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.

Amidst all the news headlines, commentaries about US fiscal deadlock and debates over the credibility of the Federal Reserve’s strategy, what stands out as most remarkable is the resilience of equities around the world. Global stock markets continue to trade within just 2.5% of their 52-week highs. Whether this is cause for celebration, however, remains to be seen. Valuation constitutes a specific concern, hence our preference for regions other than the US and, the current case for equities is indeed premised to an extent on the lack of other suitable asset classes in which to invest at present. Even if political dysfunction (especially in the US) has the ability to trump both benign monetary conditions and improving macro data, it seems to us as if equities can still broadly prevail relative to other asset classes for now.

Encapsulated within this thesis is the notion that regions other than the US have better near-term prospects. Clearly the whole world has benefited from a more robust American economy, where industrial production has been positive in all but 3 of the last 48 months. Now, however, three important considerations should come to the fore. First, even if there is every reason why this trend may prove sustainable for some time longer, the rate of change and hence scope for surprise will inevitably slow from current levels. By contrast, these two drivers are notably more positive in both Europe and Japan at present. Next, the political direction of travel and will for action is again demonstrably healthier in these two latter regions in contrast to the US. Finally, there is no denying the importance of valuation: not only do US equities trade at a 40% premium to their median cyclically-adjusted earnings multiple at present, but also given the recent move in US Treasuries, the yield on the 10-year is now superior to that of the S&P’s current dividend yield.

Concerns over the US debt ceiling and current government shutdown may be over-stated and it is clearly futile for investors to attempt to second-guess political behaviour. Nonetheless, uncertainty is rarely a positive and even if there is – as seems likely – an eventual resolution to these issues, the lack of consensus and unwillingness even to seek to build consensus in current American politics is a clear cause for concern both near- and medium-term. The ideological divide between Republicans and Democrats (not to mention within the Republican Party) appears bigger than it has done for some time and the longer the current dispute persists, the greater the credibility of all participants becomes undermined, not to mention the negative impact on the broader economy. At the least, the shutdown will likely increase caution levels among both consumers and corporates in their forthcoming expenditure decisions, while the impending corporate earnings season could see US management teams issuing conservative guidance. Even if such an outlook from corporates may eventually be exceeded, the near-term impact could be to compound the general pessimism felt over prospects.

The contrast between the US and both Western Europe and Japan could hardly be starker in these respects at present. Taking Europe first, the overwhelming victory handed to Angela Merkel’s Christian Democrat party in the recent German Elections (its best result since unification) appears to constitute a clear vote of confidence in the approach pursued vis-à- vis Eurozone recovery. Indeed, Frau Merkel is one of the few leaders in Europe actually to have increased her share of the vote since the crisis began. With no significant elections pending across the Eurozone or evident crises brewing, the maintenance of the status quo seems assured for the time being. Furthermore, now that there is a stable political situation in Germany, it is possible that Merkel may be less willing to block future attempts by ECB President Mario Draghi to pursue a potentially more accommodative monetary stance, should this be required.

Such an approach may, however, not be necessary since a virtuous circle effect is currently being created across the Eurozone by the fact that industrial production is expanding. With Purchasing Managers’ Indices up for 6 consecutive months and Eurozone production at a 27-month high, prospects seem highly encouraging. Even in Spain, for long the pariah nation within Europe, output is now expanding for the first time in three years and the property market – the root of many of its problems – appears to have hit a bottom, with the market having declined at its slowest pace during the most recent quarter since the end of 2010. Most importantly, there is a clear correlation between Eurozone industrial production and corporate earnings growth. According to research by JP Morgan, there is a five-month lag between these two factors, suggesting that the corporate outlook in Europe should continue to improve. This scenario is also occurring with equities trading some 20% below their US peers.

Turning to Japan, there are similar reasons for optimism at present. Output has also moved into expansion mode, annualised GDP growth has been revised upwards to 3.8% and business optimism (as measured by the Tankan survey) stands at its highest since 2007. An important reason for this buoyancy is, once again, the current Japanese political environment. We have written on this topic in the past, but support for Prime Minister Abe stands above 60% and both pursuit and pace of reform remains undiminished. A rise in consumption tax is being offset by corporate tax reductions and favourable breaks for capital expenditure as well as research and development-related projects and more may be forthcoming over time, particularly with regard to labour and welfare reform. Against such a backdrop, it is perhaps not surprising that Japanese corporates are buying back their own stock at the fastest pace since 2005. This should continue and a combination of the above factors has resulted in a 60% expansion in earnings for the TOPIX index year-to-date, resulting in a compression of the market’s earnings multiple (17.1x to 14.3x), supporting the case for Japanese equities.

