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.
On first sight it seems somewhat curious that many investors are not more optimistic about prospects given that large parts of the global economy are gradually recovering, the Federal Reserve’s ‘tapering’ policy has become broadly understood and accepted, there is no apparent likelihood of crisis in Europe (in contrast to the last two years) and Prime Minister Abe has been awarded a clear mandate to enforce genuine change in Japan. Should we attribute current ambivalence to traditional summer lassitude or is something more fundamental at work and of concern? Put simply, we see two issues: first, while near-term prospects are indeed encouraging, the medium-term outlook is more worrisome. Next, there are few asset classes/ strategies that appear tangibly undervalued at present. Such an outcome creates inevitable challenges for investors, but we remain confident of identifying pockets of value, particularly in equities: both Europe and Japan on a more immediate perspective, and clearly emerging markets over a longer time horizon.
Our concerns are neither novel nor have been unmentioned in previous editions of View From The Top. Highly accommodative and unconventional monetary policy has undoubtedly created a sense of comfort in recent years, namely the reassuring knowledge that Central Bankers would be on hand to provide stimulus and/or guidance whenever required, but also a sense of complacency too. Equity market highs have acted as an effective validation mechanism for such an approach to managing the economy (even if investors continue to obsess over every policy utterance made by these powers), but have ignored the fact that while the world may be in a less bad place than hitherto, the problems that led to the previous crisis have not been fully resolved, hence potentially sowing the seeds for the next one.
The global economy may now be growing, but it remains awash with debt. Total public debt to GDP in the US stands at 73% compared to 40% five years ago, when the crisis began. Although household debt has come down, government debt has risen (notably from having bailed out failing banks). Even if Europe’s periphery may now not be on the point of collapse, debt to GDP on a comparable basis still exceeds 120% in Spain, Portugal and Ireland. Of greater concern is China’s situation. While public debt stands at 72%, Credit Suisse estimates that total leverage within the Chinese financial system could exceed 230% of GDP, also taking into account its shadow banking system. In the absence of inflation, it will take a lot more than growth to diminish debt levels substantially. Meanwhile, the next consumer credit cycle is beginning in the United States, with monthly lending at its highest in over a year, to highlight but one indicator.
Policymakers (particularly in the US) may be somewhat cognisant of the challenge of creating sustainable growth while reducing debt, and recent Federal Reserve commentaries around possible planned exits from quantitative easing have resulted in a tightening of liquidity conditions, not just in the US, but also globally – whether by intention or accident. The yield on the US 10-year Treasury is now some 90 basis points higher than just three months ago. Whether this is a ‘good thing’ for investors remains to be seen as higher yields and a reduction in liquidity can have a negative impact on both equity and credit markets. While there are strong reasons to assert that the thirty-year bull market in bonds may be over (yields could not practically have fallen any further), equities are no longer as undervalued on either an absolute or relative basis as was the case just twelve months ago, while global earnings momentum is also slowing notably. Nonetheless, assets have to flow somewhere. Credit mandates have seen over $55bn of outflows in the last two months, while equity strategies have correspondingly witnessed their highest levels of monthly inflows in almost five years.
The reality that equities currently constitute the default asset class in which to invest (beyond cash), also helps to explain why there have been clear levels of dispersion across markets, more so than in any other recent year. It is starkly notable that while the Nikkei added some 35% in the first seven months of 2013 and the S&P has risen close to 20%, European indices have performed much less impressively (averaging gains of around 7%), while emerging markets have declined by more than 10%. History shows us that GDP (and also future expectations thereof) have almost no correlation with stock market performance and while some of Japan’s gains may be attributable to the sui generis nature of recent events, two other considerations bear merit.
First, many asset allocators have likely opted for low-risk strategies: if not government debt, then the ‘defensive’ merits of mega-cap US equities. Second, while this approach may have held true for some time, looking forward, valuation considerations ought also to be paramount in decision-making. The S&P may continue to benefit from investor momentum and there may remain value within the market, hence our preference for alpha over beta strategies at present, but a more compelling investment case can clearly be made for both Europe and Japan. European equities are still trading some 30% below their 2007 highs, a notable contrast to the US, and Japan’s market remains the cheapest globally on a price-to-book basis. Prospects are also notably improving in both these geographies. For the longer-term investor, there seems little doubt about the case for emerging market equities, particularly given their current 30% discount on a global earnings metric and 20% relative undervaluation on price-to-book value.
