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.

The great British obsession with the weather and the performance of stock markets would appear to have little in common. However, just as weather-watchers have been asking for how long the unseasonably warm temperatures that Britain has recently been experiencing can endure, so investors are questioning the sustainability of the year-to-date gains equity markets have enjoyed. Our position has been one of pragmatic scepticism; we have increased weightings selectively towards equities, but continue to favour credit for now (emerging market, high yield and quite explicitly not G7 Government bonds), preferring to wait for a pull-back in global stock markets before adding further to equities. Five-year lows in volatility have also presented an opportunity for us to gain greater exposure to this asset class, as a form of insurance within clients’ portfolios.

As we have written about previously, one of the main dangers faced by investors is complacency: few foresaw the rally in stock markets coming at the start of the year and after such a rapid and abrupt upward move in equities, one is wholly justified in asking where next? Before assessing future prospects some context is, however, important. While the MSCI World has gained 10.6% in the three months to 31 March, January and February (with increases of 4.9% and 4.7% respectively) were significantly stronger than March, which saw a mere 1.0% added. Moreover, performance has been highly disparate: the S&P (up 12.0%) has broadly tracked the MSCI, but within Europe, Germany has risen more than 18% against a fall of around 7% in Spain’s IBEX. Moreover, there has been an almost 10 percentage point spread between the Brazilian and Chinese equity markets, with the latter adding less than 5% YTD. Even for the S&P, exclude Apple, and the market would be up 10.2% (take out the major banks and gains would be even less impressive). In other words, performance has been both very disparate and very concentrated. Moves have been far from consistent and the reaction of equity investors to Spain and China is perhaps a harbinger of things to come.

On the positive side, policymakers and central bankers globally seem to be ‘getting it.’ In other words, via a combination of direct action and less explicit signalling, they appear to be seeking to do as much as is within their control not to let the nascent recovery go off track. Ben Bernanke in particular looks as if he understands the importance of keeping bond yields repressed (even if it means hinting at the possibility of further quantitative easing) until the macro data is robust enough to suggest they do not need to be ‘managed’ by the Federal Reserve. In Europe, a realisation seems to have dawned – at least for now (and we do await the outcome of the French Presidential Election with some trepidation) – that the costs of keeping the Eurozone project alive would be substantially lower than those attached to letting it fail.

In most countries globally, but particularly in the developed world, it is fair to assert that corporates are in better health than governments. This has significant and obvious ramifications for asset allocation. We are far from unique in believing that there is a structurally negative case for G7 Government Bonds, a point that has been eloquently made recently by commentators including GMO’s Jeremy Grantham, Bill Eigen of JP Morgan Asset Management and many others too. It would therefore be easy to make the case (put very simply) for equities relative to bonds. Despite the rhetoric of policymakers, bond yields have been rising in the past weeks (the US 10-year gained 25 basis points in March) and as the global strategy team of Credit Suisse notes, all major equity market rallies in the last fifteen years have been accompanied by rising bond yields. Although we remain in the camp that believes inflation has the potential to be a major problem over the medium-term, currently benign inflationary expectations are also clearly better for equities than for bonds.

While all of the above may be true, we would maintain that we are still in the midst of what several have referred to as an ‘ugly contest.’ Just because corporates are in stronger shape than governments, it does not necessarily mean that they are in ‘good’ shape. We have written in the past about weak global earnings momentum (the last quarter was the worst since 2008; in Europe more companies missed than beat estimates) and peak margins may not be sustainable. Much academic evidence points to the mean-reverting nature of margins yet consensus seems to believe in the case for further expansion (an additional 50 basis points in both 2012 and 2013 according to Morgan Stanley). This is perhaps too optimistic.

As ever, these things are never simple and it is crucial to be able not only to make broad generalisations, but also appreciate the nuances between different economies and companies within them. Specifically, while we are encouraged about both macro- and microeconomic trends in the US and much of the emerging world, we have notably greater concerns about the Eurozone and China. Taking the US first, even if data points regarding the strength of the economy are no longer surprising on the upside, they continue to suggest that the US is on a broad, expansionary path. The consumer (still responsible for 70% of GDP) is looking healthier and more confident, helped by an ongoing improvement in jobless claims; and, the housing market is – gradually – being fixed. Further drops in jobless claims and progression on 90-day delinquency rates would make us feel more confident.

