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.
Imagine in a scenario for 2013 where a global economic recovery is in train, helped by ongoing quantitative easing and interest rates at historic lows, a picture in which the US housing market continues to gain in strength, Europe is stable (with Spain having sought financial aid and progress being made towards further financial union) and China is transitioning successfully under its new leadership. The US ‘fiscal cliff’ may also have been averted. This is not a vision of fantasy, but a highly plausible situation. While it would be naïve to claim that the world’s problems have been solved, we see greater potential stability ahead than has been the case for some time. It is our contention that many continue to be too sceptical about the restorative impact that current central bank policy is having.
It is also against this background that we feel prospects for equities look more attractive than they have done for some time. We correspondingly favour increased allocations towards this asset class at the expense of credit. Our positioning in equities reflects a barbell approach, namely allocating between growth and value, with favoured exposure towards Europe and selected emerging markets. With regard to fixed income, our preference is for managers who have the ability to take less directional stances. We retain some limited exposure towards alternative asset managers despite their poor recent performance. A holding in gold also remains crucial.
Two key factors give us particular cause for comfort at present, helping justify our current positioning: the global expansion of liquidity and the valuation levels of equities, especially relative to other asset classes. As we have discussed in previous pieces, central banks globally have clearly committed to looser monetary policy, if not via direct action, then via emphatic rhetoric and signalling (the ECB has yet to buy any bonds directly via its Outright Monetary Transmission mechanism). Recent statements by senior policymakers at the Federal Reserve and the Bank of England also suggest that the commitment of their institutions to restoring economic stability is unwavering and, that if required, further unorthodox tools could be applied. Bank policy is being “rooted in conviction”, just as Keynes argued that it should be.
Most importantly, however, current policy does seem to be working. In other words, global credit channels are strengthening with signals from around the world highlighting that financial institutions are starting to lend once again. In the US, the earliest adopter of such policy, the evidence seems increasingly supportive. Just as a collapse in the housing market led America into financial crisis, so the housing market is leading the way out. Many data points support this assertion, but we are encouraged that housing starts (i.e. new home construction) in September were their highest in four years, with demand for new homes at its most elevated in two years, according to the US Commerce Department. Notably, this recovery is occurring without additional new leverage being taken on; public sector debt to disposable income levels are presently some 30 percentage points below their 2007 peak. Furthermore, unemployment trends are also improving. This ought not to be surprising since for every new house built, four jobs are created, either directly or indirectly. Current US unemployment, at c8%, is it lowest in almost two years.
The pending fiscal cliff (in other words a potential mandatory reduction in the US budget deficit, enforced by the expiry of various tax breaks) is often cited as the factor that could most derail America’s nascent recovery, with a worst-case scenario reducing GDP by up to 3%. While the outcome of this conundrum may not be known for some time, and will obviously be contingent on America’s choice of President, we are relatively sanguine on its impact. After much, perhaps unnecessarily apocalyptic speculation, it may prove to be a non-event, somewhat akin to the concerns that arose over the perceived threat of ‘Y2K issues’ provoking havoc, with the fiscal tightening impact ultimately deferred over several years. However, even were a more immediate compression to occur, then such an outcome could indeed further legitimise the Federal Reserve to pursue more active, and potentially more unconventional monetary policy. The logical concomitant of fiscal tightening is monetary easing.
It is also worth making the more significant point that the focus of the debate is arguably misplaced. Even if fiscal tightening were hypothetically to reduce GDP next year, this may not impact stock market returns. Research from Credit Suisse highlights that GDP growth and gains in equity indices have very little correlation (just 0.12 to be precise). In other words, some 99% of the variability in equity returns is associated with factors other than changes in economic growth. Also bear in mind the fact that stock markets globally have in fact risen in 2012 to-date, despite consensus economic growth forecasts and earnings estimates having been downgraded for most part of a year. The conclusion from these observations suggests clearly to us that buying an asset at a cheap price is more important than trying to anticipate GDP growth.
