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.

‘Doing whatever it takes’ has become the mantra for central bankers globally. While we do not believe that their recent policy actions constitute a panacea, most crucially, time has been bought and the probability of a number of significantly worse outcomes occurring in the near-term has been diminished. Risks (both political and economic) undoubtedly remain, but we feel the environment for owning equities in particular has improved notably. Over the last month, we correspondingly raised weightings in European equities and also favour allocations to other equity managers alongside selected credit (high yield and emerging market) and alternative strategies. We also retain a clear preference for allocations towards gold.

Europe has rightly been the key discussion topic in many of our notes over the past year and we have highlighted repeatedly the need not only for coordinated decision making on policy actions, but also the reality that there is much higher logic for the Eurozone to remain as one entity than there would be in it breaking up, especially since for Germany the region constitutes its largest export market. It is against this background that recent events should be considered highly significant. Irrespective of some outstanding dissenters, Mario Draghi in particular has ‘understood’ the benefit of establishing credible signalling techniques. In other words, although the European Central Bank (ECB) has yet to purchase a single government bond via the Outright Monetary Transaction mechanism, market participants are now clearly aware of the intent of the ECB to do so. Just as the ‘Bernanke put’ (to keep interest rates low for an extended period of time) has been effective in managing both the yield curve as well as – crucially – investor expectations, so Draghi’s actions should be seen in the same light. The policy should also have the potential to succeed given its open-ended nature and the fact that there is no subordination for private bond holders.

Critics have been quick to assert that the inherent flaw of the ECB’s strategy is that it creates extensive moral hazard for participants since there are now limited incentives for domestic politicians to impose unpopular austerity measures given the knowledge that the Central Bank now exists as a de facto limitless backstop for funding deteriorating economic conditions. This, however, is to miss the point. First, time has been bought to allow policymakers greater flexibility to institute more effective structural reform (labour market liberalisation etc.). Next, if the policy actions of the ECB can be considered to suffer from diminishing marginal returns each time they are deployed, then it is only logical that the absolute size of the policy (now effectively limitless) should increase proportionately. Moreover, we should also see the actions of the ECB (and indeed the Fed) as perhaps just the start of what should be understood by less orthodox policy; going forward, it seems possible that the actions of Central Banks will see the boundaries of monetary and fiscal policy increasingly blurred, with the latter potentially undertaking either direct lending schemes or funding infrastructure projects, for example.

If there is a problem with the seemingly unlimited munificence of the ECB and the Federal Reserve (not to mention other advocates of much looser monetary policy such as the Bank of England and the Bank of Japan) then it is simply that their policy actions can be seen as continuing to constitute an unproven experiment, perhaps being made up as we go along, the consequences of which will not be known for some time. One key concern is the threat of inflation. We have written previously on the nature of inflation, namely that its progression is rarely linear and when it (and the anticipation thereof) starts to rise, the shift may be both sudden and swift, hence disconcerting for many. Inflation expectations in both Europe (based on ECB projections) and the US (based on break-even rates) are already on the rise even if core rates currently remain somewhat repressed.

However, at this stage it may be more constructive to consider what are the implications for asset allocations that derive from the massive injections of liquidity into the global financial system across both the developed and emerging worlds. While the ‘new normal’ may be a world of significantly lower returns from all asset classes relative to that of even a decade ago, the return potential offered by equities in general looks currently more compelling than that of many other asset classes. Do not forget that two-year yields are currently negative in Germany and Switzerland, while deposit rates in Denmark are also now sub-zero. Also consider that according to Credit Suisse, through to the end of August, bond funds globally had seen $1 trillion of inflows since January 2009 while equity funds witnessed $140bn of outflows. Finally, when inflation does start to rise, then equities should logically outperform bonds, at least until levels of 4% (this figure being the conclusion from several academic studies we have seen).

