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.
Several things seem abundantly clear to us as we approach the end of 2013 and begin to consider what 2014 may hold in store: global GDP growth is accelerating, macro risks are declining (certainly relative to a year ago), and bond yields will likely need to rise over the coming twelve months. There are inevitable investment implications from this thesis too. Most pertinently, equities – for now – remain the most attractive asset class, and within this, we see the broadest scope for European and Japanese markets to outperform. Moreover, while credit will become more compelling as equity valuations extend further and bond yields correspondingly look increasingly persuasive, this scenario will take some time to play out. Finally, in a world of less pronounced risk and higher yields, it is hard to see how gold can outperform.
Against this background, it seems appropriate to consider not just the case for economic stabilisation and sustained equity outperformance, but also those factors which could potentially undermine such a roseate scenario. Taking the positives first, investors should not lose perspective of the fact that 2013 will almost certainly constitute the first year in which global GDP growth will have accelerated on an annual basis since 2010. Next year could also see a further improvement in the outlook given three factors. First, fiscal tightening will become less pronounced both in the US and in Europe, providing a boost to GDP. Next, credit growth is accelerating in most global regions producing a corresponding and mutually reinforcing improvement in economic activity. And, finally, monetary policy is set to remain broadly loose for the foreseeable future. Even when tapering begins in the US, this is clearly not the same as ending quantitative easing, while more monetary largesse seems probable in both Japan (via further QE) and Europe (via a possible second round of LTROs) over the coming twelve months.
If this view proves to be correct, then it is perfectly understandable why investors should be attracted towards risk assets (namely equities) and away from more defensive positioning. However, there is an important need to be mindful of both complacency and of valuations; the two are also inextricably interlinked. Optimism has inevitably been partially fuelled by the perception of prolonged accommodative monetary policy, but the irony is that this very strategy is artificially constraining the price discovery mechanism, replacing it more by price manipulation. Indeed, it will more likely be politics than economics that has the potential to undermine 2014 prospects.
It should not be forgotten that the difficult and necessary fiscal debate in the United States has simply been deferred rather than concluded. Political dysfunction in America remains significant and, crucially, the longer this endures, the greater the responsibility for managing the economy will lie with the Federal Reserve. An increased intertwining of monetary and fiscal policy cannot be seen as a positive, particularly if it exacerbates the repression of the price discovery mechanism. In reality, there is only so much that the Fed will ever be able to do to protect against destructive politicians (especially the Tea Party faction). Moreover, even within the Federal Reserve, opinions are deeply divided (as evidenced by recent Minutes), a number of its Board will be changing in the coming months and the data it will have to interpret and act on will also be distorted in the near-term by the impact of the shutdown. Maintaining a consistent and credible message with these clear challenges may become a significant issue, potentially undermining investor sentiment.
Irrespective of the above very important considerations, it remains the case that directionally US monetary policy will likely tighten over the coming year, while Europe and Japan will almost certainly continue to loosen on a proportionate basis. This supports the case for investing with a preference in these two latter regions, but a more fundamental analysis also serves to reinforce the argument. With valuation being the ultimate driver of allocation decisions, then the starkest fact remains that while the S&P has reached new nominal highs, comparable equity indices in Europe are trading some 25% below peak levels. The same argument can be made in Japan with even higher conviction. As we have discussed at length in previous notes, on most valuation metrics (particularly longer-term and cyclically adjusted proxies), US equities look currently overvalued in contrast to their global peers. Moreover, as European and Japanese GDP growth accelerates (relative to the US), there is the potential for this valuation disparity to close. Correlations between industrial production and earnings upgrades are also higher in these two regions than elsewhere globally.
While investing in Europe is inevitably a more consensual view than it was at the start of the year, valuation levels provide a significant reason for ongoing conviction. Furthermore, a clear argument can be made for asserting that crisis (a word one could hardly avoid using as recently as two years ago) has been averted and prospects look highly encouraging. Eurozone industrial production is currently running at its strongest since early 2011, unemployment appears to have peaked and retail sales growth has picked up to its best pace in almost three years. Countries are also becoming less reliant on centralised support: Irish financial aid will come to an end this December and Spain (now officially out of recession) has also reached most of the targets set by the ECB/ EU/ IMF and so may be in a position to abandon its dependency on aid early next year. Looking forward, the recently completed Asset Quality Review programme for Europe’s banks can be seen as a precursor to Europe-wide banking union and Frau Merkel’s re-election in Germany also potentially paves the way for a generally more pragmatic programme of European policy development.
