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 was just over a year ago when investors first began to appreciate fully the power of words over action. Just as Mario Draghi’s utterance that he would “do what it takes” to ensure the future of the Eurozone transformed investor perceptions, so the comment by Ben Bernanke that the Fed may consider reducing the scale of its quantitative easing programme in “the next few meetings” has had an apparent similar effect. Most crucially, however these words are interpreted (and there has been no shortage of analysis), it should not be forgotten that Central Banks never promised low volatility and high (equity) market returns. Unorthodox monetary policy continues to be an experiment still somewhat being made up as we go along. To our minds, the ‘direction of travel’ remains unambiguously clear – namely, the global economy is gradually healing. From this observation, asset allocation strategies ought also to become distinctly definable, despite the correlations witnessed in June. Put simply, under almost any assessment, equity outperformance should persist against credit; and in the former asset class, our preference is currently for the US, Japan and Europe.

There has, for too long, been a curious addiction among many to loose and unconventional monetary policy. While it was convenient perhaps to see such a strategy on the part of Central Banks as being an end in itself (i.e. that which would drive equity markets higher), it was ultimately always just a means to an end. An early withdrawal from monetary accommodation, therefore, ought to be seen as a good thing, indicative of the underlying health of the economy, or the removal of a stimulus that is now no longer needed. Some context is also important, in three particular respects. First, Chairman Bernanke’s words of 19 June could hardly have been clearer: the Fed “will remove accommodation only if the backdrop continues to improve [our emphasis in bold].” In other words, the ending of easing is not pre-determined, but data-dependent. Second, gradual withdrawal – or tapering – is a very different prospect to rate tightening; this latter event does not look likely for at least a year (if not longer). And, third, even if the Federal Reserve is now at the point of contemplating a long and gradual exit, globally, there remains a clear commitment to loose monetary policy, certainly on the part of the European Central Bank and the Bank of Japan.

Nonetheless, something definitely has changed. Bond investors can no longer rely on the Federal Reserve helping to keep yields low via policy action. Yields (as measured by that of the 10-year US Treasury) have moved by over 70 basis points in the last two months to reach 2.4%, their highest level in over two years. The biggest risk to Federal Reserve/ Central Bank credibility is not that their assessment of the economic outlook is incorrect, but more if long-term rates and corporate spreads start moving in a direction (upwards) at a faster rate than intended, thereby potentially undermining the effectiveness of current policy. That yields have recently become more elevated seems most indicative of the fact that the thirty-year bull market in bonds is nearing its end, rather than the case that interest rates will have to start rising anytime soon, particularly given the currently benign nature of inflation. As defined by the core consumption deflator (the Federal Reserve’s favoured measure), US inflation currently stands at 1.1%, its lowest in fifty years. Lower commodity prices are helpful not only in keeping inflation repressed, but in aiding recovery too.

While accepting that fundamentals will now have to play a more important role than financial engineering on the part of Central Banks in influencing the direction and performance of all asset classes, it is quite another to believe that US interest rates will start to rise anytime soon, especially given current inflation levels. However, as the direction of travel for real bond yields constitutes a move upwards back into positive territory, credit as an asset class should suffer more than equities. A repeat of 1994 (when interest rates rose both unexpectedly and abruptly, decimating returns for bondholders) looks unlikely, as much as anything since the signalling of Central Bank intentions has improved markedly since this time. Furthermore, policymakers have at their disposal – and have shown themselves willing to use – a much broader range of tools than hitherto. Importantly, the Federal Reserve could continue to extend its policy of rate targeting (denoting its expected path for interest rates) regardless of its bond purchase programme, while it could also contemplate ‘twisting’ the yield curve again (purchasing longer-dated Treasuries), should the back-end continue to rise.

The good news for equity investors is that corporate margins and earnings should remain elevated at least until interest rates start rising and/or the output gap in the labour market closes, putting pressure on wages. Neither of these factors looks likely in the near-term. Beyond the outlook for interest rates discussed previously, even if US job openings are now running at their highest since June 2008 (on a three-month average basis), unemployment is in fact currently just 20 basis points lower (7.6% vs. 7.8%) than where it stood when the Federal Reserve made its pronouncement regarding a third round of quantitative easing last September. Durable goods orders may be at their highest in three years, consumer confidence at its uppermost since 2008 and the housing market at its strongest for quite some time (prices are rising at the fastest pace since early 2006 and monthly existing home sales surpassed the 5m mark in May for the first time since early 2011), but the US economy is clearly a long way from being in a healthy and robust state. While many of these trends should be mutually reinforcing, an unemployment rate of 6.0-6.5% (per the Fed’s target), looks to be at least a year away.

