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.

It is remarkable both how little and how much can change in the space of twelve months. The arguments we made on these very pages exactly a year ago – “the case for owning equities over bonds remains firmly intact… [and] within equities we favour global exposure, but prefer Europe” – are still entirely valid, but the extent to which equities have rallied during 2013 has been most surprising, particularly given how little volatility has been experienced along the way. Indeed, investors have an awful lot to be thankful for: not just the absence of a major equity market correction, but the fact that the Fed in particular, but arguably Central Bankers everywhere have remained broadly credible, political divisions have not undermined market progress and the global economy has comprehensively begun to move towards normalisation. Looking ahead, if there are concerns, then they relate to complacency and to (equity market) valuation levels. That said, in the absence of more compelling alternative investment options, equities remain our preferred allocation heading into 2014.

With fewer than twenty trading days remaining in 2013, global equity markets have risen some 20% on average so far this year. While the Nikkei’s almost 50% gain constitutes its best performance since 1972 and can largely be attributed to the positive impact of Abenomics, the S&P’s current rise of 25% leaves the market on track potentially to deliver its best annualised gain since 1997 (a 31% move). However, a simple look back through history shows that America’s main market index has added more than 30% in the space of a year just nine times since the Great Depression – in other words, such a performance is the exception rather than the rule. With headline P/E multiples for the US back at pre-crisis levels (along with credit spreads), the IPO market at its strongest since the tech boom and even signs of covenant-lite loans making a resurgence, it is perhaps not unreasonable to suggest that another bubble is beginning to build.

The incoming Chair of the Federal Reserve, Janet Yellen, would obviously beg to differ. Not only does she assert that the US economy is operating “far short of its potential,” but also that there is currently little evidence of risk-taking visible on the part of investors. Is such a claim tantamount to a ‘Yellen-put’, namely that the Fed’s policy will remain loose, transparent and highly accommodative for the foreseeable future regardless of what happens to equity markets, or have policymakers simply misjudged the economic situation while their tacit encouragement of risk-taking may just be storing up problems for the future? There is no simple answer to this debate, but three clear observations can be made. First, it will be critical for the Fed to remain credible and consistent in its messaging if recovery is to be sustained. Next, the risk of a major (US) market drawdown at some stage in the next year is relatively high, especially given valuation levels and the fact that the S&P has seen just two down months in the last twelve (and only one greater than 5%). And, finally, by implication, we see less risk and more upside in regions other than the US.

Valuation levels and the prospects for positive surprise are both more appealing in Europe and Japan at present than they are in the US in our opinion. The arguments regarding the former topic have been well-rehearsed elsewhere and it seems sufficient to highlight the S&P’s premium both relative to historic levels and to other global indices. While we are inclined to believe that corporate margins can remain at elevated levels in the US owning to limited wage pressure combined with long-term structural drivers (automation and new technology, growing energy independence etc.), there is no denying the fact that negative earnings revisions in the S&P are currently exceeding positive ones by a factor of six-to-one. If this trend is sustained, near-term profits may not be able to keep up with current multiples, prompting an obvious correction. This is a notable contrast to Japan, which has seen the strongest level of positive revisions of any region globally during 2013, a trend we expect to be sustained into 2014. Globally, we also note that an aggregate of non-US PMIs (industrial production data, and a strong proxy for corporate health) exceeded US PMIs last month for the first time in four years. Given the correlative strength of this factor, it further supports the argument for relative US underperformance.

If the directional trend of economic data is likely to be more supportive to Europe and Japan than it is to the US, so should monetary policy. In these former regions, the story remains all about using unconventional methods to drive recovery, whereas the key challenge for the Federal Reserve now is how to keep recovery on track – without rate expectations rising too much. Low inflation has been a fillip for policymakers globally, but in particular it provides the ECB and the BOJ with the de facto mandate to be even more assertive in their monetary stances.

In the face of Eurozone inflation at a four-year low of 0.7%, the ECB has already recently lowered interest rates and Mario Draghi remains pragmatic. Do not rule out negative rates or the possibility of a second round of long-term refinancing operations over the coming year. This latter policy would be especially logical in the context of supporting small and medium enterprises. These businesses comprise 70% of the periphery’s GDP and even if southern Europe’s prospects are recovering from a low base, there is still a very long way to go. As far as Japan is concerned, its explicit policy under BOJ Governor Kuroda (and by implication, PM Abe) is to drive inflation to 2%, a reversal of two previous decades of deflation. With GDP growth slowing (to 1.9% annualised in Q3 relative to 3.8% in Q2) and VAT rises coming, expect the BOJ to be more assertive. Japan’s monetary base should double in 2014.

