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.

The most persistent question investors continue to raise (evidenced by over thirty meetings across seven countries in the last month) is whether the current equity market rally can be sustained. Few would have foreseen at the start of the year that a 10% gain in global equities might have been recorded by the end of May, and that there appears to be a greater sense of overall scepticism rather than euphoria at this state of affairs suggests to us that the case for equities continues not to be fully appreciated. At the most basic, given the present monetary, macro and valuation backdrop, we struggle to see any other asset class that currently looks better placed than that of equities. Indeed, the ‘direction of travel’ argument we advocated at the start of 2013 remains unchanged. There may well be some periods of volatility for equities (and other asset classes too), but these could in fact constitute buying opportunities, all other things being equal.

Given the circumstances of the last few years, the extent to which the commentary and actions of central bankers is analysed should hardly be surprising. Their powers to calm markets (via metaphorical ‘puts’, be they bond-buying in the US and Japan or just mere verbal commitment in Europe) has assumed an almost mythic status. It is therefore similarly unremarkable how investors have begun to fret over the potential withdrawal of stimulus in the US. Three important and inter-related points are worth making in this respect: first, unconventional and accommodative monetary policy has proven the most influential tool for helping the economy/ stock market manage through and recover from the necessary process of deleveraging; next, sustained highs in equity markets constitute a highly effective mechanism for validating this strategy; and, finally, given the self-reinforcing nature of the above, the debate over whether and when to withdraw policy may become increasingly less relevant.

Beyond the housing market and the health of the consumer, both of which continue to improve markedly in the US (the prices of homes is rising at its fastest pace since August 2008, while consumer confidence stands at a five-year high), another important factor is also helping cement the foundations of the US recovery. The budget deficit – long a source of concern – is falling rapidly: from a level of debt/ GDP of more than 10% at the end of 2009, the ratio stands at 4.1% currently. Furthermore, its current progression suggests that a level of 2.5% could be hit by 2015, well below the post-War average of 3.1%. As a consequence, not only is the debate about the fiscal ceiling likely to be less of an issue for the very near-term, but more importantly, less debt implies greater flexibility. The Federal Reserve is hence increasingly well-placed to contemplate the wind-down of bond purchases without disrupting markets, while corporates – currently sitting on record cash balances – have the scope to raise expenditure levels given the more benign fiscal backdrop (and less fear over potential tightening).

A realistic (rather than optimistic) assessment of the landscape therefore suggests that the US economy can keep growing via both consumers and corporates spending. Moreover, a steady growth path is, in many ways, the best possible outcome and US GDP growth of around 2.0% without leverage – the current situation – seems highly preferable and more sustainable to faster growth but with more leverage (that which characterised the last cycle). It should also not be forgotten that as and when the Federal Reserve decides to exit from its current strategy, not only will it likely be well-managed and clearly communicated, but a scenario of tapering or gradual exit is very different to one of outright tightening. With inflation running at less than 2% in the US and indeed falling in over three-quarters of the world’s most developed economies, there appears little pressure even to contemplate rates needing to be raised.

Low inflationary pressures and a healthier US economy are clearly conducive to better economic growth prospects globally. It is notable that the Eurozone now appears to be turning a corner with the rate of decline slowing and there being some evidence of gradual recovery. Clearly this process will take time given the diverse and dysfunctional nature of a seventeen-country economic that has experienced six consecutive quarters of recession and where continent-wide unemployment stands at over 12%, but industrial production has improved for the last two months and a majority of the periphery’s economies are close to recording current account surpluses. Just as Europe seems to be moving upwards from a low base, the same can be said of the Japanese economy. Annualised GDP growth is running at 3.5%, driven by a combination of private consumption and export growth. Consumer confidence is at a six-year high and industrial output is rising at a faster pace here than in any other region globally.

As encouraging as better global macro trends may be, these should, however, be seen as a necessary rather than a sufficient condition for further stock market momentum. Indeed, over thirty years of data suggests that the correlation between GDP growth and equity market returns is most limited. Accepting this argument implies considering what under factors are conducive to sustained gains. What matters is an environment of abundant liquidity, benign risk levels and compelling valuations.