Even if Japan has come a very long way in the last twelve months (and while the easy option would be to take profit on what has been a very lucrative trade over this time period), the potential for further upside and progress is arguably even more compelling here than it is in Europe. Any number of statistics can be used to support the assertion that Japan is improving: public optimism (according to the Economy Watchers Survey) is at its highest in ten years; demand for new home loans is at its best since 2006; machine orders are rising at their fastest pace since 2008, as are rolling three-month construction orders. Prime Minister Abe’s speech when he re-opened the Diet (parliament) last month was unambiguously entitled “growth strategy” and provides clear evidence of his intentions for the coming year. Investors should expect labour market and social security reform as well as a possible lowering of corporate tax rates (Japan’s current 40% level compares very unfavourably to the Asian average of 28%), all making it easier to do business in Japan. Abe may also receive additional benefit should the Bank of Japan accelerate its quantitative easing programme in a bid to drive inflation.
There are some dangers attached to this Japan thesis. In particular, although current price inflation of 1.0% is superior to that witnessed in the last five years, in the absence of wage inflation, progress may be undermined and growth/ confidence deteriorate (as occurred during the Koizumi era of attempted reform close to a decade ago). It will therefore be crucial to observe the success or otherwise of the impending wage negotiations, which typically occur in Japan before the country’s March fiscal-year end. In addition, while Prime Minister Abe enjoys the benefits of an undivided parliament, pushing through reform may take longer than anticipated particularly given the sclerotic pace with which the Japanese civil service traditionally operates. Much of this though remains reflected in valuation levels. Corporates continue to be cautiously positioned (with the equivalent of 30% of the country’s GDP sitting in cash on their balance sheets) while a large number of businesses still trade on multiples equivalent to less than one times book value.
The case for investing in emerging markets (beyond the clearly longer-term, more structural arguments in favour) remains more contentious. Even if many indices have recovered the losses sustained during the early part of 2013, the outlook remains mixed. China’s growth may have accelerated and anticipation has grown over the possible scope for reform that could be announced during the Communist Party’s impending Third Plenum (a once-in-five year gathering where major economic initiatives are often announced), it remains the case that credit growth is high and private sector debt – at 178% of GDP – is not sustainable, based on historic precedents. This is not just a China-specific phenomenon with leverage rising in many other countries too. Rate tightening only compounds this issue, but has also been necessary in countries such as India and Indonesia given currency depreciation and corresponding higher inflationary pressures.
Finally, 2014 will see tapering become more than just talk and instead, economic reality. Beyond the clear implications for the US, it is more than possible that the events of this summer will play out once again, with a rising Dollar pressuring a number of emerging market currencies and their economies correspondingly. In the US, as recently as early September, the yield on the ten-year Treasury touched 3.0%, a level not seen since July 2011, the peak of the Eurozone crisis. With rates now closer to 2.6%, investors could be forgiven for believing the stronger upward move was just an anomaly. However, with hindsight, the Fed was almost certainly right to defer tapering, while recent macro data in the US has also been more mixed. Nonetheless, there is a certain inevitability attached to the direction in which yields will move (particularly in the context of likely rising inflation expectations), and 3.0-3.5% levels on the ten-year do not look at all implausible over the coming twelve months. At this point, the arguments in favour of investing in fixed income potentially become more persuasive.
For now, equities remain the most compelling investment option in our opinion, with our highest conviction residing in Europe and Japan. Nonetheless, the current environment remains highly conducive for stock-pickers across all geographic regions. S&P data shows sector correlations are currently at their lowest levels since the financial crisis, reinforcing the benefits of active management. Stock-pickers should also thrive in emerging markets, where we see scope for consumer-led equity stories to outperform more export-dependent ones in the coming months. Within credit, the time will come to increase allocations, but our current preference is to remain somewhat more tactical, again favouring active managers able to invest across the spectrum and manage their duration. If there is a relative loser, then it is gold, particularly in an environment where not only risk appetites are likely to remain elevated, but real rates will also begin inevitably to move upwards.
Alexander Gunz, Fund Manager, Heptagon Capital
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