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.

Even if it has been a pleasant and sunny summer for most with no major market dislocations, the coming months are likely to prove significantly more challenging. Notwithstanding a growing list of uncertainties (the future direction of US monetary policy, how America transitions once again around its debt ceiling, whether many emerging economies will face currency and current account crises and, the risks of escalating warfare in the Middle East to name but a few), the broad investing environment also offers relatively few compelling opportunities in our view. Put simply, a scenario of rising bond yields, overvalued equities (especially in the US) and growing risk aversion is unappealing. We have moved to a more neutral stance on equities, but are certainly not positive on pure credit. Beyond cash, our strategy is one of identifying pockets of value: in particular, European and Japanese equities as well as credit strategies able to manage duration risk.

The biggest challenge investors face is balancing the evidence that the economy (the US in particular, although other regions are following) is improving on a sustainable basis with the likely unintended consequences of a lengthy reliance on experimental monetary policy. Much of the stability of the financial system since the last crisis has been premised on Central Bank credibility. And to this end, the Federal Reserve’s actions have acted as a template or proxy for other regions. All of this, however, could soon change. That the yield on US 10-year Treasuries has moved from under 1.7% to over 2.7% in less than four months has arguably already undermined some of the Fed’s hard-fought intentions. Despite the many pronouncements from the Fed’s Board of Governors, it seems that investors still do not understand the distinction between an end to large scale asset purchases (i.e. quantitative easing) and an ongoing commitment to a zero interest rate policy. Put simply, the genie is out of the bottle: even if interest rates have not begun to rise yet, the 30-year bull market in bonds is clearly over. And, where bonds tend to lead, equities often follow.

At this juncture, it is perhaps worth considering the counter-argument, namely that a normalisation of the economy implies a normalisation of monetary policy. In other words, rates are rising because the economy is improving; and this scenario, surely, ought to be good for equities. However, it is not as simple as this for two principal reasons. First, even if 2013 may be the first occasion since 2010 when the global economy will have reported year-on-year growth, there is extensive evidence to suggest that there is almost no correlation between GDP trends and equity market performance. Next, and crucially, equities are no longer obviously undervalued, and indeed in some markets, look palpably overvalued. The reality is that with the exception of a few minor setbacks, global indices have enjoyed a bull market for almost five years, with the MSCI World rallying over 110% from its March 2009 low. On a cyclically adjusted price/earnings (CAPE) basis – our preferred metric – the US market is correspondingly currently the second most expensive globally (only Columbia scores worse), while also trading at a 40% premium to its median CAPE. This looks increasingly hard to justify, especially given US earnings momentum was negative (stripping out financials) during the last quarter.

In addition, the near-term environment is complicated by a series of factors, which look especially pertinent for the US. Both the monetary and the fiscal environment are subject to challenges. In terms of the former, not only will a new – and

still unknown – candidate assume the Chair of the Fed in January, but also, four of the seven members of the Board of Governors will have to be replaced within the next six months. Being able to gauge a sense of consistent monetary direction, just as QE is ending, will therefore become increasingly hard, exacerbating uncertainty. The debt ceiling will also re-emerge as a topic in the coming weeks with the US Government likely to have exhausted its ability to borrow funds by the middle of October when the statutory debt limit is reached. Even if there is eventual resolution, the scope for brinkmanship on the part of both parties, and hence investor nervousness, is also high. Tension levels may also elevate in the near-term given the unknown impact of potential strikes in Syria.

Stepping back, the reality is that almost irrespective of all of the above, directionally, interest rates are beginning to rise – and this complicates the investing environment. In particular, it implies that the conventional risk-on, risk-off (equities versus bonds) trade that has worked so well over the last five years, may no longer function as effectively. Indeed, it has become abundantly clear in recent months that correlations (be they between bonds and equities, US Treasuries and the US Dollar, or even within equities, where relationships between the top-50 constituents of the S&P 500 are at 5-year lows) are becoming less influential. This obviously implies the need for more active asset management, hence the approach we have undertaken within Heptagon in seeking to identify pockets of value.

