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.

The economist John Maynard Keynes once famously remarked that, “when the facts change, I change my mind; what do you do, sir?” With this dictum in mind, and on the evidence we see, there is currently little reason for us to consider a change of mind. If anything, the dichotomies are widening and investors have been presented with increasing evidence of a strengthening US economy and a deteriorating outlook in Europe. This dynamic reinforces the asset allocation stance we have pursued for some time, favouring almost all other asset classes above developed world government bonds, which continue to look highly unattractive. Correspondingly, Heptagon’s preference remains for equities (with a growth tilt), emerging market credit, high yield and alternative asset managers.

Equity market volatility over the past month has provided a good opportunity for re-assessment, a time to consider whether the facts really have changed, whether this is a pause for breath or a sign of things to come, a potential repeat of last year’s ‘cruel summer.’ April was indeed the first down month (-1.4%) for equities globally since December and Europe’s weakest (-6.9%) since August, the nadir of last year’s tumult. Cognisant of the speed with which sentiment can change, for us, the key questions are how much of Europe’s troubling situation is now discounted and to what extent can a stronger US economy help support recovering global momentum? We are hopeful regarding both these issues, but considerably more confident concerning the latter. Comparisons with last year should also be treated with caution given the current absence of external shocks (remember the Arab Spring and the Japanese earthquake of 2011), although some potentially destabilising elements remain (Iran, North Korea).

With regard to Europe, to observe that much of the continent is highly indebted, structurally uncompetitive, politically dysfunctional and in (double-dip) recession is not new. We also know what needs to be done: wholesale labour market reform, a possible move towards Eurobonds (and debt mutualisation) and a clearly weaker currency. However, it is debatable how much progress is being made and our concern is that the situation is perhaps worsening. Just by the yardstick of industrial output, the current trend is certainly concerning: last reported Eurozone PMI is 45.9, the weakest reading since July 2009 and down 12 percentage points relative to a year ago. Meanwhile, continent-wide unemployment, at 10.9%, stands at its highest since July 1997.

More worryingly, the crisis also appears to be spreading. Spain has (rightly) received most coverage, but a deteriorating outlook, both political and economic, in France and the Netherlands suggests that the so-called core is also not invulnerable. The Spanish economy has shrunk by more than 5% in the last 12 months, the unemployed number almost one-in-four and its budget deficit (at 8.5% of GDP) is more than two times the average level for the Eurozone. Its targeted fiscal adjustment, equivalent to 5.5% of GDP over the next two years, is one of the largest ever undertaken by an industrial nation. If the popular wisdom that Spain is both ‘too big to fail and too big to save’ prevails, then prospects for other struggling European nations look even less attractive. Nonetheless, we should note that even in a climate of such uncertainty, the European Central Bank still has a number of levers it can pull. Interest rates (currently at 1.0%) could be cut and we should not discount a third round of LTRO. Somewhat encouragingly, lending conditions (based on the ECB’s latest lending survey) appear to be improving, especially with regard to wholesale funding and future expectations.

In contrast to Europe’s travails, prospects for the US look considerably more compelling. Even if there are fewer upside surprises accompanying data releases, what is very positive, is the breadth of US growth, witnessed across the housing market, the jobs market, the consumer and, importantly, in earnings releases. New home sales in February were their strongest in two years (although they dropped back slightly in March), unemployment has fallen 70 basis points in the last year and looks set to be below 8% by the time of November’s Presidential Election, auto sales are at four-year highs and US bank loan growth has expanded 7.5% since April 2011. Anecdotally, we hear from an increasing number of sources that the foundations (based around cheap natural gas) are being laid for the emergence of a US industrial renaissance.

The extent of America’s progress has been clearly demonstrated in recently reported earnings releases. While only around 50% of the way through the first quarter reporting season, some 70% of US-listed companies have exceeded consensus sales estimates and 78% have beaten earnings expectations. Fewer than 15% of companies have missed numbers. Results releases also highlight that corporates are spending increasingly on new capital equipment and software, with average expenditure up 35% over the last year. The disparity relative to Europe is also shockingly noticeable: admittedly the current reporting season is less advanced (only around 25% of companies have reported), but the number of beats and misses relative to expectations have been roughly equal and few corporates have talked in upbeat tones about near-term prospects.