If we accept that a stronger case can now be made for equities than has been so for some time, the next iteration is to consider the merits of different regions. It would be misjudged to assert that all of Europe’s problems are fixed (we are still a long way from fiscal and banking union) and indeed economic prospects remain more challenging here than in many other geographies (industrial output is still contracting and unemployment remains on the rise), but for now the potentially effectiveness of Central Bank actions may trump growth prospects in the minds of investors. Moreover, the promise of liquidity from the former may improve the outlook for the latter especially should financial institutions start lending again (and early signs in this respect are encouraging).

Medium-term prospects for the US economy have long seemed to us to be on a more secure footing than those of the Eurozone based on the foundations of an increasingly robust housing market (where data continues to impress on the upside – house prices are now rising at their fastest pace since mid-2006) combined with cheap and abundant domestic energy and improvements in the industrial workplace. While all of the above undoubtedly remains the case, in the near- term, uncertainty levels regarding the US investing environment, particularly relative to Europe could rise. Not only is the Presidential Election due within the next month, but the looming issue of the ‘fiscal cliff’ (i.e. legislated tax drag – which could constitute a contraction of up to 3.0% of GDP in 2013) remains a contentious topic to which there appears no consensus and no obvious answers at present, based on the literature we have read on the topic.

We have warned in the past of the dangers of complacency (which would tend to follow the recent rounds of policy response and investor relief that we have observed, with complacency then preceding crisis) and the risk of some political dysfunction should still be considered a concern in Europe as well as America. The logic of Spain (and Greece) seeing the bigger European picture by seeking financial aid while implementing austerity measures is clear, but progression towards these goals may not be straightforward. Unforeseen problems may emerge in other countries (Italy) too. In the near-term,

the impending third-quarter earnings season may also serve as an unwelcome reminder of the magnitude of challenges facing the broader economy. In the US alone, some 120 companies have already negatively pre-announced results for the quarter (including bellwethers such as Fedex, Caterpillar and Intel), the highest ratio for the S&P since the first quarter of 2009. Nonetheless, consensus continues to see over 10% earnings growth for 2013, a figure which may well be too high.

Despite these concerns (and notwithstanding the possibility of other exogenous risks such as an escalation of tension in Israel and the Middle East), current prospects look better than they have done for some time. The broad case for owning equities relative to bonds is strengthening and from a simple positioning perspective, many remain underweight in the former. With over 70% of funds currently underperforming their benchmark year-to-date (according to Trustnet data), managers currently seeking performance may also feel the need to raise equity weightings. In no region more so than Europe do we feel asset allocators and global managers are underweight and it should also bear some consideration that while the S&P is close to five-year highs, the comparable European index is still some 30% below its last peak.

Given a preference for diversification and the logic of seeking to offer uncorrelated returns, we continue to favour a range of asset classes, with our positioning centred on:

• Broad equity allocations to most regions. As discussed above, the case for European equities has tangibly improved and we see allocations in this region as complementing those towards US and global managers. Moreover, a more positive outlook for European equities should also benefit managers with high emerging market exposure given the close correlation between the two regions (the Eurozone is the biggest export market for China, for example; and European financial institutions are the biggest lenders to EM corporations). In general terms, we have a preference for businesses with strong balance sheets, attractive cash-generating prospects and the ability to de-equitise.
• Credit strategies oriented towards high yield and emerging market debt. Within the credit space, we believe that EM prospects seem more attractive relative to those of their developed market peers. With regard to high yield, we reiterate our comment made in previous pieces that current implied default rates seem anomalous particularly given the strength of corporate balance sheets. Furthermore, short duration high yield product constitutes a particularly logical strategy in a world where inflation expectations may be rising.
• No change regarding our stance on alternative asset managers. We continue to see the importance of allocations towards selected alternative asset managers (particularly within the macro and CTA space) and expect that trend-followers should prevail over the medium-term. The Euro, for example, should logically weaken from current levels, especially since such an outcome would be conducive to the region’s growth prospects.
• Some investment in gold remains crucial in our view. We see this strategy not simply as a form of portfolio insurance, but expect the precious metal to appreciate for as long as real interest rates remain negative. Moreover, gold should also benefit from an elevation in inflation expectations. Indeed September was the best month for the asset since January this year, perhaps a sign of things to come.

Alexander Gunz, Fund Manager, Heptagon Capital