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.

View from the very top: investor sentiment remains fragile despite broad equity market strength and continued yield compression in conventional fixed income. The twin spectres of ongoing US Dollar appreciation and impending US rate rises potentially complicate asset allocation decisions. Looking beyond the noise, a realistic assessment of the outlook suggests many investing asymmetries, the biggest of which exists in the fixed income market. Our preference remains for equities (especially in Europe) over bonds. Additionally, we continue to make the case for uncorrelated, alternative investments.

Asset Allocation:

• Equities: Our regional preference remains unchanged, favouring Europe and Japan near-term and also emerging markets over the medium-term. Notably, the US has been the worst-performing developed world equity market year- to-date, and this trend may continue. European valuations remain 30% below their previous peak, while US levels are some 25% ahead. We also note that Japanese equity outperformance is being driven not just by currency-related factors, but also by genuine, sustainable, structural reform. A similar trend could occur in Europe over time.
• Fixed Income: So-called ‘risk-free’ investing is increasingly becoming ‘return free.’ Yields on German government debt are now negative all the way out to seven years, while multi-century lows continue to be recorded in many countries. We maintain the view that the risk profile from conventional fixed income investing is highly asymmetric. Investors should not forget that the last time US unemployment was this low, nominal ten-year Treasury yields stood at 4.2%. Today, they are sub-2.0%. Within credit, our only allocations are in more flexible, ‘go anywhere’ strategies.
• Currencies: Current Central Bank policy, which will only likely diverge further over the year, supports the case for a weaker Euro (and Yen) and, correspondingly, a stronger Dollar. However, given the abruptness of recent moves (for the Euro-Dollar rate in particular), there is a near-term possibility of a reversion to mean of this consensual trade.
• AlternativeAssetManagers:With the search for yield becoming an increasing priority for many investors, we argue the case for some alternative investments. Our favoured liquid strategy remains event-driven, where deal activity remains strong ($811bn of activity in Q1, equivalent to 21% year-on-year growth). CTAs may also benefit from ongoing currency volatility. Investors who are happy to sacrifice near-term liquidity may also want to consider strategies such as direct lending and catastrophic reinsurance.

Headlines can be as misleading as they are eye-catching. During March, 15-year highs were seen in stock markets around the world (in Europe, the NASDAQ and Japan’s TOPIX), while yields on 10-year US Treasuries slipped below 2.0% again. Surely such an outcome ought to be pleasing both for equity and fixed income investors? Beyond the technical observation that equity market highs are always denoted in nominal rather than real, inflation-adjusted, terms, the current investing reality is much more sobering. US and global equity indices have barely moved this year (up just 0.4% and 1.8% respectively as of 31 March), while conventional fixed income increasingly constitutes a return-free asset class with shrinking yields. Furthermore, inevitable uncertainty remains.

Perhaps the most commonly occurring question investors continue to pose is what may most likely undermine the six- year rally witnessed in both equities and fixed income? Sadly, we do not possess a crystal ball or any such similar tool for predicting the future, but we do recognise two important factors: first, as we have highlighted on many previous occasions in this commentary, the need to look beyond conventional asset classes in order to generate meaningful medium-term returns; and second, at least to consider the most pertinent questions when forming nearer-term investment decisions, of which more below –

What would cause a US equity market correction?

The current rally in US equities now constitutes the longest bull market run in terms of number of months since 1945, with the price change of this recovery from peak-to-trough has only been exceeded once, during the tech-bubble. Indeed, one would have to go back over 800 days, to May 2012, just to find a period when US equities fell by more than 5% during a single month. However, year-to-date, the US equity market has performed worse than any other in the developed world. Furthermore, it is possible to construct a scenario where further gains in 2015 are limited given a combination of headline P/E valuations that are among the most demanding globally, falling earnings estimates (consensus is looking for -5.7% year-on-year EPS growth during Q1, the weakest since 2009), strength in the US Dollar (which is compounding earnings pressure) and the risk that the Fed will likely raise rates before the end of the year.

On the positive side, it would seem that the Fed has learned from the May 2013 ‘taper tantrum’ episode to be crystal-clear in its communication. In other words, rate rises – when they happen – will be data-dependent. Arguably, it is also better to err on the side of caution and only consider hikes once there is tangible evidence of sustained economic momentum. Based on the projections of the Federal Open Market Committee, rates should now only be at 0.6% by the end of 2015, notably lower than had been the case at the start of the year (1.1%).

