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.

Even with the S&P at a nominal all-time high and global equities having recorded a gain of more than 7% over the first quarter of 2013, there appears to be a distinct lack of euphoria among many investors. While some caution is only to be expected given the age of diminished expectations in which we now live, recent events clearly demonstrate that the cycle of complacency leading to crisis has yet to be broken. Despite these observations, equities remain our preferred asset class, still offering better value and less risk than credit. Nonetheless, as performance from the first quarter also reveals, this year may end up being more about alpha than beta, hence favouring stock selection.

As has occurred so often in the past, problems within the Eurozone have come to the fore once again. If the fate of Cyprus (and indeed the ongoing political vacuum in Italy) highlights anything, then it is simply that competitive austerity alone is unable to return the Eurozone to health. Similar to the fate of Lehman Brothers, the way in which policymakers have conducted affairs in Cyprus may have several unintended consequences. Regardless of whether bail-ins represent the new normal for intransigent and/or non-compliant Eurozone countries, most importantly, many – both citizens and investors – may now have lost some further confidence in the already opaque workings of the Eurozone. Vowing to do what it takes to keep monetary union together may be one thing, but if the trust in cash within the union is undermined, then so may be the credibility of the whole project. Clearly a currency union with internal exchange controls (i.e. the current situation in Cyprus) is an oxymoronic concept.

If these are (some of) the problems, then unfortunately there are no easy answers. The will to sustain the Eurozone in its current format – cynically, at least until the German Election has come to pass in the autumn – is remarkable. The hope remains that policymakers can continue to paper over the metaphorical cracks and sustain enough support for their cause until the continent’s economy is in a sufficiently strong position to provide support. Even if it may feel to the people of Cyprus that they have already left the European Union (or that it has left them), it is always worth remembering that the cost of keeping the Eurozone together in its current format would still almost certainly be lower than that of seeing continent-wide disintegration. The biggest lesson that policymakers should be drawing from events in Cyprus is the need to accelerate both structural reforms via labour market liberalisation and a framework for effective banking regulation.

From an investor perspective, it will again take time for Europe’s policymakers to rebuild trust and confidence. The ‘Draghi put’ may have been able to withstand an electoral debacle in Italy and a somewhat botched Cypriot resolution (the Stoxx 50 European market also lost just 40 basis points in March), but it is not impermeable. There is only so long by which investors can be calmed by words alone. Eurozone industrial production has ground to a halt, unemployment continues to rise (at a record 12% for the continent and surpassing 27% in Spain) and the currency remains uncompetitive against its global peers. Corporate earnings momentum is also currently weaker in the Eurozone than elsewhere. Hopes therefore continue to reside in the potentially restorative balm of monetary policy. For the ECB, interest rates (at 0.75%) have obvious scope to fall, while balance sheet expansion is also an option that could be worth exploring. The ECB’s balance sheet comprises just 108% of GDP at present, less than half the levels of the Federal Reserve or the Bank of England (221% and 340% respectively).

It certainly seems to be the case that if Mario Draghi may not be poised to pull a new monetary rabbit out of his hat, then there may be no shortage of other pretenders. Hopes are currently also riding high for rhetoric to transmute into reality in Japan via the use of unconventionally accommodative policy, and the UK (hovering on the verge of a triple-dip recession) may also benefit from some of the same when Mark Carney takes up his governorship at the Bank of England in July. For the United States, even if economic prospects do currently look healthier than elsewhere, there is still a clear need to steer monetary policy along an effective course. Both Ben Bernanke and his likely (economically even more liberal) successor, Janet Yellen, appreciate the risks of withdrawing stimulus and/or raising interest rates at too early a stage of recovery.

There is undoubtedly little cause for complacency in the United States at present. On the positive side, the housing market continues to strengthen (housing starts have exceeded 900,000 for the last two months, and remain less than half the level of their previous cycle peak), while jobless claims continue to fall (currently, to their lowest in over five years). However, large fiscal questions remain unresolved and both consumers and corporates have perhaps begun to pre-empt this somewhat. Industrial production and consumer confidence dipped in March while several bellwether US businesses such as Fedex, Oracle and Caterpillar have also highlighted presently difficult trading conditions.

