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.
Many of the ingredients responsible for the cocktail of uncertainty that characterised last year’s ‘cruel summer’ are back. This is unfortunate for several reasons, not just since the manifestation of volatility across all asset classes can induce queasiness in investors, but because an excess focus on intractable problems (mainly in Europe) can deflect attention away from generally improving fundamentals (mainly in the US). Against this background, as we have said before, it is important to divorce emotion from reality and stick to what we believe works. It therefore remains our contention to avoid nearly all assets (equity, credit and currency) with exposure to the Eurozone and to retain a preference for the US. From a tactical perspective, while severe problems clearly remain, we believe several indicators do now point to markets being in potentially oversold territory, allowing us to become somewhat more constructive on both selective equity and credit (US/ global growth and short-duration high yield respectively) strategies in the near-term.
It would be tempting to write a monthly commentary that did not mention Europe especially given we are currently at the stage of what can almost be seen as a painfully long play of epic (Greek tragic) proportions, where the fate of the Eurozone is now arguably being determined by disgruntled and potentially irrational electorates rather than theoretically more seasoned policymakers. However, not to mention it is impossible for two reasons. First, the Eurozone constitutes more than 20% of global GDP and so its prospects are inextricably interconnected with those of the rest of the world (and particularly China, given that the Eurozone is its largest single export market). Second, unintended consequences need to be considered. In other words, think back to the Russian default of 1998; this led to the collapse of LTCM, that in turn contributed to a 20% fall in the S&P, which took three months to eradicate. More profoundly, the collapse of Lehman in 2008 led to a virtual drought in money market funding and an almost 50% drop in US equities over the next six months, with the market not returning to its pre-crisis level until January 2011. To deny that Europe’s problems won’t have an impact elsewhere is highly misguided.
The challenges of analysing the European situation rationally are exacerbated by the interaction of politics and economics. It is, for example, hard to justify in a modern world broadly characterised by ‘free market’ capitalist principles why Greece, a fundamentally insolvent country, should continue to receive financial aid. It is perhaps for the fear of unintended consequences were it not to do so. It is also perhaps this logic that will drive the future direction of Europe. Put simply, the ‘cost’ of Europe breaking up would likely be significantly higher than it sticking together.
How to deal with too much debt and not enough growth need to be confronted urgently. The latter is arguably more profound, since its absence only serves to pressure further already-difficult fiscal arithmetic while also raising the tensions associated with the politics of austerity. Solutions do exist. In the near-term, a weaker Euro should help improve growth prospects somewhat, while were the ECB to cut interest rates, then this would lower debt funding. Furthermore, with regard to debt, mutualisation (via Eurobonds) is a potentially persuasive option, particularly when one considers that the Eurozone’s total government debt to GDP ratio (at 89%, according to calculations by Credit Suisse) is lower than that of the US (100%).
the case when the economy was growing at a double-digit rate last decade. The willingness of the authorities to act through both monetary means (reductions in the reserve rate) and fiscal stimulus (equivalent to at least $600bn in its most recent round) is also encouraging. Of more concern is the transition China will experience when its new leader is anointed in October and seven of the nine members on its Politburo Standing Committee are also replaced.
In summary, investors are not political analysts, but are perhaps being forced to become so given currently febrile circumstances globally. With this context of such pronounced uncertainties, our investment strategy remains one of balance, seeking to allocate to and avoid asset classes based on those observations about which one can be most certain in uncertain times. At present, our highest convictions are as follows:
- Avoid all things European, including the currency: even if there is scope for a near-term bounce based on markets being oversold and should there be further rate cuts, more monetary stimulus or some clarity emerging from the Greek Election, fundamentals remain highly challenging for the region. The Eurozone economy and many of its corporates remain in worse shape than elsewhere and a weaker Euro seems likely under most scenarios, not least since it would boost the region’s competitiveness;
- Constructive on US and global growth equities: extreme near-term bearishness may create an opportunity to increase weightings in equities. As noted earlier, global earnings momentum is stable-to-improving and margin strength seems to be enduring for now. Our preferred equity allocations are towards businesses/ managers with a focus on the domestic US economy and/or with globally diversified growth. Low leverage and pricing power are also attractive characteristics;
- Also constructive on selective credit opportunities: the tactical indicators discussed earlier are also supportive for credit and we note in particular how short duration high yield has performed well despite pressures elsewhere. High yield is offering returns of ~6% and there is limited evidence of default rates rising among US companies in particular;
- Emerging market credit also of interest, especially relative to G7: the bifurcation between EM and DM credit is notable, but hardly surprising. In other words, emerging economies (and many of their corporates) are seeing better prospects for GDP growth and are enjoying upgrades to their credit ratings relative to the inverse in the developed world. Being paid 0.0% to hold a 2-year German Bund or 1.6% for a 10-year US T-Bill, for example, does not look attractive to us; indeed, credit managers who have the ability to take on negative duration are prospering at present;
- Alternative asset managers to the fore: we have consistently favoured an allocation to alternative asset managers arguing that such an investment can improve investors’ Sharpe ratios. Recent events have been encouraging, with the weaker Euro (a 6.5% fall in the last month) benefiting a number of trend-following macro managers, while the rise in volatility (the VIX jumped over 40% in May) has also been supportive of the long volatility strategy we favoured earlier this year; and,
- Gold: similarly, we have advocated an allocation to the precious metal for sometime, with it serving as an effective form of portfolio insurance. We noted last month that its performance had been pressured by the outlook for rising real interest rates working against it. This trend has reversed for now and broader uncertainty is currently working in gold’s favour. The English poet Rudyard Kipling wrote famously that “if you can keep your head… when all around you are losing theirs.” This seems an important dictum for current times, irrespective of whether Europe’s electorates and politicians are able similarly to abide by this. The prospects for another ‘cruel summer’ exist, but there also remain some elements of both near- and medium-term optimism to which it is important to hold.
Alexander Gunz, Fund Manager, Heptagon Capital
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