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.
Might the good times be back? This is what many market indicators seem to suggest: global equities have rallied more than 4% so far this year with the S&P trading within 5% of its all-time high, while the yield on the US ten-year Treasury has approached 2% (compared to 1.7% but three months ago). These moves have also been accompanied by a fall in volatility (at least as characterised by the VIX index) towards record low levels. We have advocated the broad case for favouring equities over credit for some time and are clearly encouraged by these recent developments. We are also encouraged by the simultaneous and reinforcing impact of tentative economic recovery being witnessed in all the major global regions.
However, it has become increasingly easy to forget, especially while basking in a period of relative contentment with the prospect of sunlit uplands in the distance, that many of last year’s crises have been contained rather than resolved. Indeed, as the outlook improves, investors seem to be inured to enthusiasm and may therefore be more prone to disappointment. Put another way, the bar is being raised ever higher. The reality remains that the market (in the broadest sense) continues to be enslaved to the actions of central bankers and the seemingly restorative impact of monetary policy. While the results so far are heartening – at least in terms of raising risk appetite – the experiment remains unproven; as we have written before, one cannot escape from the idea that policy is being made up, revised and amended, as circumstances evolve. What happens when stimulus is withdrawn is still highly unclear. Furthermore, that which has been contained (the future of the Eurozone and the US debt situation in particular) will eventually need to be confronted and resolved.
Despite recent market moves, three things are clear to us: equities remain cheap relative to conventional credit, the global economy is recovering and liquidity is abundant. This is the good news and although much of it is ‘understood’, we profile some key highlights below. Our conclusion is that optimism is justified, complacency is not. A detailed consideration of the risks and challenges is also crucial and perhaps deserves more attention.
First, the good news. Synchronicity seems to be back. The term was initially popularised in 2008, when nearly all the world’s major economies (and stock markets) moved in apparent downward lockstep following the bursting of America’s housing bubble and the subsequent seizure in the country’s banking system. Wind the clock on five years, and now, a similar majority of the globe’s largest economies (the US, China, the Eurozone – and even Japan) seem to be growing, with global purchasing manager indices (PMIs) exceeding fifty, hence implying expansion.
Moreover, just as the US housing market precipitated collapse and dislocation back then, so it is leading the recovery now. Home sales in 2012 were their best since 2007 and new housing starts are at their highest since June 2008. According to Core Logic, an analytics service, house prices are now witnessing year-on-year increases in all but six states across America. Arguably the biggest issue facing the market now is not demand, but shortage of supply, with the stock of single family homes, for example, at its lowest since 2001. The corollary is that the potential for housing starts to accelerate further is clear. Current levels of 0.95m annual starts compare to a ‘normalised’ (taking into account population change and other factors) pre-crisis figure of 1.75m, some 80% higher. The strength in the housing market can also provide a platform for other parts of the economy and should the US grow its GDP at 2.0-2.5% this year (as is forecast), then this ought to be seen as an encouraging figure, especially since output expansion is being driven largely by genuine demand and the need to replace goods. Stable and sustainable recovery, albeit at a lower rate than that to which many may be accustomed seems highly preferable to more rampant, leverage-driven growth, a mistake that was made in previous cycles.
Meanwhile, in Europe, there appear to be a burgeoning number of positive indicators, pointing to progression. Continent- wide PMIs made a low in July last year, and currently stand at least at nine-month highs in several peripheral nations (Spain, Portugal) as well as in Germany. In the latter, economic confidence surveys have reached levels last witnessed in May 2010. Anecdotally, manufacturers no longer seem to be reporting negative surprises, capital goods exporters have materially begun to expand their production output and are reporting good order book growth. Credit standards are therefore being eased somewhat and consumer confidence is hence rebounding slowly. All of this is undoubtedly positive also for global trade flows and it is notable that China’s last reported export growth was its strongest since March 2009, perhaps evidence that its country’s model (and that of many other emerging nations) is far from broken yet. Even Japan, for long the poster-child for how not to run an economy has announced stimulus measures equivalent to $166bn and seen the Yen weaken, helping spur its own export market.
As roseate as this picture may be, several not insignificant concerns linger. Most prominent are the facts that the developed world remains highly indebted and, that growth (or at least the return of confidence) has been strongly supported by aggressive and deliberate monetary intervention. Both of these factors have the potential to unsettle investors. We have seen on numerous occasions that complacency is often the precursor to crisis. Some may assert that improving economic growth will be sufficient to alleviate these above observations, but such a perspective may be akin to that of the ostrich, in denial and with its head metaphorically in the sand.
