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.

And so despite much hype and excitement, the long wait continues. It remains unclear whether the ‘defining moment’ of decisive policy action has actually come, even if there is now a somewhat greater sense of urgency to solve the obvious problems. Meanwhile, crucially, growth continues to deteriorate. It feels as if we have been here before – and quite a few times too. Against this still very febrile background, we currently do not see the need to change our current asset allocation strategy: namely, preferring to invest in opportunities across high yield, emerging market credit (corporate and sovereign), US and global equity strategies as well as in selected alternative asset managers, while avoiding direct exposure to Europe for now (via equity, credit or its currency – the latter, which we expect to weaken further over the medium-term).

While the extent of genuine policy progress since our last edition of View From The Top appears debatable, two facts seem abundantly clear: global growth is slowing and the cost of servicing peripheral Europe’s debt looks unsustainable. Both will be discussed in more detail below, but it is worth noting that the yield on the 10-year Spanish bond is now almost 100 basis points higher than three months ago. The key question it therefore behoves us to ask is whether things have yet got sufficiently bad for policymakers to act more decisively; or, put another way, what else would need to happen before that decisive move is enacted? It is hard to dispute the notion that investors are somewhat fatigued with the idea of ‘defining moments’ and ‘crucial summits.’ Euphoria can also quickly turn to disappointment. Perhaps the more appropriate line of discussion now to be considering is why investors should continue to place their faith in institutions that have consistently shown themselves to be arbitrary, impersonal and irrational.

With regard to Europe (where nearly all discussions begin and end), there have now been 16 European Council meetings and 5 ‘grand plans’ in the last two years. Rhetoric is one thing, implementation quite another. After some recent research we were not at all surprised to note that only four Eurozone members have ratified the European Stability Mechanism and just three the fiscal compact. Moreover, while excessive hope continues to reside in Mario Draghi, the Governor of the European Central Bank (ECB), there is only so much that he and his institution can do, particularly in the absence of support from the Bundesbank. No common banking recapitalisation across the union could, for example, occur until there is full banking union; and the Bundesbank has said that banking union is not possible without full political union. Signor Draghi has also said on several occasions that it is not the responsibility of the ECB to undertake the necessary work of Europe’s politicians.

Irrespective of which party ultimately acts and how (we suspect more collaboration across global central banks is likely – of which more below), the need for action only continues to grow. According to JP Morgan, 80% of the world is now showing a contraction in industrial activity. In other words, Europe’s problems are inevitably having an impact globally. Much focus is naturally on Spain (deemed too large for Europe’s politicians to ignore it, for fear of contagion risk if nothing else). Here, GDP is contracting at over 2% before an anticipated 6% equivalent fiscal tightening still to come. Unemployment, at 24.6%, is also the highest on record. Hence, why Spanish bond yields are currently over 6.5%.

Nonetheless, although Spain has problems, it is far from unique in this respect. Continent-wide European industrial production has now fallen for 12 consecutive months and currently stands at a 37-month low. In the United States, Fed Governor Ben Bernanke notes that the economy has “declined somewhat” with industrial production down for two consecutive months, although service industry output has been somewhat better. Retail sales (and recall the consumer makes up c70% of US GDP) are also dropping, for three straight months, the first time this has occurred since September 2008. Meanwhile, in the emerging world, Chinese industrial production is at an eight-month low, while economies as diverse as Brazil, South Korea and Taiwan are all also reporting contractions in their industrial output too.

There are undoubtedly some bright spots, particularly in the US (which remains the most logical region globally in which to deploy capital, especially given its falling energy costs and increasing labour force competitiveness). We note, for example, that the US housing market continues to recover, with builder confidence now at its highest since September 2002. Nonetheless, it is hard to escape Carmen Reinhart’s contention that “we’re [all] speaking Japanese now without knowing it.”1 In other words, before we see a ‘Germanisation’ of Europe (i.e. adherence to fiscal austerity combined with a disciplined focus on export-led growth), we are likely to see more of a ‘Japanification’ of the developed world.

In other words, investors will increasingly need to accept that a low (bond) yield, low growth environment seems more likely than a happily harmonised Europe back on the path to prosperity, a point also eloquently made recently by PIMCO’s Bill Gross. It is worth highlighting that the much-anticipated trough in Japanese long-end yields has yet come to pass. Moreover, supportive of the Japanification thesis is the fact that deleveraging becomes inevitably more difficult when nominal income growth slows. And, trend nominal GDP is now falling in US and Europe, just as it did in Japan.

