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.

After the worst month endured by global equities since August 2010, with the MSCI’s World Index dropping 2.45% in May, two things are clear to us: first uncertainties remain, and do not look likely to dissipate any time soon; and second, if we accept this, then appropriate positioning both across asset classes and geographies is crucial. In brief, we expect a near-term period of further volatility in which selective allocations towards equities and emerging market currencies appear to us as the best relative strategies. Conversely, we have more cautious views on US Treasuries, Eurozone (especially periphery) debt and G7 currencies. Towards the end of the summer we see reasons for risk appetite levels to increase once again.

It has become fashionable to describe the current period of market uncertainty as constituting a ‘mid- cycle correction.’ In fairness, global economic (and equity market) cycles last an average of six years and typically range between four and eight. With recovery having only commenced in 2009, it does indeed seem misplaced to suggest that a new downturn cycle is imminent, although there do appear to be a growing number of headwinds that look set to impede further near-term confidence and hence growth.

Notwithstanding the fact that there is empirical support for the adage of ‘selling in May’1 (studies show that equity markets typically underperform in the second and third calendar quarters only to rally in the fourth), the list of current uncertainties with which investors have to contend continues to grow. Whether the US (and by proxy, the global) economy is able to stand on its own feet after the end of the second round of quantitative easing in June is unclear; meanwhile, the Dollar continues to weaken; the future of the whole Eurozone project is still to be resolved; and further unrest in the Middle East and North Africa is also possible. While none of the above is ‘new’ news, it has to be borne in the context of a series of liquidity, risk and valuation factors that all point to relative deterioration on a fundamental basis. We also note that the rate of downgrades to analysts’ estimates (admittedly perhaps a lagging indicator) is now at its fastest since September 2008.

If we accept the above thesis, then positioning becomes crucial. Our conviction in the case for US equities relative to European or Asian equities continues to rise; while, by contrast, we expect emerging market currencies to appreciate relative to the US (and G7). Sovereign debt should also remain under pressure.

Several complex factors are at work. If we take the US first, the beneficial effects of the ‘year-three Presidential cycle’ have been well-documented elsewhere. The prolongation of certain favourable tax breaks from the Bush era has also received some attention although it is worth highlighting that many corporates may seek to benefit from the ability to depreciate 100% of capital expenditure made during

2011. With this policy ceasing in January 2012, the economy may receive a further favourable boost in the final months of 2011.

Even without these dynamics, we also note that emerging market wage inflation is making the US an increasingly attractive location for manufacturing, a trend which only looks set to endure. Analysis from the Boston Consulting Group highlights that wages in China have increased by over 60% during the last five years. With 17% p.a. wage inflation forecast for the next five, by 2015, the cost of locating manufacturing in the US relative to China will be indifferent. This implies scope for an American industrial renaissance. Whether owing to capex/depreciation policies or wage inflation arbitrage, it is worth noting that private sector jobs in the US increased in April at their fastest rate since the end of 2005.

Turning to Europe, the picture is unfortunately markedly less clear. At its heart lies the issue that the political and economic ends of European Union remain as confused and conflicted as they have ever been. No clear political leadership or ‘consensus’ over how to manage the ongoing crisis of potential sovereign default(s) only serves to exacerbate the fundamental underlying problems.

The key question hinges on the cost to Germany (and its banks) of bailing out countries that really should admit default relative to the price of seeing the broader single currency/ Eurozone project collapse. If we accept that the former seems a somewhat more likely outcome, then this implies that Governments across Europe will continue to need to write what are effectively blank cheques. Put another way, total Greek state debt today stands at €235bn (up more than 50% from where it stood ten years ago); it is currently trading at half its principal value, implying over €100bn of paper losses. Add in the losses of Ireland and Portugal and this figure likely reaches €200bn. Moreover, with just €11bn of assets relative to an estimated €600bn of liabilities, at some stage the European Central Bank will need recapitalising.

With no immediate clarity or resolution over the European endgame, the logical strategy seems to be one of avoiding Eurozone debt, equities in periphery nations and also in listed banks across the regions. Furthermore, the Euro looks set to remain under pressure. Indeed, the Euro seems locked in a race with the Dollar (and Sterling, given 5%+ UK inflation and a stagnant economy) to the bottom, with all in a quest for depreciation. The Fed’s intention to keep its balance sheet constant following the end of easing should likely imply further pressure for the Dollar, and also for US Treasuries. Against this background, the case for emerging market over developed world currencies appears compelling, with the former set to strengthen, particularly with local inflation currently in the ascendency.

Given the above uncertainties, it seems likely that investors will be wary of re-risking near-term, particularly ahead of ending of American quantitative easing. Moreover, if history represents any guide, then mid-cycle corrections tend to last an average of four months, according to Credit Suisse. What this implies is a potentially cruel summer, but then a better fourth-quarter, with risk levels likely increasing just prior to this, perhaps in late August/ early September. The ability to depreciate fully capex may also result in a mini US corporate spending boom in the final quarter of 2011.

Investors should look to exploit this window of opportunity fully, particularly given the still unresolved factors mentioned above (European endgame, Asian inflation/ overheating). In addition, 2012 may be a

more difficult year for the US, with capital expenditure breaks curtailed, increases in employee social security and cuts to government spending planned. Combined, these factors could take up to 2% off American GDP next year.

If anything appears clear, then it is the need to stay positioned nimbly. Even within equities (one of our more preferred asset classes), intra-sector correlations have been declining in recent months – perhaps a symptom of volatility – and there now appears to be an increasing focus on stock selection and what it often termed ‘alpha’ capture. Choosing selectively, our strategies centre on preferring US over European and Asian equities and defensive over cyclical businesses. We also favour American companies with a high percentage of their revenues from non-domestic sources (beneficiaries of a weaker Dollar) as well as businesses with dominant pricing power (and so best placed to mitigate inflationary pressures).

In a world of current uncertainty (and where the Graham-Dodd P/E for the S&P stands more than 40% above its long-run average), we will continue to review regularly our stance. For now, a flight more towards quality seems logical and appropriate, but opportunities to increase risk may well emerge later this year.

Alex Gunz, Fund Manager, Heptagon Capital

1 The original saying suggests not returning to equity markets until after St Leger Day, the last race of the British horse racing season. In 2011, this falls on Saturday 10 September.