Two other arguments are also supportive of the case for equities: the strength of corporates’ balance sheets; and valuation levels. The former provides a comfortable margin of safety and also infers the potential for accretive transactions (either share buy-backs or M&A), while despite the recent move in Treasuries, the yield of the S&P is still around 400 basis points superior to that of the US 10-year. However, when it comes to equity market valuations on a regional basis, a compelling case can be made for Europe at present and emerging markets over the longer-term. Other, more structural, factors should also help the Japanese equity market trade higher in the coming months.

It is remarkable how things can change in the space of the year, with the future of Europe having arguably been investors’ major concern last summer and now seemingly occupying less attention than any other region globally. Partly because of this phenomenon, European equities are trading more than 30% below their 2007 peak, a marked contrast to the US. Meanwhile, the scope for positive surprise in the region is high, particularly as politicians begin to withdraw austerity policies and, should the Euro weaken (which would be a corollary of the currently stronger US Dollar). Industrial production has risen across the continent for three consecutive months and while readings do imply contraction, at a current level of close to 50, they also suggest that GDP is stabilising. The heart of the problem has been redressed too, with the continents’ banks now commanding an average Tier-1 capital ratio of over 11%, some 300 basis points higher than at the nadir of the crisis in 2009. Expect further signs of progress in the region as 2013 develops. Nonetheless, as recent events in Portugal do highlight, there remains absolutely no scope for complacency.

While the valuation case can clearly be made for emerging markets (with local indices trading on discounts of at least 20% to their global peers on both a price/book and price/earnings basis), it is difficult to see an improvement in prospects in the very near-term, notwithstanding the longer-term case. At present, market weakness in EM bonds and equities can partially be attributed to the unwinding of the US-Dollar carry-trade. However, it now appears the case that during this previous search for yield in the context of near-zero US interest rates, insufficient attention was paid by some to fundamentals or political risk (hence the somewhat ‘crowded’ nature of this investment strategy). China may often incorrectly be used as a proxy for emerging markets, but the recent actions of its Central Bank in seeking to control liquidity is an outcome of which investors should be wary. Moreover, the need to communicate and implement policy effectively (the current orientation should be towards further easing) is something that requires addressing across many emerging markets. Current nervousness is also being compounded by political tensions – of which there is no immediate end in sight – in countries as diverse as Brazil, Egypt, South Africa and Turkey. Clearly, for longer-term and dedicated investors in emerging markets, this recent period of price weakness creates an opportunity.

In terms of Japan, the strongest six-month rally that the Nikkei has experienced in the last fifty years (up over 30% through to the end of June) speaks to a clear change in the country’s consciousness and also that of investors towards the region. While there may have been a recent hiatus in equities, Upper House Elections in mid-July could lead to further gains. The scope for tangible change is high, particularly if – as seems likely – President Abe’s party wins control of the Upper House. In contrast to the Koizumi era of reform a decade ago, control of all three parts of the Japanese legislature would allow Abe to enact policy quickly and effectively, especially given a currently high approval rating and with no major elections scheduled until 2016. Expect reform in terms of tax policy, trade initiatives and the increased involvement of females in the labour force (the latter helping to reverse some of the demographic challenges). State estimates for GDP growth have been revised upwards five times already this year and positive corporate earnings revisions are running higher in Japan than any other region globally.

The progress of markets has never been linear and June’s correction in equities should hardly be considered surprising after the preceding strength in this asset class since the start of 2013. What remains abundantly clear to us, as detailed, is that the conditions for equities continuing to outperform bonds remain firmly in place. Our favoured equity allocations are towards high-conviction, alpha-focused managers with a global bias. In terms of credit, we have adopted a strategy of seeking limited directional exposure for some time, and indeed exited from emerging market credit strategies in recent months. Our preference is for managers able to adopt approaches based more around absolute-returns, managing duration risk actively. The current environment is also one not propitious towards owning gold (it has fallen over 25% from its 2013-high) and we did also take the decision to exit from this asset class earlier in the year. Cash has proportionately risen within our discretionary mandates as a result of these actions and while further near-term volatility in all asset classes cannot be ruled as investors accustom themselves to the ‘new normal’ of (US) Central Bank behaviour, we will likely use such opportunities to add selectively to equity strategies.

Alexander Gunz, Fund Manager, Heptagon Capital