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.

If ever advocates of accommodative and unconventional monetary policy had needed a period in which to reinforce their influence, then events from the past month have provided the perfect platform. Japan has now officially joined the converts to the cause, while Europe may be next to the party. Meanwhile, global equity markets continue to make new highs, albeit somewhat reluctantly, as most forms of credit underperform on a relative basis. The move in the gold price, moreover, serves only to legitimise further such monetary actions in our view. Sceptics may be justified in wondering not only whether year-to-date equity market gains are sustainable but also what the longer-term consequences of monetary largesse may be. These are clearly not insignificant concerns, but we currently see little reason for now to shift our current asset allocation strategy, broadly favouring equity over credit, and also sticking with some continued exposure to gold.

In crude terms, the actions announced by the Bank of Japan in April constitute the biggest monetary experiment ever undertaken. The Bank is aiming to achieve in two years what the Federal Reserve has done over the past five; or, put another way, by 2015, the Japanese monetary base will constitute some 50% of the country’s GDP, more than double the current figure of the US. Not only is this a bold approach, but it marks a deliberate change in philosophy and an abandonment of almost everything the Bank of Japan has said about monetary policy over the last twenty years. There are probably three main reasons behind such a decisive move: the obvious need for change after a long period of no growth and no inflation; the ability to enforce this change (President Abe has a 76% approval rating and a high level of political/ business support); and, the monetary precedents from elsewhere, particularly the United States.

It is clearly far too early to assess the effectiveness of Japan’s approach. Nonetheless, early indicators are encouraging. Not only has the stock market reaction served as a powerful endorsement, but a wide number of firms (from domestic enterprises such as Toyota to more international ones like McDonalds) have begun to push through wage rises in Japan, while long-term inflation expectations (based on six-year break-even rates) are implying levels of 1.5%. Notably, Ben Bernanke has praised the Japanese approach, arguing that a stronger Japan should benefit the global economy, enhancing growth prospects. This virtuous circle logic is persuasive, but it also is self-serving: the more countries that join the accommodative bandwagon, the easier it becomes to justify (and maintain) the current policy status-quo.

Many Europeans must reasonably feel envious when they consider both the stock market advances and improving economic prospects of the US and also Japan. In contrast to more than double-digit percentage gains for the S&P and Nikkei year-to-date, most European markets have gained less than half this level. Meanwhile, the expansion indicated by American and Japanese industrial production readings contrasts with a Eurozone economy that has witnessed contraction for the last twenty-one months. ECB President Mario Draghi has stated that he is poised, “ready to act” and many have concluded that an interest rate cut is imminent. Current Eurozone rates of 0.75% seem anomalously high in the context of close to zero levels elsewhere in the developed world, but it may be more pertinent to consider whether such action is enough and carries a similar weight to that which is being done elsewhere.

Eurozone interest rate cuts are arguably a necessary but not sufficient condition for helping to restore the continent (and its equity markets) to better health. At present, the ECB’s Outright Monetary Transaction (OMT) strategy remains just that, a verbal commitment that has yet to be tested in practice. Moreover, should the ECB contemplate a bolder approach such as full-blown quantitative easing Bernanke/Kuroda-style, then it may simply not work. The effectiveness of the monetary transmission mechanism is likely to be much weaker when spread across seventeen diverse economies (with different banking systems) than in either the US or Japan. There is also less political support for such action. More importantly, however, the focus on monetary policy may delay or distract from more urgent structural reform. Working towards loosening labour markets and moving towards greater banking union should assume a significant priority.

Elsewhere, there is also no scope for monetary complacency. Even if the Nikkei has rallied more than 40% since the election of President Abe, monetary policy is again just a merely necessary rather than sufficient factor for resurrecting an economy that has been long moribund. Now also is the time to enact fiscal and labour market reform, improve corporate transparency and strengthen global trade pacts. Even the Federal Reserve should not feel too self-congratulatory. Granted that the US housing market continues to heal in a highly encouraging fashion (monthly housing starts have now crossed 1m for the first time since June 2008), spurring the overall economy, but unemployment remains at 7.7%, only fifty basis points lower than where it stood four years ago, as the country first began to emerge from recession. The US participation rate (the percentage of the population considered to comprise the workforce) is also at its lowest since March 2008.