Taking liquidity first, at both a micro and a macro level, trends look highly positive. Senior Loan Officer and other comparable surveys suggest that lending conditions globally are easing. They may also ease further. In Europe (where output remains most depressed), the European Central Bank (ECB) is focused on improving transmission mechanisms and stimulating lending to small and medium enterprises. Announcements in this respect could follow in the coming months. Additionally, global central bank policy remains highly oriented towards loose policy: during the last month, not only did the ECB cut rates, but rates fell too in Australia, India, Israel, Poland and South Korea. The Bank of Japan appears unwavering in its commitment to money-printing while the incoming Governor of the Bank of England has suggested the need for monetary stimulus in the UK, at least until its economy reaches ‘escape velocity.’

Risk can be quantified in several ways and while it is highly encouraging to see trends such as new order – inventory ratios running at low levels (particularly in America) and earnings revisions rising (especially Japan), political uncertainty has long been a greater concern to us than economic troubles, particularly given the scenario outlined above. Notwithstanding the perennial threat of geopolitical dislocation, if anything, the outlook could improve as 2013 develops in most parts of the world. Fiscal debate is becoming increasingly less of an issue in the US; in Europe, no ‘controversial’ decisions are likely to be taken on the continent’s future until at least after the German Election in late September; and, in Japan, Upper House elections next month will most likely solidify President Abe’s position and strengthen his ability to enforce change. Radical monetary policy is in train and fiscal/ labour market reform could follow.

Before considering valuation, it does behove us to ask where our thesis could be most wrong. That the Federal Reserve appears so acutely conscious of managing investor expectations regarding its monetary actions (and evidently keen to avoid a repeat of a 1994 scenario where interest rates rose abruptly) suggests that there will likely be a clear and well- judged communication strategy that ought to reassure. Even if the nature of the US labour market has irrevocably changed since the last recession and even if inflation notoriously can trend in a non-linear fashion, there seems to be sufficient flexibility at present to mitigate an unexpected deviation in either of these factors.

Weaker macro trends in emerging markets (inevitable losers at present from the Yen’s devaluation and Dollar’s relative strength over 2013) are oft-cited as another source for potential concern. Somewhat slower, but also steadier growth – again with inflation currently anchored by falling commodity and food prices – should, however, be seen as a preferable outcome from a medium-term perspective to the inverse, which characterised many such economies in the recent past. The scope for policy action whether monetary or more structural in nature also remains. Regional equity market performance may improve as investor confidence in effective policy implementation becomes stronger.

And so to valuation. The case for equities relative to other asset classes remains highly compelling. Real dividend yields are high and earnings yields are improving. The record corporate cash balances noted earlier combined with an increasingly favourable macro backdrop may also incentivise the more active deployment of yield-enhancing strategies, if not accretive deals then further shareholder cash returns. Looking beyond headline market multiples (which we often sense can be misleading), we continue to identify many businesses across all geographies that appear undervalued. The scope for alpha- extraction via judicious stock-picking remains clear. From a regional perspective, the recent volatility in the Japanese market should hardly be considered surprising given the gains that had hitherto been accrued over 2013. While the case for Japanese reform and an undervalued stock market is now better understood than previously, we believe this a theme that can continue to run. However, it is also worth considering what may be the next theme that offers notable upside potential: after the US (led by housing – where we continue to have exposure) and Japan, could Europe, and particularly its periphery now be in the frame?

Elsewhere, there are two clear implications from recent policy developments that have been reflected in our asset allocation strategies. First, given the pace of US recovery and the rapidly shrinking deficit, the US Dollar should strengthen against a basket of other G7 currencies. This trend will also likely be compounded by the weaker Yen (pressurising European competitiveness) and the likelihood of limited policy change in Europe over the summer months. The other evident consequence of an improving US outlook and a stronger Dollar is that gold will likely remain under pressure hence the decision we made to exit from our gold allocations during the past month. As a result, our portfolios are currently running with high levels of equity exposure, with balance being achieved through non-directional credit strategies (where duration risk can be hedged or negated) and exposure to a small number of selected alternative asset managers. Such an approach is also justified given May’s performance in the bond markets, where the Barcap Global Aggregate index fell by almost 3%, one of its worst monthly performances in the last two decades. By contrast, the more flexible credit managers with whom we have invested typically experienced positive returns.

Alexander Gunz, Fund Manager, Heptagon Capital