Lest this observation appear too depressing, remember that there is still a lot that can be done. Politicians are going to have to accept the necessity of doing more ‘painful’ things: namely, liberalising labour markets, allowing banks to fail, cutting government spending further and privatising nationally-owned businesses. More positively, an increasing emphasis should be placed on increasing domestic manufacturing in order to displace imports (the foundations of which are being laid in the United States at present), while – where possible – lowering exchange rates in order to increase competitiveness.

Practically, what can policymakers do in the near-term to help and mitigate the risk of further Japanification (even without wholeheartedly embracing Germanisation)? Crucially, Ben Bernanke has left the possibility open for further action, stating that “additional accommodation” would be provided “if needed.” Furthermore, Mario Draghi has more than just rhetoric at his disposal. Incremental steps towards co-ordinated global quantitative easing are being made. In Europe, we should expect the ECB to reduce interest rates further (perhaps by at least 0.25% before the year-end), while bond purchases at the long-end of the yield curve (similar to the Federal Reserve’s ‘Twist’ policy) would also be a logical possibility.

Emerging economies also need to step up to the challenge imposed upon them by slowing developed world growth. Weaker western consumption creates a vicious circle effect with regard to emerging market export development.

Competitiveness in these markets has also been falling, hampered by local wage market inflation, while the external funding environment has become harder (partly as a result of deleveraging efforts at European banks). Encouragingly, there has been some action, with recent interest rate cuts in China, Brazil and South Korea. Whether these moves prove enough to bolster local growth remains to be seen. Political transition in China, weak government in India and a challenging outlook in Brazil could all prove testing in coming months.

While we may have been in this situation of suspended anticipation quite a number of times before, to assert that global policymakers have yet reached the limits of their potential influence would be incorrect. Nonetheless, as expectations likely continue to oscillate between hope and despair, investors may still be forced to dance the ‘risk-on’, risk-off’ tango with markets. We therefore advocate a strategy of pragmatism. Our investments remain focused on diversification and the ability to offer uncorrelated returns for still-uncertain times. At present, we are positioned towards:

  • Credit strategies centred on high yield and emerging market debt. Buying G7 (developed world) debt is akin, in our view, to making a future bet on global growth. It is hard to accept the notion that there is such a thing as ‘safe’ G7 debt and it does seem appropriate to raise the question of whether Germany ought to deserve negative yields on its bonds, given its clearly inextricable link with the rest of the Eurozone. We feel there are considerably more compelling opportunities in emerging market debt and high yield. EM prospects seem more attractive relative to those of their developed market peers, and the recent falls in several local currencies combined with the interest rate cut cited earlier ought to be positive for the asset class near-term. With regard to high yield, we reiterate our comment made in previous pieces that current implied default rates seem anomalous particularly given the strength of corporate balance sheets.
  • Invest selectively in global equities, but avoid meaningful exposure to Eurozone. Although European markets have basked in post-Draghi euphoria once again, prospects for the region remain the most challenging globally. Although some of this may be reflected in the relative underperformance of European equities against other comparable markets in the past year, listed companies in the region continue to disappoint most systematically, as evidenced by the high number of negative earnings revisions and disappointments, particularly in the last quarter. US (and Asian) companies have not been immune from this trend, reinforcing the need to invest in high-quality, globally diversified business with robust balance sheets. US and global equity managers remain preferred.
  • No change regarding our other investment strategies. In other words, we continue to see the importance of allocations towards selected alternative asset managers. We believe they bring clear benefits in terms of diversification and can improve investors’ Sharpe ratios. Deliberate (and perhaps excessive) intervention in currency and bond markets by central bankers and policymakers has been unhelpful, and may remain for some time, but trend-followers should prevail over the medium-term. Even if the Euro does strengthen in the near-term (again helped by Draghi rhetoric), fundamentals suggest the currency ought to weaken further, not least since it would help boost regional competitiveness. Finally, some investment in gold also remains crucial in our view. The precious metal is not just an obvious form of portfolio insurance, but would benefit should authorities engage in their perhaps inevitable moves towards even looser monetary policy.

Alexander Gunz, Fund Manager, Heptagon Capital


The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital LLP believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital LLP, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. 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. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital LLP is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital LLP disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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