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: an uneasy calm may have returned to markets, but it is also of perhaps little surprise that investors’ cash levels are at their highest since the 2008 financial crisis. The challenge for asset allocators is to consider where to go especially when global equities have rallied almost continually for the last six years and bond yields remain at broadly depressed levels. It is important though not to lose sight of the bigger picture. Volatility is still exceptionally low when viewed in an historic context, well below five-and ten-year average levels. Furthermore, the global economic recovery continues to strengthen and broaden, while policy remains supportive. Against this background, there is little change in our view: some near-term caution may be warranted, but we continue to favour equities over fixed income, preferring European and Japanese equities.
- Equities: On a relative basis we continue to prefer equities over other major asset classes based on valuation factors. Our regional views are also informed by this consideration, but influenced too by central bank policy. The lesson learned from the recent past, simply, is to follow balance sheet expansion. With the US getting closer to interest rate rises, our preference is to invest in regions with contrasting policy dynamics, namely Europe and Japan. Corporate earnings remain over 20% below peak in Europe and consensus opinion is still highly sceptical. Japan continues to perform well and ongoing reform should drive further outperformance in our view.
- Fixed Income: There is no change in our stance on fixed income. Government bond yields may have held broadly stable in the last month, but the more significant global trend remains towards gradual reflation (particularly in the US). This implies higher bond yields and further underperformance. As a consequence, we retain only limited allocation to this asset class, favouring only a few ‘go-anywhere’ strategies with more flexibility.
- Currencies: It remains the case that no country currently wants a strong currency. Yet, growing monetary policy divergence should result in the Euro (and the Yen) weakening relative to the Dollar. We recognise that currency weakness is not a zero-sum game and that much of these trends seem discounted. As a result, we currently have no active currency positions.
- Alternative Asset Managers: We have long advocated uncorrelated strategies within portfolios and are encouraged by the ongoing performance of both CTA (Commodity Trading Adviser) and event-driven strategies. The former is benefiting from current market volatility, while for the latter, M&A remains unabated, with deals up over 20% YOY.
What have we learned in the last month; what matters most now?
Events in China and Greece have been top-of-mind for most investors in the past month. This has resulted in a lot of ‘noise’ and not just related commentary but also volatility. From our perspective, two clear and simple observations can be made. First, we have seen once again that the delusions of politicians will always have unpredictable consequences. As a result, the biggest issue for both China and Greece (or perhaps the broader Eurozone) and correspondingly investor attitudes towards them, is one of trust and credibility. Recent events in these countries suggest that the ‘rules’ continue to be made up. For the European Union and the Chinese authorities, there is an ongoing and necessary learning experience. Inevitably it will take time to rebuild credibility and therein lies the opportunity for the patient, longer-term investor.
Moreover, as a result of such events, there is a marked need for all investors to refocus on fundamentals. Exogenous and unforeseen events will likely continue to cause near-term market gyrations, but a reversion to more conventional decision- making tools such as the business cycle and corporate earnings generates an important conclusion: global economic data are robust and equity valuation levels are now lower than they have been for some time (as discussed in more detail below). From an asset-allocation perspective, a focus on fundamentals suggests a still-compelling case for equities over fixed income and within equities for Europe and Japan.
Why we prefer Europe over the US
One of the most important lessons learned over the recent past is not to fight the direction of Central Bank policy. Looser(r) policy is generally supportive for equity markets. Regardless of unpredictable external events, it seems more than likely that the Federal Reserve will raise interest rates before the year-end. As well-telegraphed as this pending event has been, it will inevitably provoke some market volatility. Against this background, investors should not only consider the ongoing divergence of US and European monetary policy (Yellen says full employment is coming “closer into view” while Draghi says he will use “all instruments available” to spur growth), but also the notable valuation differences between the two regions.
