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.

New years often signal new beginnings, but in many ways investment prospects appear no different from when we last published our views roughly a month ago. In other words, the same old problems remain and investors could correspondingly face an environment as similarly challenging as that experienced during 2011. Nonetheless the start of 2012 does provide some grounds for optimism, a time for resolutions and the opportunity at least to consider new and alternative strategies. The hope is that policymakers will show increased levels of pragmatism and flexibility in resolving the debt crisis while political machinations in general do not also undermine economic progress. This latter point is particularly crucial, with elections due in the US, France (with potential implications for the rest of the Eurozone), India and Mexico among others as well as the appointment of a new Premier in China.

For now, we see few reasons for changing our current asset allocation stance, favouring credit over equity. In particular, emerging market debt (based on the easing cycle) and US equities (given economic prospects) appear attractive, along with selective exposure to other forms of credit and certain hedge funds. Much still stands in the balance, and we will continue to look for reasons to move to a less cautious, more optimistic stance as the year develops.

The central challenge remains how the developed world may be able to grow while paying down a potentially insurmountable debt burden, a problem exacerbated by the fact that certain policymakers still fail to recognise this dynamic. Austerity appears to be an impotent solution and default remains politically unacceptable for now. With Central Banks now operating under effective fiscal dominance, namely the inability of governments to stabilise debt or even fund themselves at reasonable rates, inflation will likely be engineered (via more quantitative easing) and real rates across the yield curve be pushed further into negative territory – whether they like it or not. The expectation, therefore, is that Central Banks will be able to save the day. Even if more quantitative easing does not work (and we are somewhat sceptical), it can at least help improve investor sentiment, something that is both needed and desirable. What concerns us, however, is whether political short-termism may trump economic logic once again. A series of pressure points (mainly in Europe, but with global ramifications) could cause policymakers to abandon a rational approach to problem resolution.

In particular, six factors concern us and could derail progress. First, sovereign credit ratings downgrades in Europe by S&P and others are potentially imminent and would increase refinancing costs for already indebted nations. On a related point, some €80bn of bond redemptions are due in Italy alone during the first quarter of 2012, while Credit Suisse estimates that some €600bn will need to be refinanced across Europe over 2012. Next, liquidity (across credit channels) is drying up globally and is back to pre-Lehman levels in many countries. Banks are also finding themselves with diminishing sources of collateral.

The already difficult environment in Europe (in its December report, S&P cited ‘political dysfunction’ across the continent as being one reason for putting many countries on negative watch) may become more stressed with French elections due in April. Should President Sarkozy fail to get re-elected then his successor may look to renegotiate the last-revised EU pact (both leading opposition candidates have indicated they would do so). Unanimous support from Member States is required and, if put to the electorate via national referenda, France may not be the only state to seek to bring about further policy revision and hence funding deadlock. As mentioned previously, political uncertainty is not just a European risk, but also a concern in the US (and elsewhere). A two-month extension to payroll tax freezes is a delay to the inevitable and fiscal deadlock is a real possibility, which would undoubtedly undermine sentiment, particularly in an Election year. Finally, we should not deny the risk of other exogenous factors, to name but a few: ongoing tension in the Middle East (particularly should Iran become more assertive), possible unrest in Russia, the wildcard of North Korea and a return to more protectionist trade policies globally.

Balanced against these pressure points is our observation that expectations are currently set at very low levels, and hence there is much greater scope to surprise on the upside. Beyond the more generic ‘wish list’ for greater rebalancing (increased emerging market consumption to offset developed world debt), improved competitiveness (further supply-side liberalisation), co-ordinated quantitative easing globally and a more cohesive European Union (even if this is smaller, but more tightly bound fiscally), there are also several other important developments that give us notable cause for optimism.

A renaissance in US manufacturing, growing energy self-sufficiency and ongoing innovation are fundamentally important drivers. We see evidence of all three at present, and while none is likely to change investment sentiment in the very near-term, they constitute encouraging signs that could pave the foundations for a period of future secular growth. With Chinese wage inflation at over 13% (and greater than 20% in some key export industries), the cost of doing business in the US continues to fall and could equalise, according to some reports, within three years. Abundant domestic supplies of shale gas (combined with increasingly efficient extraction techniques) should also lower costs further. Meanwhile, there is palpable evidence of innovation across several sectors (with regard to genetics in healthcare and ‘mass personalisation’ through processes such as three-dimensional printing in industry) that could drive medium-term growth.

Against this background, while we remain prepared to shift our investment strategy when we see more evidence of positive developments and policy resolutions, we are happy to retain our current stance for now. That the S&P was the best performing major equity index globally in 2011 is telling of investors’ risk appetite levels and it is fair to concede that prospects for the US do appear more attractive than elsewhere. Moreover it should not be forgotten that despite the current vogue for all things Chinese, the US (consumer) remains the world’s largest potential growth engine for now.

The debate nonetheless remains open over the extent to which America can drive the rest of the world to better growth and whether there is enough momentum to suggest decoupling can and does work. Successful growth and decoupling would imply a higher rating for US equities and a stronger Dollar (although conversely it may reduce the imperative for a further round of Fed-endorsed quantitative easing). In terms of asset allocation, therefore, the following strategies currently dominate our thinking:

• Within equities, favour the US: prospects currently look most attractive in this region globally and our preference is for liquid, large cap business offering compelling dividend yields. Companies with diversification, pricing power and proven innovation are also favoured;
• A stronger US Dollar and a correspondingly weaker Euro: under almost all scenarios relating to the European Union’s ultimate future, its currency should weaken, especially given the region’s near- term risks and below-average growth prospects;
• Gold to continue its gains, despite the Dollar: sustained negative real interest rates combined with general macro uncertainties should see gold outperform further, despite its historic inverse correlation with the Dollar;
• Within credit, emerging market debt is favoured: The monetary easing progress is further advanced in emerging markets than elsewhere, benefiting fixed income within the region. Additionally, we favour allocations to managers that are able to invest across the credit spectrum (government bonds, corporate credit, rates etc.) and have the ability to take on negative duration;
• High yield remains attractive: default risks still look low (especially on a short duration basis)and yields are compelling, although we note this asset class may be volatile in the event of increasing risk aversion levels; and,
• Selective hedge fund allocations: Many managers have endured a difficult 2011, but those using systematic trading strategies ought to benefit, particularly when fundamentals reassert themselves. Funds that offer low correlations to other asset classes are also attractive. Low expectations do give us some confidence, but there is still a lot that can go wrong. At the least, ongoing ‘muddle through’ is simply not sustainable. On a scenario where policymakers fail to do the right thing, 2012 could be much worse than 2008 for investors. It is clear what needs to be done; our hope (if not fully our expectation) is that the necessary is enacted with swiftness and alacrity.

Alexander Gunz, Fund Manager, Heptagon Capital