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.

Based on the recent performance of equity markets in particular, investors could perhaps be forgiven for believing that the world’s economic and financial problems have been fully solved. The S&P is at levels last seen pre-Lehman and has risen 7.3% in the three months to the end of August, far from a repeat of last year’s ‘cruel summer’ scenario. Despite such robustness that at times has bordered on euphoria, we see little reason for changing our currently pragmatic asset allocation stance. The danger of complacency becoming established and disappointment subsequently ensuing looks possible to us, especially in the near-term. As a result, we continue to favour a selection of opportunities encompassing US and global (but not European) equity strategies and also those in high yield, emerging market credit (corporate and sovereign) and certain alternative asset managers.

Among the most notable data points for us at present is the fact that volatility, as measured by the VIX Index, is currently the lowest it has been in almost five years. This seems highly anomalous. Relative to late 2007, the global outlook has become notably more challenging. Unlike the situation five years ago, investors now have to contend with the legacy of the sovereign debt crisis and related banking crisis. As a result, world economic growth has remained below average (~3.5% versus ~5.0% trend) and unemployment in most of the developed world is still stubbornly high. Furthermore, serious questions have been raised about the sustainability of the Eurozone in its current form while the US faces a severe potential ‘fiscal cliff.’ Politically, there is currently also much uncertainty with regard to the Middle East and North Africa..

The way in which present equity market strength and low volatility can be reconciled with such macro dislocation can best be explained in our view as follows: for much of the recent past, investors have been exposed to a repetitive – and still essentially unbroken – cycle characterised by crisis, response, relief and complacency. On this analysis, if we are currently in the last of these four phases, then the scope for ‘crisis’ to ensue once again in the near-term would seem relatively high.

Two questions logically arise from this thesis: first, what factors may precipitate a crisis-like scenario; and, what is required to break the cycle? The answer to the first question is contained with the second. The problem of too much debt and not enough growth is clear, and of particular concern in Europe – which remains the epicentre of the storm. It would be naïve to expect there to be one simple solution, and resolution should be seen more as a process of metamorphosis through ongoing structural reform. However, both in Europe and elsewhere, effective policy development is predicated on co-ordinated and consistent action.

For much of the recent past, there has been a palpable lack of this and investors have become accustomed to the idea famously expressed by Franz Kafka that “progress had been made, but the nature of the progress could not be quantified.” 1 The reality is that however much faith may be being placed in the potentially restorative actions on Mario Draghi and Ben Bernanke, central bankers do not operate in a vacuum. In other words, not only are there key political constraints, but also only a potentially limited number of policy tools available. More generally, tangible progress requires political coordination. Getting 27 European Union Members States with their own local agendas to reach accord constitutes a significant task. The US also faces its own issues.

Herein lie the potential seeds of the next set of near-term challenges, factors that could see equity markets and other related assets correcting in the coming weeks. It is clear from almost all the macro data points that growth remains anaemic, with purchasing manager surveys and unemployment reports confirming a disappointing trend across Europe, the United States and China. As a result, expectations are set high both for the Federal Reserve and the European Central Bank to embark on further monetary stimulus, whether in the form of more quantitative easing, interest rate cuts or via other mechanisms. Bernanke’s most recent comments from Jackson Hole leave the door firmly open for such an outcome, particularly should there be incremental evidence of economic deterioration, especially in the form of sustained joblessness.

With regard to Europe, we refer to the earlier two points. The Draghi view that the ECB may be “sometimes required to go beyond standard monetary tools” and deploy “exceptional measures” is not one wholeheartedly endorsed by the rest of Europe, and in particular, the Bundesbank.2 How quickly the ECB can act therefore remains uncertain, especially since the German Constitutional Court will not meet to review the legality of the European Stability Mechanism (to which the Bundesbank would be the biggest contributor) until 12 September. It is ultimately in Germany’s interests for the Eurozone not to fall apart, since it constitutes the country’s largest export market by far, and competitive trade with its neighbours has been the primary driver for the country’s economic renaissance. That said, both the Bundesbank and Angela Merkel are likely to want to see Europe’s future evolve along their own terms, which may not be consistent with those of the ECB.

Even if Germany is not the problem, then there are numerous other potential European flashpoints to consider. Over the course of the next month, the Dutch hold a General Election, the Troika (the EC, ECB and IMF) visit a currently non-compliant Greece to review its progress on debt reduction and both the Spanish and Italians will have to refinance large chunks of their debt. Despite recently sanguine markets, Spanish 10-year yields still stand at over 6.5% and Italian yields at more than 5.5%. We also note that Spanish deposit outflows are currently at record levels and domestic political tensions are rising, with some regions (Catalonia, Valencia) pressuring the central government for immediate direct bail-outs, even before any EU help has been sought.

As has been the case for much of the last few years, most focus has (rightly) centred on developments in Europe. Nonetheless, it is worth noting that in the US, the housing market – a theme we have been discussing since the start of this year – is showing further signs of recovery. The NAHB builder confidence survey stood at its highest in August since early 2007, building permits are at four-year highs and the Case-Shiller house price is now recording year-on-year increases. Such improvements can help lay the foundations for future economic progress and we remain more confident on US prospects than those elsewhere in the developed world. The impending fiscal cliff (which some suggest could reduce GDP by up to 4%) may receive a lot of commentary and hence drive some uncertainty, but progress on its resolution does not look likely in the very near-term.

In every global region (and there has not been space in this piece to discuss the somewhat mixed near-term prospects facing much of the emerging world), various uncertainty factors persist. To suggest that all potential risk is discounted in market expectations therefore seems incorrect and events in the coming weeks may raise a number of challenging questions. We hence advocate a strategy of pragmatism. Our investments remain focused on diversification and the ability to offer uncorrelated returns. At present, we are positioned towards:

• Credit strategies centred on high yield and emerging market debt. We feel there are compelling opportunities in emerging market debt and high yield. EM prospects seem more attractive relative to those of their developed market peers. It remains hard to accept the notion that there is such a thing as ‘safe’ G7 debt. 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.
• Invest selectively in global equities, but avoid meaningful exposure to Eurozone. Although European markets outperformed US in the last three months (EuroStoxx 600 up 11.0% versus S&P 7.3% higher), prospects for the region remain the most challenging globally and results from Eurozone listed companies continue to disappoint most systematically. Our preference is for investing in high-quality, globally diversified business with robust balance sheets. US and global equity managers remain preferred.
• No change regarding our other investment strategies. We continue to see the importance of allocations towards selected alternative asset managers and expect that trend-followers should prevail over the medium-term. With regard to the Euro, despite recent strength, fundamentals suggest the currency ought to weaken further, not least since it would help boost regional competitiveness. Finally, an investment in gold also remains crucial in our view, not just as a form of portfolio insurance, but also since it would benefit from (perhaps now inevitable) moves by the authorities towards looser monetary policy.

Alexander Gunz, Fund Manager, Heptagon Capital