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: the year has begun as the last ended, with heightened levels of uncertainty and abrupt moves in many asset classes, particularly equities. The ongoing decline in developed world government bond yields accompanied by further falls in the price of oil and other commodities and combined with the outperformance of safe haven assets suggests that near-term risks may be rising. Nonetheless, we remain constructive on the right investment strategies, at the right price, continuing to favour equities (especially European) over credit. Additionally, we make the case for uncorrelated, alternative investments.

Asset Allocation:

• Equities: On a relative basis we advocate equities. Nonetheless, the risk-on rally of recent months has meant that it is increasingly hard to find value in this asset class. This is particularly the case in the US, where the S&P has outperformed equities in the rest-of-world by more than 90% over the last five years. A stronger Dollar is also proving a notable headwind to many US corporates, as evidenced in the current reporting season. Against this background, we favour Europe and Japan for the near-term, and emerging markets over the medium-term.

• Credit: January was the month that saw five-year government debt turn negative for the first time ever in Germany and Japan. Low rates will likely prevail in developed markets for some time longer, particularly given the weakness in the oil price and the clear absence of inflationary tendencies. Investment returns from conventional debt therefore look unattractive (even if there may be further yield compression), reinforcing the case for flexible, ‘go anywhere’ credit approaches.

• Currencies: Current central bank policy suggests that all roads lead to a weaker Euro (and Yen) and, correspondingly, a stronger Dollar. Events from the last month support this view although we would caution that the ‘Dollar trade’ has become increasingly consensual and so may be at danger of reversing at some stage in the near-term.
• Alternative Asset Managers: 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 is still notable (and up year-on-year). 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.

With only a month of 2015 gone, our view that the year would be characterised by pronounced levels of uncertainty has clearly been borne out. Recent events have confounded even the most astute and reinforce the logic not only of pursuing diversified asset allocation strategies but also remaining nimble and pragmatic. Partially provoked by the unprecedented actions of two of the world’s major central banks (the ECB and the Swiss National Bank) and the election of the first non- mainstream, anti-austerity party in Europe (Syriza in Greece), equity markets have moved forcefully in both directions as has the VIX indicator of volatility. It is noteworthy that the average one-day move (either way) of the S&P over January has been 0.92%, compared to just 0.53% for the whole of 2015. At the same time, the VIX has averaged 19.1 year-to-date, higher than its 14.5 level recorded in 2014. Meanwhile oil and copper have also continued to move down.

Sceptics are, therefore, perhaps entitled to wonder whether these large moves, combined with widening credit spreads and the outperformance of perceived safe havens such as gold are a harbinger of worse to come. Even if we are unable to provide a definitive answer to this debate, it remains highly pertinent to ask the right questions. These naturally drive the framework for an informed asset allocation strategy. Our thoughts below throw light on some of the key concerns.

How much faith should investors place in central bank policy?

Five years on from the Federal Reserve’s first round of quantitative easing, the pursuit of unconventional monetary policy remains an experiment with unproven results. Moreover, with inflation rates continuing to trend down globally, central banks are – rightfully – being forced into further unpredictable behaviour. The action of the Swiss National Bank in abandoning its currency bank has also brought to the fore once again two related issues: the credibility of central banks and the effectiveness of their policy. However elegant the theory behind quantitative easing might be, it remains far from clear whether central banks have practically been able to create inflation, control their currency, drive demand and maintain financial stability. Nonetheless, where such a strategy can be seen to be effective is in helping to act as a signalling mechanism, a sign of intent. In other words, history seems to bear out that there is a notable correlation between central bank expansion via money printing and a weaker currency. This certainly has clear investment implications.