In the US, moreover, policymakers also seem to have adopted the mindset that they will seek to do all they can to perpetuate the nascent recovery. Ben Bernanke in particular seems highly conscious of not wanting to tighten rates too soon (being aware of the unfortunate precedent when this was done in 1937, sending the US back into recession). The Fed even seems willing potentially to tolerate some inflation – especially if this does mean driving growth. The implication is that further monetary stimulus may be unnecessary at this stage – another notable distinction relative to Europe – although the flexibility remains to return to it if necessary.

If we accept that prospects for the US indubitably look better than they have done for some time (although fiscal tightening in 2013 will need to be managed carefully) while the same cannot be said for Europe, then what at least gives us a degree of confidence is that relative to last year, investor scepticism seems higher and assumptions for growth lower. Consensus expectations for 2012 GDP growth currently stand at 2.3% for the US, while a 0.4% contraction for Europe is assumed. These look highly reasonable, based on what we currently know. Furthermore, according to Credit Suisse, 12-month forward revenue and earnings expectations are lower today than they were this time a year ago.

Investors are, of course, entitled to ask whether they should be paying a premium for current corporate earnings if they have been supported by global monetary and fiscal stimulus. Equities should only be seen as attractively valued if current levels of profitability can be sustained, and the recent earnings season – at least in some regions – has been supportive in this respect. In addition, on a relative basis, if inflation is increasingly being ‘tolerated’ (currently running at 2.7% in the US, 3.5% in the UK), then equities clearly benefit more from mild upward pricing pressure than would bonds. There is

2

Heptagon’s View From The Top

little evidence currently to suggest that inflation is running out of control, and slowing GDP growth in some emerging markets (especially China) is also likely to be helpful near-term in constraining rising prices. Sceptics may point to the risk of developed world stagflation scenarios, but there does not seem much to support such an assertion at present.

It is against this background, that we currently see limited reason to change our asset allocation preferences. The above trends serve only to reinforce our current thinking, namely:

• Equities: corporates clearly have healthier balance sheets and cash flow-generating abilities than do governments.We favour companies with diversification, but a high US bias, and prefer growth as a style (still a scarce commodity) over value. Stocks that have pricing power and the ability to de-equitise look especially well positioned. Our equity allocations quite explicitly do not favour business listed in, or with high exposure to, the Eurozone;
• G7 Government Bonds: yields look fundamentally unattractive and challenges, particularly in the Eurozone, remain. A healthier US economy and comments from the most recent Fed Minutes suggest that there is limited urgency to ease further. Correspondingly, we do not see a case for G7 Bonds in investors’ portfolios;
• Credit: relative to government bonds, we see other, more attractive opportunities in credit, particularly within the emerging market and high yield space. Looser monetary policy in the former (Brazil and India, among others, have recently lowered rates) and still-wide spreads in the latter create opportunities, although these are now more discounted than was the case at the start of the year;
• Alternative Asset Managers: those with long volatility positions (which we have advocated) have suffered, partly as the VIX has remained at a low level. However, we believe that trend-followers will benefit over the medium-term and an allocation to this asset class remains merited, especially as a mechanism for increasing portfolios’ Sharpe ratios;
• Currencies: if the divergence between prospects for the US and Europe ought only to widen, then the case for the US Dollar to strengthen relative to the Euro seems clear. The Dollar looks set to remain the world’s de facto reserve currency for now, whereas a weaker Euro would undoubtedly help the continent’s competitiveness; and,
• Gold: key for how gold performs is the outlook for real interest rates, with the two being inversely correlated. We will continue to monitor this dynamic carefully. We also note that the last quarter was the first since 1999 where the S&P outperformed gold, a trend that has continued in the past month. Risks clearly remain, but the global economy in general seems on a stronger footing now than it did this time last year. Our hope is clearly to avoid a repeat of last year’s ‘cruel summer’. For now, however, we remain more pragmatic than outright confident.

Alexander Gunz, Fund Manager, Heptagon Capital