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: from Greece to China, recent events and corresponding market volatility may be a harbinger for an uncertain summer ahead. Admittedly, global equity markets have not seen a monthly correction of more than 5% in over three years, but our reasoned assessment of the global landscape suggests that any weakness should be seen as a buying opportunity. Put simply, a focus on fundamentals reveals a slowly recovering and reflating global economy that continues to be influenced by accommodative, flexible, and pragmatic central banks. Valuations for many asset classes look undemanding, and our preference remains for equities, especially in Europe and Japan as well as emerging markets (especially China) for the longer-term.

Asset Allocation:

 Equities: There is no change either in our view on this asset class or in our regional allocation. The global equity risk premium (effectively the excess return available in equities relative to the risk-free rate) is still more than double the level which would typically characterise a market peak. Meanwhile, global earnings revisions have begun to rise again (after flattening in April and early May) and are unlikely to be derailed in the near-term by events in either Greece or China. Europe has a bigger output gap than any other developed world region, implying the economic cycle still has a long way to run, supported by ongoing loose policy. Japanese earnings momentum is still the best in the world. Structural reform also reinforces the case not just for Japan but China too.

 Fixed Income: A combination of severe over valuation and gradual reflation (particularly in the US) has led to bond yields rising and fixed income underperforming year-to-date. Even if there is a near-term move towards perceived ‘safe(r) haven’ assets such as government bonds, it seems hard to see a reversal in the broader trend. A combination of increasing inflation expectations, higher real yields and the relatively imminent likelihood of rate rises in the US result in a limited allocation to this asset class, favouring only a few ‘go-anywhere’ strategies with more flexibility.

 Currencies: Further near-term weakness in the Euro seems possible, especially with investors likely to favour more defensive currencies such as the Dollar and the Yen. A weaker Euro is inevitably positive for the region’s economy, yet clearly currency weakness is not a zero-sum game and most nations (developed and developing) are currently seeking to pursue similar strategies. As a result, we currently have no active currency positions.

 Alternative Asset Managers: Investing in uncorrelated strategies makes sense, particularly in light of current events. We continue to believe that CTA (Commodity Trading Adviser) strategies should benefit from policy divergence and higher market volatility. Meanwhile, with global M&A volumes up almost 30% year-to-date, event-driven managers are continuing to prosper for now.

How much does Greece matter? Not a lot

For a country that comprises 0.2% of the world’s population and contributes just 0.4% to global GDP with a total stock market capitalisation of just €13bn (over 50 times smaller than Apple’s value), it is remarkable how many column inches have been filled with commentary on this topic. We will be brief, but put simply, the tragedy befalling Greece is largely

one of its own making, brought about through the deliberate actions of the current government. Whichever way the country’s impending referendum goes, the consequences are likely to be dire for the country’s citizens, but much less for the rest of Europe/ the world.

Most importantly, it is worth remembering that the world is a notably different place to four years ago when the Greek debt situation first became an issue. In contrast to in 2011, the European Central Bank is visible and active, able to print money effectively without constraint. Additionally, the periphery ex-Greece has embraced reform, Europe’s banks have generally restructured (following the Asset-Quality Review), creditor risk has diminished and the continent’s economy has returned to growth. While there will be inevitable fears that an uncertain and potentially unfavourable Greek outcome may lead to contagion elsewhere within the Eurozone, these above factors may mitigate the risk. Further mitigation may be provided in the form of an additional policy response from the ECB. (European) equity market weakness represents a buying opportunity in our opinion, particularly for investors who missed the 15% rally in Q1. European equities are currently trading more than 7% below their mid-April peak.

The investment case for European equities

Much has also been written on this topic in the past, by ourselves and others, but of most interest to us is the fact that Europe constitutes the only developed market region with a notable output gap. Contrast European unemployment of 11.1% with the Japanese economy at full employment (the number of people currently out of work has not been so low since 1997) and the US and the UK likely to reach this level within the next 6-12 months. Spare capacity implies that it will take labour across the continent quite some time to get pricing power. This has positive implications for corporate profit margins (which should also benefit from operating leverage as demand picks up). Furthermore, such an outcome implies an economic cycle that still has a long way to run. Correspondingly, monetary policy should also be able to stay looser than in other regions.

