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.

Few would have foreseen at the start of 2012 that equities would deliver their best performance in three years, beating bonds by over 10 percentage points. While the Bank of America Merrill Lynch Global Broad Market Index of bonds rose 5.7%, the MSCI All-Country World Index added 13.4%, or 16.8% cum dividends. Misquoting Winston Churchill, the main reason for such an outcome was that politicians (and central bankers) ended up “doing the right thing… after they’ve exhausted all the alternatives.” In other words, unprecedented intervention and monetary stimulus proved enough to stave off the collapse of the Euro and a Chinese hard-landing, while the robustness of the US economy and relative stability in the Middle East surprised many.

For 2013, expectations are now set somewhat higher. The global economy is undoubtedly in better shape than twelve months ago, but the dynamics of excess leverage will continue to cast a cloud over prospects for returns from all asset classes for some time to come. As Jeremy Grantham of GMO writes, there are “no easy answers in the age of repression, only difficult choices.” That said, we believe the case for owning equities over bonds remains firmly intact, with there being scope for 2012’s performance to be replicated (and maybe bettered) over the coming twelve months. Put simply, equities are cheap, the risk-return profile on conventional G7 credit in particular is highly asymmetric and fund flows point to a clear bubble in bonds. Within equities, we favour global exposure, but prefer Europe. For fixed income, managers that have the ability to adopt non-directional positioning seem the most logical source of exposure.

If there are risks for the coming year (beyond complacency – although undemanding equity valuations should help keep a cap on this for now), then they appear more political than economic. Strengthening global macro momentum may reduce political dissension, but significant questions remain unanswered. The debate over the US fiscal cliff constitutes a microcosm of those discussions that will need to be had time and again across the developed world, namely, that taxes most likely need to rise and state expenditure fall until debt levels are much lower than is currently the case. In the US, discourse over a potentially elusive ‘grand bargain’ will need to start soon again, most likely in the next two months. Elsewhere, extremist politicians have the potential to destabilise Europe’s still-sclerotic moves towards closer union, while in Japan, despite the election of a new and dynamic Prime Minister, practical implementation of policy may prove harder than simple rhetoric.

Despite such concerns, there are many reasons for optimism. Our analysis points to improving trends in most major global regions. Taking the US economy first, we have written extensively about the recovery in the housing market over the past year, but data in this respect continues to impress. Last reported figures highlight that building permits (a strong proxy for new housing demand) are at their highest levels since July 2008 and home-builder confidence is at a point last observed in 2006. While clearly highly encouraging, these housing market trends merely rest at the forefront of a broader recovery in the US. Unemployment is at its lowest in four years, inflation stands at just 1.5% and corporate profitability is its best since mid-2006.

There is potentially much more to come as well. It is notable that durable goods spend as a percentage of GDP in the US is running at its lowest since World War Two while the corporate capex to sales ratio has remained barely unchanged since the end of the credit crisis. It is often asserted that businesses will be reluctant to raise expenditure levels until there is fiscal clarity – and this has been notably elusive. However, to keep the debate in context, government spend is already lower and taxation higher in real terms than at this stage of previous economic cycles. Meanwhile, with a third of the House of Representatives and Senators up for re-election every two years, there is little incentive to front-load spending cuts. In other words, corporates (and investors) should come to expect more compromise and react accordingly.

That which can most help the US (and arguably the global) economy is the restoration of confidence. This is a function not just of fiscal clarity but also of effective signalling. Key for the US is how to extricate itself from perpetual stimulus. In the respect, the message from the Fed seems to be clear, namely when unemployment falls to 6.5% and/or inflation rises to 2.5%. By contrast, a strategy of maintaining low rates until at least 2015 may simply keep corporates (and individuals) cautious for longer. However, while the building blocks for recovery are in place, stimulus does not look likely to be withdrawn just quite yet but potentially within the next twelve months, at least based on current trends. Indeed, by the time Fed Chairman Bernanke steps down (at the end of this year), the debate over the relative hawkishness or otherwise of his successor may not be as significant as many imagine.

