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.
With global equities up more than 20% from their October lows and volatility (as measured by the VIX) down over 20% since the start of the year, it is tempting to assert that we are now in the full throes of a new bull market. Contrary to the fears of the sceptics, concerted global monetary easing/ stimulus appears to be working and Greece has not (yet) imploded, with politicians seemingly realising that the costs of Europe falling apart would be higher than those of staying together. We are enjoying the ride – for now – and at Heptagon have correspondingly increased exposure to more risky asset classes (especially emerging market equities) as the year has developed.
However, it remains crucial to distinguish between excess complacency – that the global economy’s problems have been fixed – and whether genuine improvements are/ have been taking place, laying the foundations for the next phase of secular growth. It is also worth noting that strong rallies can occur even in the course of long-term bear markets (Japan has seen six within the last twenty years) and there exist a number of factors that could easily and quickly derail sentiment and growth prospects. Decidedly mixed earnings momentum and geopolitical uncertainties remain of particular concern.
Monetary policy, more than any other factor, has been responsible for the volte face witnessed in investment sentiment over recent months. In Europe, the ECB’s first long-term refinancing operation (LTRO I) had a bigger impact than almost anyone foresaw, and a similar sized take-up for round two (with 50% more banks applying for funds, implying the stigma of utilising the facility is diminishing) is also likely to be helpful. Meanwhile, the Central Banks of England and Japan have committed additional funds to their own easing programmes, and the Fed has signalled that interest rates will likely remain at repressed levels at least through until 2014. In aggregate, the efforts of these four Banks (as well as the SNB in Switzerland) mean that their balance sheets now account for more than 25% of GDP, double the level of four years ago. Further support has also come in the form of interest rate cuts by nine different emerging market economies in the last three months.
In other words, easier monetary policy has generated much needed liquidity within the financial system, correspondingly boosting sentiment and risk appetite. Importantly, this stimulus has also not yet led to inflation, which has indeed remained stable, and even trending down in some markets. We have, therefore, the best of all worlds. In this Panglossian outcome, investors have shrugged off almost all bad news, including rioting in Greece, not to mention 20%+ unemployment in most of southern Europe. Against this background, it behoves us to ask two questions: what happens when monetary stimulus is withdrawn; and, what happens if inflation (expectations) start to rise?
The answer to the first question is a necessary unknown at present since quantitative easing is an experiment never-before tried. Nonetheless, it is definitely fair to assert that each subsequent round of stimulus has been less effective than its
predecessor, partly because of the law of diminishing returns and also since investors begin to anticipate its impact (and discount it) before the event actually happens. More cynically, the pursuit of ultra-loose monetary policy could be seen as an act of desperation, the only tool left to Central Bankers and Governments when all else has failed. How an organisation such as the European Central Bank (with a €2.5trillion balance sheet, and growing) would be recapitalised also needs to be considered.
The hope of Central Bankers globally is that with the impact of monetary policy and the fullness of time, the world economy will be strong enough to stand on its own feet without the help of intervention. The data in this respect is mostly favourable at present, with US industrial production have expanded in three of the last four months (but still 7.5pp below its January 2011 high), with similar trends being present in Asia and even Europe (albeit with the latter powered principally by Germany). Unemployment also seems to be falling and consumer confidence recovering, both of which are helping to create a positive feedback loop with regard to the housing market, especially in the US. Longer-term, as we have written before, the abundance of shale gas reserves and technological innovation are among the drivers may create the foundations for the next growth cycle.
However, not all is positive. Inflation remains the spectre that has the most potential to derail the nascent economic recovery. Furthermore, the transition from a phase of benign inflation (where we stand currently) to one where inflation starts rising aggressively is not linear, and is likely to be sharp, sudden and unanticipated. In this respect, an almost 40% rise in the price of crude oil since its October low represents a risk with higher oil prices having the ability to drive pricing pressure (and higher inflation expectations) upwards across many segments of the global economy. History shows that elevated oil prices (in 1973-4, 1979-81, 1990-1 etc.) have consistently led to higher inflation. It does not seem likely that tensions in the Middle East will dissipate anytime soon, potentially prolonging oil’s ascendency.