Europe, however, is more of a concern even if Greece is no longer dominating the headlines on a daily basis. Industrial production (measured by the Purchasing Managers’ Index) is continuing to point to contraction with readings of below 50 since August last year and the 130 basis point decline in March was undoubtedly worrying. A bigger worry is that liquidity remains sclerotic despite the weight of Draghi’s LTRO initiatives. Data from the ECB shows that loans to non-financial corporations rose at a slower rate in February than in January, while last-reported annualised growth of 0.7% is the lowest since early 2010. Given the size of China’s GDP (whose contribution as a percentage of global GDP is more than ten times that of Greece), a slowdown here would be a significant problem with which to contend. The signs are not encouraging, with local Purchasing Managers’ Indices now showing highly mixed signs (particularly using HSBC’s measure). Retail sales and housing market trends have also been weak.

Everywhere it is incumbent on policymakers not to lose focus. Even if the health of the patient is notably better than last year, he/she has still not metaphorically even left the hospital yet. For the US, more significant than the impending Presidential Election (if unemployment continues to fall then an Obama victory looks likely) and whether or not the Bush tax cuts get extended again (we think probable, in some form) is the fact that ‘Operation Twist’ comes to an end in June,. Based on our above observations, it will be crucial for the Federal Reserve to take a view on how to continue to keep the yield curve (especially the long-end) as flat as possible, consistent with the original ‘twist’ policy implemented by the Fed in 1961. If not more QE, then more Twist is likely.

For Europe, even if Greece has been ‘contained’ for now, the broader problems of indebtedness and structural uncompetitiveness, particularly in the periphery, remain. We read increasingly about the challenges facing Spain, the Eurozone’s third largest economy. This is a country with a still unproven Prime Minister (and not a technocratic pragmatist like in Italy) who appears to want to set his own agenda, while unemployment continues to rise. In China, there is little new to report, yet our concern remains on the importance of avoiding a hard landing and also managing a smooth transition of power later this year. Global interconnectedness (with Europe being China’s biggest export market and it banks being the largest lenders to Asian economies) should not be discounted.

All of the above suggests a need still to tread very carefully. Nonetheless, a few things seem abundantly clear to us and are correspondingly reflected in our asset allocation strategy:

• Regardless of the sustainability of the equity market rally, one clear by-product of year-to-date strength is that volatility is at five-year lows. Given its inverse correlation with equities, we have increased exposure to volatility as an asset class;
• In view of the current yields that are offered on G7 Government Bonds combined with the inherent risks facing these economies (in general terms, and on a relative basis against emerging economies), there are substantially better investments elsewhere in credit; moreover, we explicitly favour fixed income managers that are able to take on negative duration and exploit the current asymmetry in G7 yields (i.e. the risk of yields falling further is substantially smaller than the potential gains to be made from them rising);
• Even if rising bond yields are conventionally ‘good’ for equities, there remain a number of opportunities else where in credit. In particular, we favour credit strategies that provide exposure to emerging markets and, to high yield. The case for both strategies is well-understood: the former is a beneficiary of looser EM monetary policy and a general improvement in ratings, while currently implied default rates in the latter seem unwarranted;
• For equities, a near-term pull-back is possible, which could present opportunities, but more importantly, we expect current stock market divergences to persist: in other words, partly premised on economic fundamentals, we see a stronger case for the US than much of Europe, and within Europe, we anticipate ‘core’ (i.e. Germany) to outperform periphery. We favour US and EM-listed business, especially with high diversity and dividend-paying abilities;
• If yields on US Treasuries continue to rise (and the caveat here is the nuancing of Bernanke’s rhetoric), then this implies a stronger US Dollar. What has surprised us more has been the strength of the Euro (now 1.33 against the greenback versus 1.26 as recently as mid-January). A stronger Euro seems anomalous: growth prospects for the region are weaker than elsewhere and strength in the currency has the perverse effect of reducing competitiveness and hence potentially deferring/ stifling recovery; and,
• We have long understood the logic of owning gold, not only conventionally as a scarce asset and a store of value, but also to benefit from the strong correlation between low/negative real interest rates and outperformance of the precious metal. If higher relative yields persist, then gold will likely correct downwards. A 6.7% fall from its 2012 to-date high may therefore have further to go. Being based in London, we also hope (even if we cannot predict – with any accuracy at all) that late March’s weather may prevail for some time longer.

Alexander Gunz, Fund Manager, Heptagon Capital