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: the bubble hasn’t burst yet. Equity markets and government bond yields have remained broadly range-bound over the course of 2015, but the recent pronounced volatility both within and across these asset classes is perhaps most indicative of what is to come. The same problems persist – not enough growth and too much debt globally – and there seems to be a clear lack of solutions. Our emphasis therefore remains on valuation and on assets that have the ability to deliver superior and preferably uncorrelated returns. Beyond a consideration of alternative assets, we prefer equity over credit for now, and Europe and Japan over the US.
- Equities: Global earnings revisions turned negative in July and show no signs of improvement, weighed down by theUS and the impact of the stronger Dollar. Japan is the only region currently seeing upgrades and equities here should continue also to benefit from structural reform. For Europe, we also see sources of upside, particularly from operating leverage. Meanwhile, emerging market equities trade on lower long-term multiples than at any stage in recent history. Active managers should benefit from the growing divergence in potential returns achievable from different regions.
- Fixed Income: Similar to equities, fixed income markets should continue to diverge, driven partly by monetary policy. In the US, government yields are already beginning to steepen at the front-end, a move set to continue. By contrast, yields can still trend lower in Europe and elsewhere. Trades in general remain asymmetric; with risks weighted to the downside. Investment grade and high yield debt also look clearly challenged given leverage concerns and hence widening spreads. We hence favour only very limited allocations, and preferably via unconstrained strategies.
- Currencies: Further US Dollar appreciation is currently a highly consensual trade, but needs to be seen in the context of the biggest move witnessed 2015 to-date in the Dollar Index seen for 25 years. A shift of a similar magnitude looks unlikely in 2016. Even if there are good reasons for further Dollar strength, expect also periods of mean reversion. Alternative Asset Managers: With broader market uncertainties growing, we continue to favour investments to genuinely uncorrelated assets such as catastrophic reinsurance, infrastructure assets (such as energy) and private equity.
Headlines can be misleading. A superficial look at US 10-year Treasury yields or the MSCI World shows that their levels are almost unchanged relative to this time last year, perhaps suggestive of a placid investing environment. The reality is rather different. Not only has there been significant intra-year volatility in both the price and yields of government bonds as well as in global equity market levels (the MSCI World has touched both 1550 and 1800 in the last year), but also notable divergence between and within markets. The current spread between US Treasuries and German Bunds is, for example, the widest it has been in 25 years. Meanwhile, for equities, contrast the fact that the S&P is currently within 2% of its all-time high, while comparable European, Japanese and Emerging Market indices remain at least 15% below theirs.
Against this background, we believe it is possible to make two assertions that will likely influence investment strategies going forward: first, intra-month/year volatility and divergence look set to endure; second, at some stage, something is going to have to give and one of the current equity/ fixed income bubbles will burst. Admittedly, it is rare for markets to crash when there is collectively so much worry and scepticism, but being complacently ignorant of the current investing reality is also not a tenable stance to adopt. Below, follows our framework for thinking ahead.
We all know what the problem is; the challenge is to know when it really becomes a problem
Put simply, never has so much money been printed ($8trillion since 2009) nor have base rates been so low. As a consequence, global debt is now equivalent to over 2.5x GDP and has increased by some 20% since the end of the financial crisis. Despite such monetary largesse, global GDP growth has not exceeded 3% for the last five years, while based on current Central Bank projections, inflation – even in two years’ time – will not have surpassed their respective targets for a decade. High debt therefore needs to be seen in a context of an absence of sustained growth and inflation.
Even as US monetary policy gradually begins to tighten, globally, the monetary environment will remain loose, effectively sustaining the addiction without addressing the broader problem. The current signs of pressure within the high yield market (which do not seem restricted uniquely to the energy sector, and appear to be spreading) are potentially a precursor for what is to come. Without steady growth or inflation, debt just won’t go away, prompting the risk of further defaults. We can’t say when the bubble will burst, but fear it will. What starts in credit often spreads to other asset classes.