Compared to a year ago, Europe’s situation is perhaps the most notably different. The region has been enjoying a period of relative stability (note how the mini constitutional crisis in Portugal was dealt with swiftly) and the scope for positive surprise is arguably higher here than elsewhere. Of most note, European industrial production is beginning to converge with other global regions and tentative expansion (i.e. a PMI reading of greater than 50) was recorded in July for the first time since October 2009. With European new orders at a two-year high, this is also an encouraging sign, since this trend tends to lead GDP by around two quarters. Furthermore, during the current reporting season, at least forty major global corporates signalled in their earnings releases that prospects were now improving. Consumers too will have benefited from a reduction in inflation by around one percentage point (2.5% to 1.5%) in the last year, boosting disposable income.
If this is the beginning, then there is still more to be done. The already-mentioned debt levels of several periphery nations may create a structural impediment to longer-term growth. To this end, progress needs to be made on accelerating continent-wide banking union and improving lending to smaller businesses. This latter strategy may also result in improved prospects for the longer-term unemployed. Even if the Spanish unemployment rate fell for the first time last month since 2007, more than 26% of the workforce is still without jobs.
Turning to Japan, while it may be heartening to hear the Bank of Japan use the term ‘recovery’ for the first time since prior to the Fukushima accident in its last statement, there remains substantial structural reform that needs to be
effectively implemented. The recent Upper House Election ended six months of electoral hiatus and Prime Minister Abe has now been given the ability to enforce legislation aimed at driving growth. The lesson from other economies is that Central Bank largesse can constitute only a necessary but not a sufficient condition for recovery. May did witness the largest rise in headline inflation in over two years, but wages need to start rising too in order for consumers to enjoy some of the potential benefits from an improved outlook (inflation without wage gains proved the partial undoing of the Koizumi administration). Against this background, employment, fiscal and trade reform are also crucial. This change, however, will not be immediate. Investors should be patient since the will clearly exists and support for Abe remains high.
While it is easy to point to signs of change (and hence recovery) in Europe and Japan, it should not be forgotten that the outlook in America continues to improve. The housing market is strengthening further, with builder confidence (generally a very strong lead-indicator) and house price rises both at seven-year highs. Given such optimism levels combined with a shortage of supply, the recent elevation of mortgage rates may not be a negative if it helps the market to grow at a steadier, more rational pace. Higher rates should not deter prospective purchasers, just make them more reasonable. General prospects, not just for the housing market, but also the broader economy, will clearly be helped by rising payrolls, increasing hourly earnings (currently at their strongest since July 2011) and consumer confidence at six-year highs.
The same, sadly, cannot be said for many emerging nations, which appear to be struggling at present. Beyond the perennial issues of dysfunctional domestic politics and broader geopolitical tensions, a number of economies are slowing while also grappling with exchange rates that make their exports less competitive. The difficulty for China in particular in moving from 10% GDP growth to a more normalised rate of 6-7% should not be underestimated, whether this change is brought about through explicit policy or more natural rebalancing. Moreover, being only one year into a decade-long Presidency, some of the policies now being enacted by the administration will inevitably take time to come to fruition. Nonetheless, more positively, should European economic prospects improve markedly (as seems possible), then there is a very clear geared effect upon emerging markets, with the former being the biggest export market for the latter.
Even if the general global economic trend is oriented more towards improvement than deterioration, the challenge of asset allocation remains somewhat problematic. Ours is a pragmatic approach: being aware of the medium-term structural problems, but also recognising current realities: in other words, beyond the default option of cash and its negligible return prospects, allocating to where we see value, both in equity and credit selectively. Within equities, 2013 has made a very demonstrable case in favour of active management (with an equally-weighted S&P outperforming a weighted version by way of example), hence our preference for high-conviction, alpha-focused managers with a global bias. From a regional perspective, Europe and Japan appear to offer the most compelling near-term opportunities. In terms of credit, we continue to favour managers able to adopt approaches based more around absolute-returns, managing duration risk actively. At present, we also have no exposure to gold, which could remain pressured despite its recent recovery. 2013 may not herald a repeat of previous recent ‘cruel summers,’ but it does not mean that the investing environment is unambiguously benign, far from it.
Alexander Gunz, Fund Manager, Heptagon Capital
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