Investors that have not been fixated on Greece may have noticed that Eurozone industrial output is currently at a 12- month high with the comparable figure for the region excluding France and Germany at its best since March 1997. Credit demand across Europe is also currently at its strongest level in eight years, according to Credit Suisse. Given the relatively small size of Greece noted earlier (and the fact that 75% of its GDP is domestically based with a large percentage of the remainder derived from tourism), these trends look broadly sustainable. Nonetheless, Greece should again serve as a crucial reminder of the need for the rest of the Eurozone to continue with reform. In France and Italy in particular, more needs to be done, although we are encouraged by the gradual direction of travel.

What potentially matters most for global investors: US monetary policy?

Janet Yellen has tried to be as explicit as her role permits in highlighting that the tightening of US interest rates will be ‘gradual’ and that they will not follow a ‘mechanical’ formula. This is encouraging, but investors still raise two potentially valid concerns: first, whether the economy is robust enough to support rate rises; and second, whether a meaningful acceleration in wages may force the Federal Reserve to embark on a more assertive policy. Our simple answer is affirmative to the former and negative regarding the latter, at least for now.

Most of the recent data suggest that the first quarter slowdown in the US economy was caused by temporary factors. Indeed, consumers are currently spending at levels last seen six years ago. Furthermore, with jobless claims below 300,000 for 16 consecutive weeks, the labour market seems in good health. Job openings across the country are currently ahead of their 2000 peak. In other words, there is greater job demand now than in the Internet boom era, when unemployment was 1.5% lower than current levels. Importantly, however, job creation is occurring while inflation remains benign. In the US, it is presently just 0.9%, still very low for this stage of the cycle (having been below the Fed’s 2.0% target level for 38 consecutive months), but something that will require monitoring.

The conclusion we draw is that the US in 2015 does not appear to be either Japan in 2000 or Europe in 2011. Interest rate rises – when they happen – will unlikely push the US back into recession. Furthermore, investors have arguably pre-empted an outcome of gradually higher rates. Greece notwithstanding, the steepening of the US yield curve and the rise in inflation break-evens (the difference between the nominal yield and the real yield on an inflation-linked bond) suggest that reflation is becoming increasingly discounted. US equities have proven remarkably robust (the S&P trading in a tight range of 2,050-2,100 for much of 2015) this year, while yields on 10-year Treasuries have strengthened by over 70 basis points from their lows. This reinforces our conviction in the generally overvalued nature of credit relative to equities and we would expect this trend to be broadly sustained for some time, at least until the 10-year yield exceeds 3.0%.

Europe’s recent equity price action looks small compared to China’s: buy China

Almost as many column inches have been filled with the debate over whether the price action in the Chinese equity market is heralding the end of the country’s bull market as have been occupied with musings over Greece’s future. Sure, a fall of some 20% since the Shanghai Composite’s 12 June high marks a major correction, but investors should be mindful of the 100%+ rise in the market in the last year and the fact that such notable opportunities to reconsider the investment case are rare.

The negative arguments centred around excess equity supply (from new IPOs), weak earnings growth in the context of economic deceleration and high levels of margin debt focus on near-term sources of concern and seemingly miss the bigger picture, namely one of structural change in China. Six key points are worth highlighting. First, real interest rates are still positive, suggesting that the Central Bank has ample room to continue easing monetary policy. Next, there is also plenty of scope for the government to be more accommodative in its fiscal policy. In addition, it seems clear that the ongoing transition of the Chinese economy from central planning to more of a market orientation will continue. Combined with this, the active reform of state-owned enterprises constitutes one of the most significant changes to Chinese policy in over two decades. Meanwhile, the campaign against corruption remains ongoing. Finally, consider valuation: current metrics are markedly below peak levels. Multiple reasons suggest that investing in China now for the longer-term constitutes a compelling strategy.

Alexander Gunz, Fund Manager, Heptagon Capital