Discussions over valuation levels tend inevitably to be fraught with controversy and we have tended to shy away from any mention of absolute numbers (such as P/E ratios) in these reports. To assert, for example, that equities are ‘cheap’ at present one does however need to ask the question ‘against what?’ Historic time horizons have their limitations given that the last ten years includes the massive dislocation that was the collapse of Lehman Brothers and its associated aftermath, while the last thirty have been characterised by the great moderation brought about through the repression of inflation. Moreover, we should not forget that over 40% of the S&P’s constituents have changed in the last ten years (more in the last thirty), reducing the validity of like-for-like comparisons. Additionally, indices have their own limitations: given the increasingly diverse nature of their constituents’ end-markets and revenue streams, the S&P (and especially the FTSE in this respect), may not actually be representative of the underlying market they are said to represent.
With these considerations borne in mind, while it would be clearly misjudged to make bold claims about the absolute valuation levels of equities at present, relative to cash and to government bonds, equities represent good value, trading on a normalised yield well above these other asset classes. On this basis, it is also worth noting that the disparity between (equity) dividend yields and real bond yields is wider in Europe than in the US at present, with the differential in the former being close to a forty-year high.
While some of this discrepancy can be explained by the more pronounced nature of Europe’s problems that have endured over the recent past, the potential for recovery in the region is arguably now proportionately higher. In the last six months, Europe’s benchmark index (the SX5E) has outperformed the S&P by a factor of almost five. More importantly, there is growing evidence that the ‘tough medicine’ being imposed on the continent is working. Not only are Greek ten-year bonds at their lowest since September 2011, but export volumes across the continent are rising (particularly in the periphery nations) and industrial production – while still in negative territory – ceased falling in February. Europe is also a clear beneficiary of emerging market trends (we have discussed trade and financial linkages previously) and we note in particular that Chinese inventories are rising again, consistent with an improvement in growth.
Incremental progress needs to be balanced against the dangers of complacency. There are still many factors that have the potential to derail prospects, in particular geopolitical dislocation (potentially in the Middle East) or misjudged political action (either with transition in the US or with Greece’s/ Spain’s requests for financial aid, for example), but neither uncertainties over Central Bank continuity nor those relating to the threat of inflation ought to feature among them. If – as is being demonstrated – the policies of the Federal Reserve, European Central Bank et al appear to be working, then simply put, there is little obvious reason for them to be changed. With regard to the US in particular, it should be noted that Fed Governor Bernanke’s period of employment does not end for a further thirteen months. Based on the current environment, the logic for his successor to embark on an abrupt change of policy would be low. Even if this were hypothetically the case, then by late 2013, the robustness of the economy may be sufficient to withstand any policy shift.
While the emergence of inflation will likely be abrupt (and arguably not easily foreseen), the risk of it posing a meaningful threat in the very near-term seems low. Given the output gap that currently exists in most developed countries, there is clear scope for employment numbers to rise without there being any immediate upward pressure on wages. In addition, the moderation in Chinese economic growth (towards a more ‘normalised’ rate of 6-7% a year) is helping to repress upward pricing pressure in raw materials. Global food shortages and the corresponding impact on prices would be significantly more disruptive. However, for as long as inflation (and inflation expectations, more importantly) remain below 4% – as is the case at present – this is not a negative outcome for equities. Indeed, under such a scenario where pricing pressure is rising, equities would typically outperform government bonds, supportive to our thesis.
With these considerations in mind, we have repositioned our asset allocation strategy over the past month. While we continue to favour diversification and the associated benefit of seeking uncorrelated returns, our positioning is as follows: with regard to equities, we see an increasingly strong current case. Our preference here is to pursue a balanced approach to managers following both growth- and value-based strategies. By region, we see the greatest upside potential for Europe and emerging economies at present. In terms of credit, we have long avoided G7 debt, but many other credit strategies have witnessed strong rallies in the past year (and longer) and we correspondingly see the asset class in broad terms as looking over-stretched. It is hence our view that within the credit space, less directional managers and those with the ability to assume more tactical positioning (such as taking on negative duration) may have the best scope for delivering performance from here. Elsewhere, alternative asset managers have struggled in recent times as levels of monetary and currency-based intervention have risen. While such managers do have the ability to boost diversification, with intervention levels set to remain elevated, their ability to deliver stable and consistent returns may continue to be notably constrained. Finally, we stick with gold, up c10% YTD, and still a highly valid form of portfolio insurance.
Alexander Gunz, Fund Manager, Heptagon Capital
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