It should clearly not be forgotten that the Federal Reserve has a dual mandate, both to pursue low inflation and low unemployment. While there has been clear success with regard to the former, the same cannot be said of the latter. Indeed, the very absence of inflation should encourage the Fed to be bolder. In other words, at the least, to continue with its current monetary policy, if not accelerate it. Until the unemployment rate is tangibly lower (and/or participation levels higher), there would seem to be little justification for the Federal Reserve to withdraw from its present accommodative stance. Moreover, Janet Yellen, the likely successor to Ben Bernanke, has also signalled that there is scope for inflation to rise at least to 2.0% (from its current reported 1.5%) before the Fed may even begin to contemplate alternative actions.

The interests of the Federal Reserve conveniently coincide with those of equity investors. Equities benefit substantially more than bonds from a scenario of limited actual inflation but rising (and well-managed) inflation expectations. The ultimate logic behind unconventional monetary policy is for it to incentivise and hence reward riskier behaviour. Notwithstanding the fact that there is a limited link between stock market returns and economic growth, the ammunition exists that could be conducive to both: American corporates are sitting on 11% cash reserves as a percentage of assets – the highest on record – and consumers have seen their average household wealth rise in 2012 for the first time since 2005. Even in a far-from perfect world, an increase in optimism and spending from current, still-repressed levels should have some success in fulfilling the Federal Reserve’s aims.

Inflation (and expectations thereof) are, however, rarely linear and the danger of an abrupt upward move cannot be discounted. As we have discussed in the past, merely the perception of, rather than actual, deflation may indeed be a necessary precursor to inflation. The very absence of its growth should logically prompt more forceful policy responses. It is against this background, that the recent move in the gold price seems anomalous. While it may be erroneous to justify holding gold simply in the belief that the pursuit of extended quantitative easing will provoke more inflation, those fearful of deflation would be well served to remember that what follows such a circumstance should be as evident as the fact that winter precedes spring. The global experiment with unconventional monetary policy is only getting bigger, not smaller. This is the consequence of excess debt, much as austerity, where practised, is too.

If the logic for currently owning equities over credit is persuasive, especially under such a scenario outlined above, it is necessary to consider how best to position within the asset class. Investor sentiment is far from euphoric and many continue to struggle to reconcile notable year-to-date market gains alongside valuation levels and the reality of living in a low-return world. Double-digit advances so far in 2013 for many equity market indices/ strategies may be one thing, but their sustainability is quite another. Headline multiples (the S&P trades on more than twenty times cyclically-adjusted earnings) may only reinforce this concern. However, not only is corporate profitability continuing to improve in the United States, as evidenced by the current reporting season, but more importantly, there is still value to be found within some parts of the market. The scope for alpha capture via stock selection over beta-style positioning remains compelling.

This pro-alpha argument also clearly applies to other regions too. Valuation is a less contentious topic for debate in Europe, but growth prospects are also notably less attractive. Meanwhile, even if the Japanese market has already returned substantial gains in recent months, not only is there substantial valuation support (the TOPIX trades on a price-to-book ratio less than half of its twenty-year average), but the current pace of reform (and will to implement it) makes previous attempts look timid. The precedent of the Koizumi Premiership in Japan from 2003 to 2005 saw the local stock market rise some 140%. For emerging market investors, gains of these levels are not the stuff of dreams and may be achievable over the long-term, partly given the structural dynamics of these countries (population growth, industrialisation, emerging middle class). However, in the nearer-term, Japan’s gain may be their loss. A weaker Yen clearly impacts the relative competitiveness of export-led economies such as South Korea and Taiwan, while weak Eurozone product demand only compounds the issue. Although these trends may continue for some time, monetary responses via interest rate cuts and/or further fiscal stimulus could act as logical ripostes.

Beyond allocations within equities, other strategic asset decisions currently appear much clearer. Even if US equities are no longer undervalued against historic norms, equities as an asset class in the broadest sense are still substantially more attractive than conventional credit, particularly in terms of yield. Much unconventional credit also constitutes a source of concern. The search for yield appears such that Rwanda, to cite but one example, was recently able to issue US$400m of ten-year bonds at a rate of 6.8%. The most defensible credit strategy at present, therefore, seems to us one of investing with managers that have the ability to implement non-directional strategies, hence limiting or even negating duration risk, while avoiding an explicit bias towards yield. As far as gold is concerned, not only is there a persuasive strategic logic in continuing to hold the asset for the tactical reasons enumerated earlier, but also, it should not be forgotten that its ten-year annualised returns of close to 17% leave the performance of not only credit, but also equities looking most paltry by comparison.

Alexander Gunz, Fund Manager, Heptagon Capital