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.

During the last month the two words that have seemingly occurred with most regularity in discussions over global stock markets have been ‘resilience’ and ‘complacency.’ This is perhaps hardly surprising after the MSCI World Index added 4.0% in April, its strongest monthly gain in 2011 so far. Equities have undoubtedly been helped by a positive first quarter earnings season where some 75% of the S&P’s constituents reporting to-date have beaten consensus expectations, but the above combination of events has served only to increase our conviction towards adopting a generally more defensive stance.

For now, equities remain more attractive than other asset classes, but we are of the view that stock markets globally are due a near-term correction. This will inevitably create opportunities in time, for which Heptagon will seek to position itself effectively. In brief, clouds have been gathering over equities since the beginning of this year, and based on the three key factors we use for assessing our positioning – risk, liquidity and valuation – lead indicators are trending negatively. Our concerns can be summarised as follows:

 Economic confidence is waning: ISM Manufacturing New Orders fell from 68.0 in February to 63.3 in March, the largest one-month drop since December 2008. The trend weakened further in April, when New Orders slipped a further 80 basis points. In Europe, IFO Business Expectations have now fallen for two consecutive months;

 Inflation expectations are rising: Headline US CPI has risen from 1.6% in January to 2.7% in March (April’s figure has not been released yet). European CPI has also moved higher, up 40 basis points since the start of this year and 130 points in the last twelve months. As has been well- documented elsewhere, commodity and oil prices also continue to edge upwards;

 Earnings momentum is close to peaking: According to analysis from JP Morgan, over the last month, sell-side estimates in Europe have seen a higher percentage of companies witnessing downgrades than upgrades for the first time since July 2010; and,

 None of the old problems has gone away: namely, the need for structural deleveraging, the risk of further sovereign debt crises in Europe, and concerns over Asian over-heating.

The combination of peaking PMIs and earnings’ revisions rolling over has historically coincided with a correction in equities. Similarly, in previous instances when inflation expectations have been rapidly rising and the US 10-year break-even has traded above 2.5% (currently at 2.6%), equities have typically experienced a period of downward pressure over the following three months. Moreover, these negative trends could potentially be exacerbated by the impact of gradual withdrawal of monetary stimulus in the US (discussed in more detail below). It is against this background that we see a case for adopting a somewhat more defensive strategy and moving towards lower levels of net equity exposure, while also

remaining highly nimble in our positioning. When we consider what matters, the following seem to us logical strategies to adopt for now:

• Despite our noted concerns, we still prefer equities relative to bonds (they continue to look cheap, especially relative to fixed income markets: cash is essentially yielding nothing and the spread on the S&P’s earnings yield relative to that of the US ten-year Treasury note, for example, is over 300 basis points);
• We expect the US Dollar to remain weak, with negative implications for US Treasuries. The recent FOMC meeting reinforced our sentiment that the Fed seems in no hurry to shrink its balance sheet for now; although the second round of quantitative easing (‘QE II’) will end in June as scheduled, the Fed has signalled that it intends to keep the size of its balance sheet constant by replacing maturing securities. This goes some way to explaining, in our view, why the US Dollar Index has continued to weaken, currently standing at 73, its lowest level since June 2008. A low probability of fiscal retrenchment scenarios (with one year to go until White House elections) should also keep the greenback suppressed. While the impact is negative for Treasuries, we note that a weak Dollar is positive for large US companies which derive significant revenue streams from outside the US. Correspondingly, examples of stock we favour stocks include Pepsi, Teva and Ralph Lauren;
• We prefer developed market equities relative to those in emerging markets (valuation levels and inflation constitute distinct sources of concern in the latter) and believe the US can continue to outperform relative to other geographies (helped by the Presidential-cycle effect discussed previously);
• With regard to emerging markets, we continue to favour Russia and Central/ South America over Asia (some examples include Carlsberg – for Russian exposure; and Walmex – as a way of gaining exposure to the Mexican economy);
• Elsewhere, we favour equities with strong pricing power and/or those that have natural inflation hedges (examples include US/Canadian-listed railway stocks and consumer staples businesses such as Nestlé with strong brands and dominant global franchises);
• We also continue to favour equities with dominant franchises, superior IP and secular tailwinds (this plays, for example, to several names within the tech sector and also a number of plays that are related to them with regard to the ongoing proliferation of the online world – hence the case not only for IBM but also for Amazon); and, In conclusion we believe there remains a case for equities relative to other asset classes, but we are also of the view that risks are rising, hence the rationale for adopting a somewhat more defensive stance.

Alex Gunz, Fund Manager, Heptagon Capital