However, even if monetary conditions remain broadly benign (and highly accommodative elsewhere in the world), there are other factors to consider. US GDP estimates have been revised down since the start of the year while factory production, retail sales and consumer-confidence are all at four-month lows. Some of this may be a function of seasonal weather-related factors, but these indicators will remain important to monitor. More encouragingly, lending conditions both to corporates and consumers remain positive for now. Conclusion: there are many reasons to believe that the investing environment for US equities will remain relatively more challenging than other global regions through the remainder of 2015. Our nearer-term preference remains for European and Japanese equities.

Are investors discounting deflation excessively, and not considering the possibility of inflation?

Low (US) interest rates and favourable global monetary conditions are premised on the absence of inflation. There certainly has been little evidence of it in the developed world in the last five years, while currently weaker commodity prices also support the argument. However, as we have written previously, inflation does not suddenly manifest itself unexpectedly overnight, while expectations matter more than actual headline figures.

We cannot help observing that four of the world’s largest economies (the US, Japan, Germany and the UK) are now all getting close to full employment. Taking the case of the US in particular, based on current payroll trends, unemployment could be at just 4.5% this time next year. As a consequence, there is some evidence of growing upward wage pressure. The rolling three-month annualised rate of wage growth in the US is at its highest in two-years. Big retailers (Target being the latest) also continue to raise salaries for many workers. Meanwhile, in Japan, basic pay is currently rising at its fastest rate in 15 years, albeit from a low base. Major employers such as Toyota, Nissan and Fuji have indicated that they may raise salaries by as much as 3.0% during the current spring salary negotiations season.

Even in Europe, long-mired in recession, negative deposit rates are forcing both individuals and corporates into spending their cash. European consumer confidence stands at its highest in seven years and there is also some evidence of salary increases. In Germany, the country’s biggest trade union, for example, recently secured a 3.4% year-on-year rise for its members. Two-year inflation break-evens are now actually positive in Germany, France and Italy. Conclusion: financial repression via monetary printing has kept yields on government bonds artificially low. The last time US unemployment was at its current 5.5% level, the nominal yield on the US ten-year was at 4.2% (in real terms, current yields are, admittedly, much more comparable with historic precedents). Inflationary pressures may not become immediately embedded, but soon the logic of not holding conventional fixed income should become clear.

When will the outlook for emerging markets become more attractive?

It is notable that emerging market equities have underperformed developed market equities by more than 50% during the last four years. While it would be easy to suggest that this trend may continue (exacerbated by a stronger US Dollar and weaker commodity prices), it is potentially more interesting to consider other outcomes. The reality is a complex one where the broad term ‘emerging markets’ may be misleading. While there is one group of countries (including India, Indonesia, Mexico and Poland) that appear to have embraced reform and more domestic, consumer-led models, others (most notably Brazil and Russia, but also Turkey and South Africa) have yet to do so.

Against this background, there may be merits in being country-selective. China also remains a notable unknown. There is a clear transition challenge and the economy is currently adjusting to this. Industrial production is, for example, at an 11- month low. Nonetheless, the Chinese government remains highly proactive and has stressed its commitment to accommodative and flexible monetary and fiscal policy. Conclusion: the longer-term model for emerging markets is highly persuasive; their share of global GDP has doubled in the last ten years and they will account for 70% of global growth in the next five. Our preference is to be selective, favouring models which are shifting away from export orientation to consumption.

Final word: will US Dollar strength reverse?

The first quarter of 2015 marks the biggest change in the Dollar-Euro exchange rate since 1992, when the UK left the Exchange Rate Mechanism, the precursor to the Euro. Many commentators now suggest that parity is inevitable. A contrarian view would suggest that there may be scope for some mean reversion, particularly given the abruptness of the recent move (11.3% in the first three months of 2015). It should not be forgotten that the macro outlook in Europe has notably improved in recent months, while the US experience shows that currencies can appreciate at the same time as money printing is occurring once confidence in the recovery becomes sustainable.

Alexander Gunz, Fund Manager, Heptagon Capital