It is clearly hard then to make a convincing case for US equities at present given the arguments previously outlined, even if GDP growth is running 2.5% annualised, industrial production is at a 2-year high, unemployment at a 4-year low and builder confidence at its best since 2005. Indeed, it may be more constructive to consider what impact higher rates could have on disrupting this roseate environment. We note that new US home sales in July (the last month for which data is available), showed their largest monthly drop in almost 3 years, perhaps a harbinger. Meanwhile, recent reports from a large number of US retailers (particularly on the discretionary side) have also disappointed relative to expectations.

If not the US, then where? In terms of Europe, there is clearly no room for complacency and the continent faces a number of notable structural challenges. Whereas the US has gone some way to deleveraging, with bank loans to households and non-financials now just 80% of GDP compared to 120% at peak, in Europe (which topped out at a similar level), the comparable figure remains over 100%. Unit labour costs in Europe also remain notably higher than in the US and have yet to decline notably across much of the continent. These factors are clearly continuing to cast some form of shadow over Europe’s prospects and it is notable that the constituents of the Stoxx 600 have reported negative net earnings surprises for three consecutive quarters.

However, Europe is trading at its biggest discount to the US (on a median CAPE basis) since 2008, during which time the latter has outperformed the former by more than 50%. In addition, European equities have rallied despite poor earnings momentum. Indeed on a quarter-to-date basis (through to the end of August), the Stoxx 600 has added 4.3% against just 1.7% for the S&P and 2.1% decline for the Nikkei. This implies that when companies do report better earnings, there is significant scope for a further rerating, especially if the economy is simultaneously improving. The European economy reported for Q2 its first period of annualised GDP growth in seven quarters, while consumers across the continent are at their most optimistic since July 2011. German Federal elections later this month are unlikely to change significantly these trends and could even bring Eurozone reform back onto the agenda again.

Similar valuation arguments can also be made for Japanese and emerging market equities, particularly relative to the US. In the case of Japan, the Nikkei’s 40% discount to its median CAPE makes it the fourth cheapest market globally (the other three are periphery Eurozone nations). For Japan, however, the key is for policy momentum to be maintained and for execution to move beyond rhetoric. With the Diet (parliament) reconvening this month, it seems reasonable to expect an increase in newsflow and for Prime Minister Abe to implement legislation aimed at liberalising the economy. The Bank of Japan also needs to play a role and improving communication, thereby reinforcing credibility.

As far as emerging markets are concerned, the valuation argument is again unambiguous (trading on its lowest price/book multiple in almost a decade), but the outlook is complicated by a series of factors. Beyond the unwinding of the US Dollar carry-trade and the general cutting of risk by investors, several issues are of concern. Many countries (Brazil, South Africa, Turkey, Indonesia and India among others) are seeing their current accounts under pressure as a result of weakening currencies. In India, the issue is rendered more problematic by the growth in non-performing loans as well as rising political pressures. Developments in the Middle East represent another issue with the Syrian conflict constituting just part of a broader proxy war taking place throughout the region that doesn’t seem at all close to concluding (a higher oil price is also clearly deleterious for global growth). Finally, even if near-term trends in China point towards stabilisation and the avoidance of a hard-landing scenario for the economy, the broader structural issue of credit growth well in excess of GDP growth remains unresolved.Overall, the inevitable conclusion is that there are very few safe havens for investors at present. Nonetheless, there remain a series of precepts which we believe it is important to follow:

Don’t ignore fund flows: with the bond bull market ending and yields rising, assets will continue to flow out of credit and will need to find a home somewhere, be it cash or equities;

• Valuation trumps almost everything: global equities may be better placed than credit given the above, but some regions (in particular the US), look notably stretched from a valuation perspective;
• Correlations are deteriorating: especially given that today’s environment of rising rates and over-priced equities constitutes a relatively unprecedented scenario; and, as a result,
• The importance of active management is increasing: passive, trend-following strategies may come under pressure and our preference across all asset classes is for managers that have high-conviction and are alpha-focused.

The corollary is that cash weightings have increased within our portfolios as we wish to be positioned not just defensively but also opportunistically, poised to take advantage of any corrections that may occur. Within equities, we have a more neutral stance than was the case three months ago, having reduced exposure to the US while favouring Europe (and Japan, to an extent). In terms of credit, we continue to favour managers able to adopt approaches based more around absolute-returns, managing duration risk actively. Such an approach, we believe, will best serve to protect and enhance investors’ capital in what may be more challenging times ahead.

Alexander Gunz, Fund Manager, Heptagon Capital