In Europe, the Euro has fallen around 10% in the last three months, helping drive stock market outperformance. Nonetheless, money printing is not a panacea. For Europe to return to meaningful economic growth and sustainable stock market outperformance, easing needs to be accompanied by structural reform. This may prove more challenging. The Federal Reserve faces a different problem: while it is clear that the US economy is growing, the credit market in particular is showing that it does not believe the Fed’s projected rate hike path. Indeed, with inflation break-evens now lower than they were at the time of QE2, Operation Twist and QE3, it would seem difficult to raise rates in the near-term. Something will have to give and the credibility of the Fed may hence be called into question, with notable ramifications. Conclusion: even if Central Banks are not omnipotent, their actions do matter. Their chosen courses of action provide only a necessary but certainly not a sufficient rationale for constructing investment decisions.

What are the implications of a stronger US Dollar?

Our discussions with other participants in the investment community show that there is an almost overwhelming consensus that the US Dollar should strengthen over the remainder of 2015. Where there is such unanimity there is always a good reason to be sceptical. This observation notwithstanding, a stronger Dollar implies a tightening in financial conditions for all non-US based borrowers, especially in emerging markets. It is also beginning to have an impact on the earnings of US-listed corporates. Many large companies, from Microsoft to Pfizer and Procter & Gamble to Caterpillar have reduced their financial guidance based on the rise of the Dollar.

This leads to the obvious question, what if consensus expectations for S&P earnings growth are too high? These currently stand at c7% for 2015; what if this figure ends up being closer to zero? Indeed, the past month has seen the biggest drop in forward earnings estimates for the S&P since 2009 (according to data from Morgan Stanley). This is clearly not an encouraging sign for a market that has risen more than 200% from its lows and currently trades on a multiple of earnings that is high by most relative (geographic or historic) levels. Conclusion: a stronger Dollar has negative implications both for debt and equity investors. The near-term case grows for considering other regions in which to invest.

Might Europe finally deliver?

Investors have grown used to disappointment when it comes to considering economics, politics and investment returns in Europe. At the least, however, the combination of a lower oil price and a weaker common currency should add between 0.5-1.0% to Eurozone GDP in 2015, according to most estimates. These two factors should also help the outlook for corporate earnings. Notably, MSCI data shows that since 2012, aggregate Eurozone earnings estimates have fallen by 7% and dividend forecasts by 5%. 2015 could be the year that this changes, driving equity markets higher based not just on a multiple rerating (as has been the case since Draghi’s ‘do what it takes’ speech) but also on fundamentals.

The one caveat to this roseate assessment remains (as has often been the case) politics. There exists perhaps too great a level of complacency that despite recent events in Greece, the project of broader European unity will hold together. The working assumption remains that the Germans (as de facto European leaders) will ultimately place more emphasis on sustained union than on Greek fiscal rectitude. However, viewed from the perspective of Syriza, the party now leading Greece, it may well be impossible to satisfy the three objectives of staying in power, ending the bail-out and retaining the Euro. Even if the Greek situation is ultimately resolved favourably, the voice of non-mainstream parties across the continent is only likely to become louder as time goes on. Conclusion: the overall investing environment in Europe is undoubtedly improving, but the risk of politics undermining progress cannot be dismissed.

How concerned should investors be about slowing growth in China?

Much has been made of the fact that China’s rate of GDP growth in 2014 was its slowest in more than 20 years. This, however, needs to be seen in context: 7.4% output hardly constitutes a slow-down after two years of growth at 7.7%. Furthermore, some deceleration is also inevitable given the law of large numbers, that the absolute size of China’s economic base is some 100% larger than was the case a decade ago. The more important point also to retain is that China is undergoing a momentous transition, from producer to consumer. This seems to be being managed effectively via both government and central bank policy. Low inflation (which has dropped from 6.0% to 4.0% in the last three years) also gives the Chinese central bank (PBOC) scope to cut rates if needed.

The implications of such a policy should also be evident. In the near-term, the global tendencies of deflation and central bank balance sheet expansion will remain pronounced. Over the longer-term, China represents one of the most exciting potential investment opportunities (along with other selected emerging markets such as India). These nations have above- average domestic growth prospects, which should also be reflected in market valuations over time. Conclusion: slowing Chinese growth needs to be seen in a relative and global context; the local investment environment remains attractive.

Alexander Gunz, Fund Manager, Heptagon Capital