Investors may also draw reassurance in these above two regions that there appears to be a general yet extensive alignment between political and economic imperatives. Put another way, there is broad-based support in the Eurozone and Japan for current monetary policy, which is likely to remain oriented in an accommodative direction. The current thinking within the Federal Reserve has become somewhat over-shadowed by the more recent debate over America’s fiscal situation. Nonetheless, it is difficult to disagree with the Fed’s contention that “asset purchases are not on a pre-set course” and while investors may also be thankful that tapering is not occurring at the same time as fiscal impasse, exacerbating uncertainty, several difficult issues still need to be addressed. First, tapering cannot be deferred forever and communication over this topic – and also on forward rate guidance – needs to be as clear as possible. Next, the Fed (and arguably the White House) needs to develop a clear understanding of the labour market, and in particular whether the decline in the participation rate is structural, since this is crucial to its mandate for seeking full employment. Finally, investors still lack certainty on Ben Bernanke’s replacement. Even if Janet Yellen is confirmed, suggesting a certain amount of continuity, it may take some time for investors to appreciate the nuancing of future Fed policy.

All of the above has inevitable implications for emerging markets in addition to just the US. It is notable not only how the US Dollar and US Treasury yields have weakened (respectively at current two- and one-month lows) since American fiscal uncertainties have intensified, but also how many EM equity indices and local currencies have reversed much of the sell- off that occurred since May over the last month. Beyond the inter-linkages between these factors (i.e. lower yields and a weaker Dollar are good news for emerging economies), the recent stabilisation that has occurred in China has also been helpful. Recent data suggest that China may have turned a corner, with industrial production at its best since May 2012, export growth accelerating and other proxies such as electricity consumption and steel production also trending positively. Nonetheless, with credit growth still running well in excess of GDP (the former doubled in September), there may be problems ahead for the Chinese economy.

In more general terms, even if export-led emerging nations including China (but also South Korea and much of Eastern Europe) are currently benefiting from Dollar weakness and more stable conditions, those nations with notable current account deficits remain under pressure. The inevitable need to import capital constitutes a clear negative for countries including India, Indonesia, Thailand, Brazil, South Africa and Turkey. Indian GDP growth has slowed to its lowest since the end of 2009, Indonesia has been forced to raise interest rates twice in the last month and Thailand recently entered a technical recession. Against this background, while risks for emerging markets appear notably less pronounced than was the case three months ago, our strategy remains for now one of more selective geographic investments.

On the assumption that uncertainty is a given, we continue to believe that there are very few ‘obvious’ safe havens for investors at present. Even if the recent move in US Treasuries and the Dollar may suggest otherwise, the broad future direction in which developed market yield curves are trending seems clear. Put another way, the scope for further yield compression is limited and on this logic, the case for owning directional credit looks low at present. Moreover, even if the yield on the US 10-year does now exceed the dividend yield of the S&P, the broad valuation argument for credit over equities does not yet seem compelling. At some stage, this argument will prove more supportive to credit, but 10-year Treasury yields probably need to be in the range of 3.0-3.5%, versus 2.6% currently, based on today’s economic outlook.

As a result, it all comes down to valuation and hence to regional allocation. Our strategy, therefore, within equities is to favour Europe and Japan over the US. And, within credit, we prefer to stick with managers adopting non-directional strategies with the ability to take on low or even negative duration. Above all, the current environment plays to the strengths of those managers able to pursue active, bottom-up strategies. Active strategies have notably outperformed passive ones year-to-date, and we expect this trend to endure for some time further. In addition, we stress the importance of keeping relatively high cash levels within investors’ portfolios, not simply as a defence tactic, but also so as to be able to act opportunistically, when the appropriate moments occur.

Alexander Gunz, Fund Manager, Heptagon Capital

Disclaimers 

The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. 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. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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Heptagon Capital LLP, 63 Brook Street, Mayfair, London W1K 4HS
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