The solution: plan for the new investing reality
An era of financial repression means that future returns are unlikely to be comparable to those achieved historically. Long- term annualised returns from a balanced portfolio of equities and bonds have typically averaged 8-10%. Most forecasts assume that holding a similar portfolio for the next ten years will return perhaps half this level, just 4-5%. Even this may be an optimistic assumption should excess debt levels and the corresponding lack of ‘new’ solutions from Central Banks (in the event of economic slowdown and/or growing defaults) compromise returns. The corollary is that for those investors seeking returns higher than those broadly anticipated, there will be an increasing need to consider unconventional and uncorrelated assets as a means of boosting returns and broadening diversification.
What to do in the near-term
Despite proximity to the year-end, December is unlikely to be a quiet month for investors. Events in this month may also be a possible foretaste for what is to come in 2016. Both Central Bank policy and politics are set to dominate. Investors currently accord a 74% probability to the Federal Reserve raising rates for the first time in almost a decade when the committee next meets on 15 and 16 December. Should the Fed fail to move, then this may raise questions over the credibility of their recent messaging and hence have an adverse near-term impact on markets. Going forward, the consistency of the Fed’s messaging will be crucial for investors to retain confidence. With US monetary policy poised to diverge from that of other major Central Banks globally (indeed, it seems likely the ECB will commit to an increase/ extension of their programme during December), investors should also be aware of the potential unintended consequences that may arise from diverging policy. These will likely cast an influence over currencies, rates and corporate earnings.
Regarding politics, December sees regional elections in France and a general election in Spain, both of which may be a cause for uncertainty. For 2016, the main political event will likely be the US general election, but further political discord in Europe may become evident, whether over Britain’s potential relationship with the rest of the continent (culminating in a referendum) and/or the fragile state of Greece’s finances (which will likely need to be addressed once again). Meanwhile the refugee crisis and a febrile Middle East will not disappear anytime soon. Expect more volatility.
What to do? We reiterate the point made many times before: valuation trumps almost everything. We put more emphasis on this factor than we do on economic trends, where correlations between GDP and equity market returns are limited. In other words, we choose to invest where there is value. We note that the global earnings yield (inverted P/E) is close to 5% and the dividend yield 2.5%. Japanese and European equities currently trade on lower multiples than in the US (by at least 10% on near-term metrics and more on a longer-term basis). Across every region, there remain undervalued businesses in which to invest, playing to the strengths of active managers. Contrast current equity multiples with the c2% yield offered by 10-year US government debt and a yield of less than 0.5% available on a German Bund of 10-year maturity.
Favour Europe and Japan over the US
The US bull market in equities is now 82 months’ long with the S&P having risen over 200% from its lows. This in itself should not signal the end of the bull market, but at the least, investors should expect more volatility, not just from imminent interest rate rises, but also from decelerating earnings trends. US earnings per share are now 30% above their previous peak levels (according to Goldman Sachs), flattered by share buy-backs. However, 2016 earnings estimates – relative to where they stood at the start of this year – have been cut by a faster pace than in any other region globally. Consensus is looking for just 8% growth in 2016, a reduction from the 13% level forecast at the start of the year. A stronger US Dollar, upward wage pressure and higher interest rates limiting the relative attractiveness of buybacks may all contribute to further downward pressure on this assumption.
Forward earnings estimates have also come down in Europe, although the rate of downgrades relative to expectations at the start of the year has been the slowest since 2010 (according to UBS). Moreover, there are clear reasons for confidence. The economy should improve further in 2016 relative to 2015, having some impact on demand, but more on margins. Operating leverage from lean cost structures should be clearly beneficial, helped by limited wage pressures (unemployment is still c11%) and raw material prices at secular lows. Earnings should also continue their clear upward trend in Japan, the only region not to have seen earnings downgrades this year. More companies continue to implement the Corporate Governance and Stewardship Codes with clear benefits, while the pace of positive country-wide reform remains strong.
Final word: don’t forget about emerging markets
After three years’ of consistent underperformance relative to developed markets, valuation is now looking more supportive. On a cyclically adjusted earnings (CAPE) basis, emerging markets now trade on their lowest ever multiple, just 12.8x, relative to a 13.5x level marked at the time of Asian crisis in 1997/98 (based on data from JP Morgan). Comparable multiples for Europe and Japan stand at over 15x while the US trades on more than 20x. Many of the challenges facing this broad region have not disappeared, but there does appear to be some value emerging for the longer-term investor.
Alexander Gunz, Fund Manager, Heptagon Capital
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