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.
While the core thesis for 2013 seems relatively clear to us – namely a world of continued accommodative monetary policy, slowly recovering global growth and relatively undemanding equity valuations – many investors seem to feel as if they were in a similar situation to that of Homer’s Odysseus when confronted with the choices of Scylla and Charybdis. In other words, even if the direction of travel is clear, the journey will be one that is far from plain sailing and indeed substantial challenges remain: on the one side, exogenous and mostly political uncertainties; and, on the other the dangers of misplaced optimism and excess complacency. Our conviction in favouring equities over other assets classes remains unchanged, but we acknowledge not only that there will be periods of volatility over the remainder of the year, but also that dispersion within the asset class is occurring and will most likely continue to do so.
We have made the case for owning equities over credit (in broad terms) for some months now, and see little reason at present to alter this assertion. To reiterate briefly, the scope for further yield compression in conventional credit seems most limited and, as a consequence, equity yields (on both an earnings and a dividend basis) look significantly more attractive. However, what has been most notable from the first two months of 2013 has been not how equities have indeed outperformed credit, but how the US and UK markets have each gained more than 7% (and Japan, over 11%) while by contrast most European indices are in negative or barely positive territory.
The reasons for these differences are manifold, but currency and politics are among the most significant factors. Overarching these elements is the need to recognise the realities of excess leverage in the developed world. Put another way, economic policy – by necessity – will continue to be flexibly supportive until both debt and growth return to more ‘normalised’ levels. Conventionally understood, policymakers have three tools at their disposal to advance these ends: monetary policy, fiscal policy and exchange rates (it would be tempting to include supply-side reforms, but these have been disappointingly slow to occur, particularly in continental Europe). The first of these has become the de facto global strategy and it has become an accepted maxim that central banks will ‘do what it takes’ until the world can be seen to have reached not just stability but full recovery. Apparent rejection of fiscal policy (or, bluntly, austerity) goes some way to explaining Europe’s relative woes. And, perhaps most contentiously, the debate has now begun to move more towards exchange rate strategies. Even if monetary policy has not been quite as effective as some had hoped, the devaluation of one’s currency is a markedly explicit way of stimulating domestic growth.
It is no coincidence then, that some of the notable gains enjoyed by the Nikkei and the FTSE in particular can be directly ascribed to the weakening of the Yen and Sterling against other major currencies. By contrast, despite a recent pullback, the Euro has generally strengthened on a relative basis in recent months. Nonetheless, it would not only be too simplistic attribute equity market performance directly to exchange rate shifts, but also to believe that such a strategy is sustainable over the medium-term. While the G20’s latest comments on currency moves unsurprisingly constituted a non-event, it remains the case that devaluation is ultimately a zero-sum game; not all countries can undertake such strategies
simultaneously and were they to do so, the possible end result of potentially restrictive trade tariffs would clearly be deleterious to global growth prospects. Moreover, in the case of the Euro in particular, Mario Draghi has shown in the past that he is an arch-pragmatist. With European Central Bank interest rates still at 0.75%, there is obvious scope for these to fall and indeed Germany especially would likely advocate a lower rate (and a weaker Euro) as a fillip for its economy, particularly with elections due in September or October.
Europe’s problems may, however, take more than an interest rate cut or a weaker currency to solve. The ‘Draghi put’ in its current form seems to have offered an effective form of salvation for now, but the OMT (Outright Monetary Transaction scheme, announced last September) has yet to be activated and it is also notable that there has been no recent progress, and hence some slippage, on either continent-wide banking union or fiscal union. Investors may therefore be placing too high expectations on the restorative abilities of policymakers and also potentially forgetting the destabilising impact that politics can have. The Italian election outcome serves as an (un)timely reminder in this respect. Even if Italy has had 64 different governments since 1945 (compared to 44 in the United States since the country was founded) and even if the country’s current account balance is presently in surplus, the election result is a tacit rejection of austerity politics and its correspondingly high levels of unemployment. Not only is the uncertainty somewhat unfortunate for European equity market prospects in the near-term, but other flashpoints (in Spain, Greece – and even possibly Germany) may also come to the fore during the year. Periphery bond yields have also started to rise once again.