Ideological rivalry in the US between Republicans and Democrats over how to resolve the fiscal cliff is higher now than when the government was last forced into shutdown, in August 2011, raising the possibility of repeat. While some may claim a victory that the debt limit does now not need to be discussed until May, it remains the case that the issue does need to be discussed at some stage. Public debt is equivalent to over 100% of GDP and theoretically raising the ceiling is tantamount just to delaying the inevitable, it does not change the absolute level of debt. Hard decisions need to be taken. Spending cuts and/ or tax rises could reduce growth and certainly impact confidence. Similarly challenging issues beset Europe. While the continent may be recovering, it is still from a very low base. Unemployment stands at a record 11.8% for the Eurozone. Correspondingly, don’t discount the resistance that remains to austerity, which still has the potential to be a vote-loser (watch for the outcome of the still-uncertain Italian election later this month, and also the still-febrile Spanish situation), while broader structural reform for the EU – which could help alleviate unemployment among other things – may well be off the agenda, at least until the outcome of the German election is clear this Autumn.
The consequence of fiscal and structural deferral is that it puts a greater burden on the effectiveness of other policy actions, namely monetary intervention, but also increasingly, exchange rates. Both have their limitations. Keynes famously asserted that for monetary policy to be effective, it needs to be “rooted in conviction.” In other words, it has to be credible. The Federal Reserve and the European Central Bank (ECB) more recently have proved exceptionally effective in their signalling, a strategy that has undoubtedly helped improve risk attitudes. The challenge is how to develop policy from here. There exists an inherent contradiction in the idea of quantitative easing (QE) being effectively unlimited, but discussions already beginning in the US over exit strategies. Debate over the latter may undermine effectiveness in the former. Meanwhile, the ECB has yet to receive a request for the activation of its Outright Monetary Transaction scheme. How it practically proceeds with this process when such a request comes is therefore far from clear. In Japan too, after the rhetoric comes the reality. Asset purchases will not begin until the start of next year and the country’s 2% inflation target remains just that, a loosely defined goal with no explicit time horizon. Over the past year, investors have come to expect more from central banks; their scope for disappointment is therefore higher. This may be reinforced by imminent leadership change at the Fed, the Bank of England and the Bank of Japan, all within the next twelve months.
Growing your way of debt is inevitably more appealing rather than defaulting on it (still something of a possibility in both the US and the Eurozone) or inflating it away (the potential end-product of the great QE experiment). Debasing your currency can clearly help in this respect. Indeed, Japan, which is perhaps more structurally challenged than any other developed country by an absence of growth and a presence of debt is instituting policy explicitly aimed at reducing the value of the Yen. The country’s currency has fallen more than 12% against the Dollar over the last three months. This is perhaps a sign of things to come. Conversely, while Europe’s recent economic progress has been encouraging, a 10% rise in its currency (against the Dollar) over the last six months is almost certainly deleterious to growth and corporate earnings. An effective strategy on the part of the ECB may therefore be to lower interest rates (or institute other actions), to bring about a lower Euro. However, currency debasement is a zero-sum game. Not all countries can weaken their currencies simultaneously and indeed growing tensions over such strategies may exacerbate the other severe economic challenges that exist not to mention possible geopolitical tensions.
To reiterate our earlier assertion, optimism over prospects is justified, complacency is not. Against this background, the logic of investing in undervalued assets is only reinforced. The broad case for equities therefore appears clear with conventional G7 sovereign and corporate debt offering a significantly inferior yield (against stocks using either an earnings- or dividend-based approach). On a regional basis, while it may be harder to justify currently investing in the US from a simple valuation perspective, both Europe and Japan continue to appear exceptionally good value, both on a historic basis and relative to the S&P. We have been encouraged by positive earnings momentum in all regions, which support the case for overall multiple expansion. Moreover, while $7bn may have flowed into equities in the first two weeks of this year (and almost certainly more since then), this figure remains small in the context of $100bn of outflows in 2012 (or at least $600bn since 2007). Elsewhere, there has been little change in our asset allocation approach, favouring portfolio diversification. In other words, within credit, our preference is for those managers that have the ability to implement non-directional strategies and limit duration risk. Many alternative asset managers may well continue to struggle, for at least as long as policy intervention remains. And, the current repression of inflation (combined with low, but potentially rising interest rates) may cap meaningful upside in the gold price, its defensive merits notwithstanding. Equities therefore can continue to prevail for now.
Alexander Gunz, Fund Manager, Heptagon Capital
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