in 2015, they will likely be of a dovish hue. With the budget deficit falling (to less than 3.0% of GDP relative to a 2009 peak of 10.0%) and the Republicans controlling both the House and the Senate, the political environment should also be relatively benign. The only problem, however, with such a roseate outlook is that much of the above already seems reflected in equity market valuations.

With regard to Europe, 2015 may well see a reverse of this 2014, namely where expectations for growth will start the year ahead cautiously but end it strongly. ECB President Mario Draghi has made beating deflation his objective and it would seem likely that the European Central Bank will embrace further stimulatory actions. However, monetary stimulus is not sufficient to drive Europe out of its current malaise, only necessary. In other words, structural reform is required, particularly in France and Italy, even if it may be unpopular. The outlook for Europe is also somewhat clouded by political uncertainty. Extremist politics seem to be on the rise in many countries and elections are scheduled for the next year in Greece, the UK, Portugal and Spain. Moreover, clearly any signs of further economic weakness (occurring before the potential benefits of reform and stimulus kick-in) could stretch the glue that currently binds Europe together.

An election will also be central in investors’ minds when considering Japan, even if it will take place this year, rather than next. On 14 December, Prime Minister Abe will seek to win the support of the Japanese people, allowing him to govern through to 2018, coincidentally the timespan during which Central Bank Governor Kuroda will also remain in his role. It seems likely that Abe (and Kuroda) will be given an extension of their current mandate and growing signs of coordination across the Japanese business, economic and political spectrum are only to be welcomed.

Turning to China and coordination is nothing new in this country, but the year ahead will likely provide further evidence of the authorities’ ability to manage the transition from a production-led to consumption-based economy at the same as economic growth slows. Elsewhere in the emerging world, in contrast to 2014, where elections dominated the agenda in many countries, there are no major such events scheduled for the coming year. In other words, investors will need to focus more on fundamental prospects, which will inevitably be impacted by developments in China and elsewhere. One additional China-specific factor to consider is the development of the Shanghai-Hong Kong Stock Connect programme, which should enhance the prominence of the domestic Chinese equity opportunity. While far from a panacea, it constitutes another indication of the authorities’ intentions to make the market more accessible.

We can conclude four things from the above. First, there seems to be a clear decoupling occurring at present, with the US economic outlook improving while that for the rest of the world remains mixed. It is less clear though whether the US will continue to get better or the rest of the world will catch up. Regardless, the 30% drop in oil prices over the last year should provide a fillip for consumer confidence and hence GDP in most industrialised nations. Next, even if the US does raise interest rates next year (which is not guaranteed), global monetary policy will remain loose, driven in particular by action in Japan, China and Europe. Indeed, the recent moves on the part of the Japanese and Chinese monetary authorities may force the ECB into an even more aggressive stance. Third, and related to the previous observation, the corollary of looser money is a weaker currency. The ‘race to the bottom’ between the Yen, the Renminbi and the Euro probably means that the Dollar will continue to strengthen by default. Finally, betting on US equities has generally been the ‘right’ trade for the last five years, with the S&P outperforming the Stoxx Europe 600 by more than 60% in Dollar terms over this period. It may also be the right trade for 2015, particularly if politics end up undermining prospects in Europe (and also perhaps Japan).

Nonetheless, we leave you with the tantalising concept of mean reversion, namely that prices or valuations will eventually converge back to average levels. Consider current valuation data and the argument looks persuasive. US equities trade on 15.2x forward earnings and 2.8x book value, with forecast earnings growth of 11.6%. By contrast, the metrics for Europe are 13.4x earnings, 1.7x book and 12.7% EPS growth. For Japan, they are 13.9x, 1.3x and 13.0% (all data courtesy of Morgan Stanley). In other words, should things just get a little better in Europe and Japan, then the scope for an equity market rerating in both these geographies is significant. Investors often under-estimate the time that it takes to build consensus, especially among politicians and bureaucrats. In Europe, with 28 sets of country-specific interests to be reconciled it is arguably even more complicated. Nonetheless, the analogy of a super-tanker remains a highly valid one: while it does take a long time to change direction, once it does, its impact can be very powerful.

Alexander Gunz, Fund Manager, Heptagon Capital