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.

Just twelve months ago, the term stability would only have been used on these pages when prefixed by the words lack of. In contrast, when considering the outlook for the year ahead, relative stability seems a much more appropriate expression. Risks clearly remain, but from both a broad economic and political perspective, investors can at the least hope for more of the same. In other words, there seems to be a wide and increasingly global endorsement of accommodative monetary policy, which could become gradually more unorthodox. Meanwhile, politically, with the exceptions of Italian elections in April/ May and the German Presidential Election in September (where indeed the opposition is more pro-European than the incumbent Merkel’s CDU party), 2013 marks a rate year where no other major votes are scheduled.

It is against this background that we believe in the potential for more risky assets to outperform over the coming year. In particular, the case for equities to outperform fixed income (in broad asset class terms) looks compelling. Not only does the scope for further yield compression in conventional credit look limited, but on most valuation metrics, equities look attractive, especially from a longer-term cyclically adjusted context. Within the equity space, our preference is for European equities, while we believe there is also a good case for seeking exposure to the Japanese market on a near-term tactical basis. On the credit side, investing in non-directional strategies is our preferred approach.

With the impending US ‘fiscal cliff’ foremost in many investors’ minds, it may appear highly incongruous to be making a case for increased stability. The arguments relating to this topic have been well rehearsed elsewhere, but from our perspective, it seems that the debate is beginning to assume proportions akin to those that revolved around ‘Y2K’ issues. While the final outcome may not be known for some time, one that precipitates the US into full-blown recession seems perhaps the least likely. Far from global havoc (as the Y2K naysayers also feared), compromise seems a much more likely result. Put simply, it is in no-one’s interests – neither Democrats nor Republicans (and certainly not the President’s, keen to establish more fully his legacy, now freed from the concerns of re-election) – to enact policy that could curtail nascent economic growth.

Some combination of tax increases and spending cuts therefore seems the most likely outcome. Indeed this is a scenario investors should get used to: structural indebtedness means continued incursion by the public sector on the private sector. However, on the flipside, more punitive fiscal policy does effectively legitimise Central Bankers to pursue (even) more liberal monetary policy. What one hand takes away, the other gives. As 2013 develops, we should certainly expect an ever greater blurring between fiscal and monetary policy. The adoption of direct lending schemes by Central Banks and even directly funded infrastructure projects may increasingly become the norm.

Notwithstanding investor expectations that Central Bankers remain on standby to ‘do what it takes,’ even if more restrictive fiscal policy enactments in the US (and elsewhere) do result in negative hits to GDP growth, the global economy may now be in a sufficiently robust position to withstand the impact. Taking the US first, most data points seem highly encouraging. Of particular interest, we note consumer confidence (on both Conference Board and University of Michigan readings) stands at its highest in almost five years, with expectations also at similarly elevated levels. The ramifications of this are potentially highly significant, especially given that the consumer constitutes some 70% of the US economy.

The evidence of a more optimistic consumer is already clear in the housing market, with builder confidence and house price rises running at their strongest levels in six years, delinquencies at their lowest in five, and new starts at their best in four. This improvement is also coming with the absence of a notable expansion in credit, as evidenced by loan officer surveys. Meanwhile, inflation remains low and could continue to do so for some time given the significant slack in the domestic labour market (hourly earnings, for example, continue to fall, suggesting limited evidence for upward wage pressure). With this backdrop, US corporates may even be in a position to deliver both further margin expansion, but also – for the first time in some years – tangible top-line improvements too.

In Europe, the picture may appear less roseate, with the continent in recession for the second time in four years and industrial production in the periphery down over 30% (in Greece and Portugal) from its peak. Even in Germany, business confidence is at its lowest since February 2010. Nonetheless, there are signs of progress. At a political level, the most recent round of discussions over Greek debt highlights clearly that policymakers remain fully committed to the European project despite the highly challenging fiscal arithmetic (and social disintegration) facing Athens.

Although it may not seem evident at first sight, and particularly not to the disenfranchised and unemployed, the logic of current European policy action is becoming increasingly clear. In other words, domestic demand deflation is occurring, helping drive convergence within the currency union. Current account deficits are falling in peripheral nations, with Spain’s at its lowest in eight years and Greece actually having run a surplus for the last three months. Moreover, it should not be forgotten that such progress is being made even in the absence of more active policy intervention from the European Central Bank. No country has yet to request use of the OMT facility, while Draghi also retains much other monetary ammunition, especially with interest rates still at 0.75%.