By contrast, the Fed has a more delicate balancing act it needs to undertake. While investors now seem to appreciate the distinction between tapering and tightening, any hint that that the Fed may be willing to tolerate higher rates expectations could lead a sharp sell-off in equities, particularly given the causal relationship between the S&P, the US housing market and the American economy. From one perspective, it therefore seems logical for the Fed to start tapering as soon as possible. Not only does this send a clear signal regarding its confidence on prospects, but it also begins to shift the influence of policy more towards forward rate guidance.

With America’s core consumption deflator (i.e. its proxy for inflation) at just 0.7%, and unlikely to rise notably in the near- term (it has been below 2% for the last four years), there is scope for the Fed to suggest rates can remain low for at least the next three years. If investors begin to believe that such an assertion is credible, the ability for the housing market to make further progress – housing starts more than 50% below their peak –would seem more assured. However persuasive this approach may sound, building consensus across the Federal Reserve Board could prove a challenge, particularly given the divisions evidenced in recent Minutes (particularly relating to understanding and targeting unemployment) and possibly exacerbated by new members joining in the coming months.

Moreover, even if the Fed does prove successful in managing successfully expectations, there is still little it can do to prevent or offset political dysfunction. Politics, much more than economics, could be the factor that derails equity market progress in 2014. For the US, not only does the debate over the fiscal ceiling need to be resolved – most likely during the first quarter, unless the metaphorical can gets kicked further down the road again – but as the year develops, November’s mid-term elections may increasingly come to the fore. Fiscal policy is likely to remain a key source of tension between the two parties and it is self-evident that divisions between Democrats and Republicans (as well as within the Republican Party) remain rife. Elsewhere, even if parts of Europe’s periphery (Ireland, Spain, Portugal) are making progress, Greece remains highly challenged and Italy problematic. May’s elections for the European Parliament may result in several flashpoints with the potential emergence of more extremist parties in some regions being an obvious source for concern. Even in Japan, despite Abe’s LDP controlling politics, progress may stall, particularly if the Prime Minister finds himself struggling to face down special interest groups.

Investors in emerging markets are generally much more accustomed to managing through both economic and political uncertainty, but the biggest issue for 2014 may be one of relative underperformance. As developed markets move towards normalisation, particularly accompanied by US tapering and a likely corresponding rise in the Dollar, such a scenario will particularly pressure export-dependent emerging markets (given their Dollar currency peg). Much has been written about the positive developments announced during China’s Third Plenum and while these do have the potential to be at least as significant as Abenomics in the medium-term, inevitable questions relate to the speed and visibility of reform. The logic of moving away from production (export-contingent investment) towards consumption is, nonetheless, highly persuasive.

Our brief observations about emerging markets underlie a notably more significant point: in this region as in others, the importance of stock-picking is absolutely critical. Just as 2013 has notably seen active strategies outperforming passive ones, so such a trend should continue to prevail in 2014. It is against this background that while we are positive on equities over other asset classes and also acutely conscious of valuation levels (hence our relative positioning with regard to the US), attractive businesses can be found in all geographies globally. We currently favour global equity managers, but our regional preference remains for Europe and Japan. Within emerging markets, our preference is for those strategies most exposed to consumer (over export-dependent) plays.

Much of this note has deliberately focused on the outlook for equities simply because we see best scope for this asset class to outperform heading into 2014. At some stage this trend will reverse and credit will become more compelling, both strategically and from a valuation perspective. For this to be the case, however, yields on the US ten-year Treasury probably need to be in the region of 3.0-3.5%, in contrast to 2.8% at present. Our current credit exposure is limited to non-directional absolute return strategies and selected short duration high yield. Elsewhere, we have begun to invest in selected alternative asset managers, particularly in the event-driven space, which is seeing increased activity given the recent performance of equity markets. Gold will likely underperform in a world where macro risks are diminishing and rates are (directionally) rising, while cash remains a somewhat unattractive defensive option at present. So, equities it is for 2014, but we remain pragmatic rather than outright optimistic.

Alexander Gunz, Fund Manager, Heptagon Capital