Relative complacency and political uncertainty are likewise factors that can beset US prospects. Investors have long been in thrall of Fed Chairman Bernanke’s (and increasingly now his deputy and potential successor, Janet Yellen’s) comments, but any hint about the possible withdrawal of quantitative easing strategies has been sufficient to induce market jitters and a downward lurch in equities. This is perhaps not altogether unsurprising given that the S&P is within 5% of its all-time highs and its earnings multiple – even on a cyclically adjusted basis – now suggests fair valuation rather than undervaluation. Investor reaction to Fed pronouncements appears to confirm for us what we have asserted for some time, namely that the current policy experiment (arguably being undertaken globally, albeit in slightly varying forms) is not only unproven, but also being made-up as events evolve.
While it may be easy to criticise policymakers, the Fed does seem to be aware of the dangers of withdrawing accommodative policy too early (the error made in the 1930s) and indeed the whole debate about exit strategies may be rendered irrelevant should the nascent signs of US economic growth prove enduring. We have been encouraged for some time about housing market progress (just as this precipitated recession, so it can lead recovery) and observe that new home sales are currently at their highest since July 2008, house price rises at their best since June 2006 and foreclosures at their lowest rate since January 2007. Recent industrial production (ISM) numbers, durable goods orders and consumer confidence indicators all augur well.
The debate therefore is not just one of how much further the S&P can reasonably move against this backdrop (and admittedly earnings momentum has been improving in the US with over 70% of companies exceeding expectations in the most recent reporting season, compared to just 40% in Europe), but also what could undermine prospects. Even if optimism towards (US) equities as an asset class – and correspondingly valuations too – are higher than they have been,
there seems to us still to be significantly more irrational exuberance attached to the asset classes of (US) corporate credit and high yield. Not only should the limited scope for yield compression argument be considered, but also the fact that the last year’s returns from these asset classes seem sui generis, and therefore hard to repeat. As importantly, just as politics has shown its ability in the past to temper general optimism levels towards more risky assets, so it can in the future. The US sequester (i.e. $85bn of enforced spending cuts) took effect from 1 March and how to manage the debt ceiling will still need to be discussed in the coming months. Uncertainty in this respect constitutes a clear negative; downward pressure on GDP as a result of the discussion outcome would be even worse.
The cycle of complacency, crisis, response and relief about which we have written in the past and that has (sadly) characterised recent times has, in our view, not been broken yet; more reasonably, it is just spinning at a slower rate than that to which we have become accustomed. With liquidity being abundant, risk aversion levels relatively low and valuations undemanding on a relative basis, being positioned in equities seem to be a logical strategy. However, with both stock market and sector correlations falling, as the early part of 2013 has demonstrated, this could be a year for stock pickers, one more about alpha than beta. Our general approach is to work with managers that have high conviction strategies, concentrated portfolios, significant tracking error against their benchmarks and an emphasis on businesses with sustainable competitive advantages and significant free cashflow generation.
From a geographic perspective, Japan and Europe have been the regions where we have had highest conviction. In Japan, the incoming head of the central bank looks set to become another advocate of accommodative and unconventional monetary policy, joining the global chorus. This is clearly encouraging, combined also with increasing political cohesion in the country. Despite the recent rally in equities, expectations for future returns are still low. While the Nikkei has gained 22% in the last three months, it should be noted that during the last period in which reform brought about change in Japan (the Koizumi era, 2003-2005), the rally that endured then saw a gain equivalent to 140%. In terms of Europe, the challenges facing the region are clear, but we return to the valuation argument, namely that the market trades at a c30% discount both to the S&P and to its ten-year cyclically adjusted earnings multiple. Notwithstanding somewhat lacklustre performance year-to-date, some of the managers that invest in European equities and with whom we work have been able to deliver returns of greater than 6% so far in 2013, as a result of their stock picking.
If not equities (and indeed there is clear logic in having a diversified multi-asset class portfolio, just one that is currently more biased towards stocks), then within credit, we continue to favour managers that have the ability to implement non- directional strategies. The attraction of such managers is their ability to limit duration risk and potentially even adopt negative duration positioning as part of their mandate, a logical approach given the current rate regime. We are somewhat less positive on alternative asset managers such as macro hedge funds or CTA (commodity trading adviser) strategies since they may well continue to struggle, at least for as long as policy intervention remains. As far as gold is concerned, further near-term upside may be capped, particularly since the scope for interest rates to move lower looks limited. On the contrary, if our thesis on the broad outlook proves correct, then rates may even begin a very gradual ascent, even if not this year.
Alexander Gunz, Fund Manager, Heptagon Capital
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