European prospects may also be helped by an improvement in the outlook for emerging markets (and, of course, the US). China – whose largest single trading partner is the Eurozone – may have seen a bottoming in its economy evidenced by a variety of metrics. Not only are real GDP and capital spending trends showing signs of improvement, but bank loans and money supply (especially M2) are also both trending more positively. Early indications also suggest a potentially more consumer-friendly stance from China’s new Premier. Improving lending standards, accompanied by still-loose monetary policy is a trend prevalent not just in other parts of Asia but also in Latin America too.

Given the backdrop depicted, it behoves us to ask whether prospects almost seem too good to be true. Far from being optimists, we prefer to position ourselves as realists. At this stage, our concerns are more geopolitical (failure to resolve the fiscal cliff in the very near-term, ongoing tensions in the European periphery and more pronounced dislocation in the Middle East over the medium-term) than economic. Such a perspective allows us to take a constructive approach to asset allocation. Our strategy since September has been to favour equities over credit and our conviction in this respect continues to grow. This is less a function of the macro outlook (we demonstrated in last month’s View from the Top how limited correlations were between GDP growth and equity market returns) and more the consequence of valuation.

IMF data shows that there has been a cumulative $1.2trillion of inflows into global bonds since the start of 2008 (through to October 2012) relative to comparable outflows of $400bn from equities. As a result of such moves, we believe many asset allocators are already at maximum levels for fixed income; those which are not, are faced with the prospect of investing in a generally expensive asset class, where risks are highly asymmetric (especially if/when rates start to rise). By contrast, equities are still generally unloved – in our opinion – and look cheap on many metrics. On a real dividend yield basis and when comparing bond yields against equities’ dividend yields, earnings yields and book value yields, the case for stocks is clear. Moreover, the ratio of short rates against equities’ earnings yields also adds support to the argument.

We are happy to invest in equities on a global basis across all major regions, but whereas we have favoured US and globally diversified strategies for some time, incremental allocations to this asset class – and where we have current strongest conviction – have been made in Europe and Japan. With regard to the former, the region appears currently priced for depression, trading on a cyclically adjusted P/E (CAPE) basis more than 30% below long-run average rates. European equities arguably constitute an opportunity similar to that afforded by investing in emerging market equities at the end of the 1990s. At the time, the latter was severely out-of-favour (impacted by the Asian currency crisis among other factors) only to be the best performing asset class over the ensuing decade. Parallels with Europe’s situation today seem strong.

For the shorter-term investor, Japanese equities (on a currency hedged basis) may also offer a rare opportunity. The country faces major structural challenges, particularly demographic, but both economic and political catalysts for change – from a very low base – are currently in place. With regard to the former, Japan is set to be a net importer for the first time since 1981. The corollary of such an outcome is a weaker Yen, which could lift equity prices, especially those of exporters. Politically, elections are scheduled for later this month. The opposition candidate and favourite, Mr Abe, has signalled clearly his desire to pursue unconventional monetary policy in order to stimulate the economy, suggesting the potential printing on money until a goal of 2% inflation is reached. This is both necessary and consistent with the trend towards increasingly coordinated global monetary easing. Even if Japan’s reality proves different to Abe’s rhetoric, change could provide a near-term fillip for domestic equities.

Elsewhere, we continue to believe there remain some selected opportunities in credit, but – put simply – see more potential within equities. Our preference within the former category lies with less directional managers and those that have the ability to assume more tactical positioning (such as taking on negative duration). On a longer-term view, the case for emerging market corporate debt clearly outweighs that of comparable debt within the developed world. With regard to alternative asset managers, prospects are also somewhat challenging, at least for as long as policy intervention (with its impact on currencies and yield curves) remains – likely for some time, in our view. We have therefore reduced exposure here. Finally, we do retain some holdings in gold (for portfolio insurance reasons as much as anything), but with all the evidence currently in our possession, prospects for equities over the year ahead look the most potentially compelling.

Alexander Gunz, Fund Manager, Heptagon Capital