Even without the threat of inflation, the economy’s health is still highly fragile, particularly in Europe. Despite the LTRO, liquidity in some credit channels is still deteriorating (note that the last ECB lending survey at the start of February showed that 42% of banks surveyed had tightened standards of lending in the last three months, the largest percentage since the Lehman era), while GDP growth remains highly correlated to real M1 growth. This is still sluggish, up just 1.9% in the Eurozone in January, and similarly moribund in other global regions (rising by just 3.1% currently in China). For Europe, the relative strength of its currency since the start of the year (against the US Dollar) is also unlikely to be helpful for the region’s competitiveness, with every 10% move in the currency taking 70 basis points off the Eurozone’s GDP, according to research from Credit Suisse.
Finally, a significant nagging concern (which is also supportive of the complacency thesis) remains: if the fundamental outlook and investor sentiment both seem to be improving, then why does global earnings momentum continue to be revised down? Another piece of research from Credit Suisse shows that momentum is currently at its lowest since November 2008, while negative pre-announcements in the past quarter are at their highest in three years. We have said it before and will say it again: corporate profitability does not exist in a vacuum. If either consensus expectations are too high or the economy is not recovering at the pace indicated by recent statistics, then the scope for disappointment is significant. It is worth bearing in mind that Purchasing Managers’ surveys tend to over-state the strength of recovery since they largely reflect trends in the private sector, while much of the current retrenchment is taking place in the public sector. Moreover, where corporates have typically disappointed has been in terms of margins; if sales growth remains anaemic, then margins will almost certainly have to fall, with the benefits of levering an already lean base being constrained.
If we do see causes for optimism, then these remain tempered, and risks seem finely balanced at present. Our asset allocation strategy is correspondingly one of pragmatism, where our current strategies include:
- Emerging Market (EM) credit favoured: this asset class is a logical beneficiary of looser monetary policy, with lower interest rates driving growth. More fundamentally, just as DM (Developed Market) credit ratings are deteriorating, so EM ratings are improving. Over time, there is also good potential for emerging economies to increase their cross-holdings of EM currencies and bonds;
- High yield still attractive: we continue to believe that default risks look low given the health of corporate balance sheets and current cash levels. Spreads are consistent with at least 6% default rates, which seem unwarranted. Short- duration looks particularly compelling;
- Although a strong case can be made for EM credit and high-yield, G7 Government Bonds look less preferable: current yields are negative in real terms and as mentioned previously, the longer-term outcome of quantitative easing and the LTRO run the risk of being inflationary;
- Within equities just as in credit, our preference is for EM exposure. This is the main area where Heptagon has increased exposure since the start of the year. In particular, emerging market dividend payers look interesting; companies that show capital discipline by returning cash to shareholders constitute a compelling risk-adjusted way of gaining exposure to the region. Elsewhere, US equities (especially tech) screen well, given the region’s prospects and current relative momentum;
- In the alternative space, our current focus is on gaining exposure to volatility. We believe this represents an attractive strategy for improving portfolios’ risk-return profiles; and the logical time to consider investing in volatility is when it is low, especially since it is inversely correlated with equities. Exposure provides a hedge against potentially large market corrections; and,
- We continue to favour gold (and proxies–such as gold miners). The asset remains a store of value against currency debasement. Additionally, negative real interest rates continue to be supportive of the gold price.
In conclusion, while we are happy to enjoy the ride for now, there is every reason to believe that it will continue to be bumpy. Clear risks remain and there is a lengthy list of factors that could serve to derail and perhaps halt the current rally. The danger of complacency is also significant, and given the seeming current vogue for Shakespeare references, investors would do well to note the advice that went unheeded by Caesar, and be beware of the Ides of March1.
Alexander Gunz, Fund Manager, Heptagon Capital
1 Arguably England’s greatest playwright is referenced by GMO’s Jeremy Grantham and JP Morgan’s Michael Cembalest in their most recent letters to investors, with both citing Hamlet. In Julius Caesar, the eponymous tragic hero is warned twice by the soothsayer (in Act I, Scene II and in Act III, Scene I) to be beware the Ides of March. Interested readers of our piece may also be aware that the term Panglossian, mentioned earlier, comes from Candide, by the French (not English) author Volaire, pertaining to the character Doctor Pangloss and his naïve or unreasonable optimism.
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