With US corporate profits some 28% above their last cycle peak and European profits 20% below their corresponding previous peak (according to data from UBS), this gap is the widest on record. A combination of an improving macroeconomic backdrop, a weaker currency and the benefits of operating leverage should allow European corporates to narrow this gap and improve their valuation rating. It is also worth bearing in mind that while US corporates continue to exceed earnings expectations (over 75% of the S&P’s constituents have surpassed consensus estimates during the current quarter), much of this outperformance has been driven by share buybacks (which are at record levels) rather than improved operating performance. Over 50% of US companies in fact reported weaker than anticipated revenues during results season and many have cited both Dollar strength and emerging market weakness as near-term concerns.
Despite these trends (and the fact that market breadth in the US is narrowing: fewer sectors driving outperformance is often seen as a sign that the market may be reaching its top), investors remain somewhat sceptical about prospects for Europe. Some of this scepticism may have been exacerbated by the recent Greek debacle, but an interesting recent study shows that the number of buy recommendations across the STOXX Europe 600 Index from equity analysts is lower now than it was during either the TMT sell-off of the early 2000s or the financial crisis of 2008/9 (data courtesy of Barclays).
It is also worth considering that the (ironic) consequence of the Greek crisis is that it may foster a desire to proceed towards deeper fiscal and political integration, at least for those countries who want it. The rationale for such deepening is precisely in order to avoid future potential crises that may endanger the union. Rather than focus on Greece, consider that Spanish employment growth is currently its fastest in eight years while in Italy the government recently raised its GDP estimate for the first time in five years. What these two examples show is that structural reform can yield benefits. For the longer-term health of the Eurozone, embracing further reform, creating jobs and emphasising the importance of technology within the economy (the broad model adopted by the US and the UK in recent years) will be the key to sustainable success. After the worst quarter of performance in three years for European equities during Q2, we reiterate our positive stance.
Japan, the ‘forgotten’ market: why the country should be on more investors’ radars
With the US and Europe comprising some 75% of the MSCI All-Country World Index, getting positioning ‘right’ on these regions clearly matters. Yet Japan makes up another 10% and has in fact markedly outperformed both these other geographies on a year-to-date basis. Indeed, the TOPIX has seen 5 consecutive quarters of gains and currently stands at an 18-year high. With concerns about the timing of the Fed’s next move, the future of Greece and prospects for China are top of many investors’ minds, it seems to us as if Japan has perhaps been – wrongfully – ‘forgotten’ and merits revisiting.
A combination of quantitative easing, a weaker currency and some structural reform (the model now, of course, being adopted by Europe) has led to Japanese corporate profits as a percentage of GDP reaching 12.8% as of the end of Q2, well in excess of the 10.4% level posted in 1989 at the peak of the last bubble, according to the Ministry of Finance. Despite this, return on equity, at c9%, is still roughly half levels recorded by corporates in other developed markets. The key hence for Japan to drive further equity outperformance is to improve returns. The evidence we see of intention in this respect is compelling. At a corporate level, a growing number of companies are adopting the Corporate Governance and Stewardship Codes resulting in the appointment of independent directors, improved disclosure and an increased emphasis on shareholder returns. Meanwhile, the Abe Government (which commands a large majority and high popularity) continues with further reform, in tax, labour, energy and immigration policy. We expect further progress in broad reform to support an equity market which still looks inexpensive on a global basis.
Endnote: China – look beyond the noise
It behoves us to provide some commentary on China given the pronounced moves in the market and the fact that prospects for the country currently rank as the most significant investor concern (based on the last BoAML Fund Manager Survey). The magnitude of dealing with deflating two clear bubbles in credit and housing has inevitably been compounded by the psychological impact of now deflating a third bubble, in equities. Context, however, is important.
Investors should not forget that despite the recent setback, the Chinese equity market has still risen by close to 70% in the last year. They should also listen hard when a Central Bank/Government says it will ‘do what it takes’ to enact reform and change. This was the lesson learned from both the Federal Reserve in 2008 and the European Central Bank in 2012. The publication of China’s next five-year plan (spanning 2016-2020) this autumn should only reinforce its commitment in this respect. It will clearly take time for sentiment to find a near-term bottom in China, but the longer-term investment case remains intact. We note that China’s (stock) market capitalisation to GDP ratio of 60% stands at half its 2007 peak and compares to a similar ratio of currently over 130% in the US...
Alexander Gunz, Fund Manager, Heptagon Capital
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