Such an outcome may though not be a bad thing. Indeed, ironically, the biggest potential risk facing the Federal Reserve may in fact be that the US economy grows too fast, with such an outcome implying the possibility of a premature conclusion to the policy of zero interest rates, and its corresponding impact on margins and multiples. There is not a lot of evidence of this at present, but this still does not make life at the Fed easy. Its other challenge is in understanding how the US labour market may have structurally changed in the four years since the recession ended. Still-benign monetary policy is premised on the assumption of an output gap between actual and potential GDP existing within the economy. However, it is possible that the size of the labour force (i.e. those willing to work) and how they decide to participate (i.e. full-time versus part-time) may have fundamentally changed. Sub-2% inflation may be currently benign, but as we have written previously, inflation’s progression tends neither to be linear nor predictable. Should the labour market – inflation transmission mechanism be functioning in ways that the Fed may not be able to gauge fully, then the risk of a sudden round of abrupt interest rate rises cannot be fully discounted.

For equity investors, the anticipation of some inflation, without any evidence thereof, is an ideal outcome. Equities tend to outperform under such a scenario (at least until expectations surpass 4%), while holders of fixed income instruments correspondingly suffer. Recent monetary policy has been driven by policies designed to increase levels of risk appetite and it is therefore logical that policymakers should seek to perpetuate such an outcome. Even if this approach is not via active policy, then signalling can be highly effective. Against this background, signs of caution from the Fed should not be read as pessimism, more as an exercise in expectations’ management.

If neither European woes nor a fundamental misjudgement by US policymakers over the state of the American labour market ends up undermining the outlook for equity investors, then what could? Beyond the perennial list of exogenous

factors such as political dislocation in the Middle East, a slowdown in the prospects for emerging economies does bear some consideration. Among the major regions, current growth indicators in China and Brazil look patchy at best, while the political landscape in India seems uncertain. Longer-term, the growth argument is clear, but the near-term impact has manifested itself in terms of emerging market equity underperformance in the initial months of this year. Moreover, for Europe (where growth is clearly most challenged presently), its interconnectedness with the emerging world is most stark, being the largest net trading partner with this block.

Relative even to a year ago, prospects for both the global economy and investors look markedly better. They will also likely continue to improve, at least for as long as policy errors are kept to a minimum. However, given the risk not only of error, but also noting the still-fragile recovery, there is clearly no room for complacency, not least for its ability to precipitate potential crisis. While this may be important context, when it comes to asset allocation, valuation is crucial. Investing in assets at attractive prices certainly trumps trying to anticipate GDP growth and also arguably attempting to second-guess policymakers.

It is against this background that we draw comfort from the fact that global equities as measured on a cyclically-adjusted Shiller P/E multiple still look undervalued, trading on a rating of 13x against a long-term average of 15x. Clearly such a ‘global’ figure does not take into account regional variations, namely the relatively expensive nature of the S&P as compared to the attractiveness of the European and Japanese equity markets. However, as we have discussed previously, such an environment is highly conducive to stock-pickers. With seemingly lower systemic risk characterising global markets than in 2012, the relative performance of regions, countries, industries and individual businesses will be less correlated, supporting the idea of 2013 being a year for alpha more than beta. We express such a strategy via investing in managers that have high conviction, expressed by concentrated portfolios, significant tracking error against their benchmarks and an emphasis on businesses with sustainable competitive advantages and significant free cashflow generation.

It also remains the case when considering equities relative to other asset classes, and credit in particular, that the valuation argument is highly supportive. The yield (expressed either in terms of earnings or dividends) that investors can earn on equities continues to be compelling relative to most forms of credit. In addition, under the predominant inflationary scenario we have outlined (where expectations are rising but actual levels remain repressed), equities should again benefit at the expense of credit. Similarly, when interest rates do eventually have to rise, equities should again come to the fore. As a result, we believe the most defensible credit strategy at present is to invest with managers that have the ability to implement non-directional strategies, hence limiting or even negating duration risk. Our stance on other asset classes remains unchanged: namely limited exposure to macro hedge funds at present and the continued presence of a small tactical allocation towards gold.

Alexander Gunz, Fund Manager, Heptagon Capital