In Europe, beyond the headlines of recession and record unemployment levels, the tough medicine is working and confidence is being restored. IMF data shows that labour costs in all periphery countries except Ireland have been falling for the last year, while export growth has been improving. With the exception of Italy, the Eurozone’s other peripheral nations are forecast to end 2013 with current account surpluses, and Greece at 3.2% – an impressive achievement for ostensibly the region’s least compliant member. All of this is reflected in lower bond yields, with Spanish and Italian ten- year debt now at less than 5% (compared to c7% a year ago) and Greek paper of a similar duration trading now at close to 10% relative to over 20% in 2012. While there is scope for further progress to be derailed (most so by maverick politicians), there are few major elections scheduled across the continent for the coming twelve months and German leader Angela Merkel will most likely seek to defer any major decisions about the Eurozone’s future until after her probable re-election in the autumn.

Turning to Asia, the Chinese economy appears to be stabilising. With exports constituting some 30% of GDP, healthier US (and Eurozone) markets should be supportive, while domestically the housing market shows evidence of expansion, and importantly, without evidence of excess leverage being taken on. Political leaders here and in many other emerging markets also seem to understand the benefits of judicious monetary policy as a mechanism for stimulating their local economies. Finally, in Japan, there is the promise of real change for the first time in many years. Again, this may help restore confidence. With a super-majority (in other words, the Lower House can veto the Upper House), new Prime Minister Shinzo Abe intends to embark on unlimited easing and inflation targeting.

Even if monetary policy does not prove successful in delivering growth per se, in Japan – as elsewhere – its purpose is also critical in helping to avoid less bad outcomes. The easiest choices in a difficult world relate simply to doing that which can restore confidence. Moreover, monetary policy is becoming less and less conventional and conversely more unorthodox.

Removed from the academic rationale of repressing bond yields, the ‘new normal’ is about seeking to stimulate the real economy. Not only is this supportive of our equities versus bonds argument (since a recovering economy with the withdrawal of quantitative easing in its original form makes owning fixed income relatively more risky), but also eminently logical. Before, however, embracing fully the power, dynamism and flexibility of the modern Central Banker, let us not forget that there remain some things that not even the combined might of the Fed, the ECB et al can counter. If the lesson of 2012 (and indeed many years previous) was to expect the unexpected, then the biggest potential destabiliser for 2013 is geopolitical instability, a tail risk that is hard to remove.

The above arguments make the case for equities over bonds look compelling, particularly as we move closer to the time at which conventional stimulus is removed. Notably, the yield on the ten-year US Treasury has jumped from 1.6% to 2.0% in the last six weeks, potentially a sign of things to come. As has been well-discussed elsewhere, bond markets have enjoyed a remarkable thirty-year period, with US AAA-rated corporate bonds as an example peaking in 1981 at 15.5% only to touch hundred-year lows last year. If history is any guide (and it may at least rhyme, if not repeat itself, to borrow Mark Twain’s phrase), then drawdowns – when they happen – will be significant. Furthermore, bondholders are arguably subject to additional risk at present given that coupon payments are so low in the current low interest rate environment.

Conventional (G7 sovereign and corporate) credit is not the only area about which we have concerns. It is worth noting that the earnings yield on the S&P is now superior to that offered by US high yield, the first time this phenomenon has been witnessed in more than twenty years and perhaps indicative of recent flows into this asset class. The search for yield elsewhere within the credit space is also potentially worrisome, with Bolivia, for example, issuing sovereign US-dollar denominated debt for the first time in ninety years, at 4.9%. It is against this background that our principal strategy within the credit space is to favour those managers that have the ability to implement non-directional strategies.

Our relative bullishness on gold is also tempered by current developments. While the logic in owning the precious metal as a form of portfolio diversification remains, it is hard to see the gold price going any higher in the very near-term. Repressed inflation and low interest rates (which have limited scope to fall further) cap the upside for gold, while improving US macro data clearly only brings forward the time at which stimulus is withdrawn. Over the medium-term, we also note that US energy independency and its corollary – a stronger Dollar – is most likely a negative for gold.

This leaves equities (we are keen to avoid most alternative asset management strategies for now – at least for as long as policy intervention remains). Stocks have seen consistent ($600bn) outflows since 2007, look cheap in most regions on a cyclically adjusted P/E basis, and should benefit from improving appetites for risk. While we are happy to invest in high quality equities on a global basis, we wrote last month about the case for investing in Europe over the long-term and Japan in the near-term in particular. The European argument remains strongly intact with valuations on the above basis two standard deviations away from the mean and sentiment/ positioning still broadly negative. For Japan, with the market up over 10.0% in December, our inclination is to book some profit, although the region remains even more attractively valued and even less in favour than Europe.

Alexander Gunz, Fund Manager, Heptagon Capital