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: one simple fact is clear – equities are continuing to outperform, despite higher bond yields and mixed macro data. We do not think investors should be concerned that the MSCI World is just 2.0% away from its all-time nominal high. There will always be big debates, whether currently about the timing of US interest rate rises, the place of Greece within the Eurozone and the risk of a possible hard-landing for the Chinese economy, but what ultimately matters is valuation. Equities remain, for now, the most attractive asset class on a relative basis. Higher bond yields will not undermine this scenario for some time and their recent rise is indicative to us of a healing and gradually reflating global economy. We find most favour in European and Japanese equities near-term and see a growing case for EM (especially Chinese) equities over the medium-term.
- Equities: There is no change either in our view on this asset class or in our regional allocation. With European P/E ratios on a cyclically adjusted basis some 50% below US levels and European earnings still some 20% below previous peak levels, the case for the former region over the latter is clear. Valuation also reinforces our conviction in Japan (which has also witnessed 10 consecutive quarters of earnings upgrades – unrivalled globally), while EM equities also look inexpensive, particularly given that earnings estimates are currently rising faster than in the developed world.
- Fixed Income: Despite the biggest one-month move in European bond yields since records began, many yields are still lower than where they began in 2015. It seems hard to make the case for most fixed income investments in the knowledge of rising inflation expectations, increasing real yields and the relatively imminent likelihood of higher interest rates in the US. There remains a clear risk of further abrupt moves in bond markets and hence our allocation towards this asset class is limited, favouring only a few ‘go-anywhere’ strategies with more flexibility.
- Currencies: As Central Bank policies diverge, so should currencies. However, the importance of mean reversion should not be discounted. Fundamentals argue for a stronger Dollar, but given the move witnessed year-to-date, our preference would be to wait for a better point to revisit this trade and we currently have no active currency positions.
- Alternative Asset Managers: Investing in uncorrelated strategies makes sense in a low-return world. We have long- favoured event-driven managers and have been encouraged by a recent resurgence in deal-activity. CEO confidence is at its highest in five years and a majority of US and European corporates have a free cashflow yield in excess of their corporate bond yield, implying the ability to finance deals. In addition, we advocate allocations to CTA (Commodity Trading Adviser) strategies, with such managers looking well-placed to benefit from current trend divergence.
Why it’s all about valuation: Followers of financial markets are subjected to a daily barrage of news and interpretation. We always question how much of it really matters and prefer to try and focus on what actually does. In one sentence, our decisions about asset allocation are primarily based on valuation. Against this background, it is worth considering what, if anything, investors should read into Janet Yellen’s comment of 6 May that “equity market valuations at this point are generally quite high.”
Context clearly matters. Given the unorthodox monetary experiment undertaken by the Federal Reserve in the last five years, it is undeniable that Central Banks have to accept partial responsibility for creating the current valuation environment via their printing of fiat currency and implicit manipulation of the yield curve and currencies. Next, it is always important to separate absolute and relative observations. We do not disagree that on some metrics valuation levels for US equities look high against their history and versus other regions (hence our current limited allocation towards this asset class), but this is not the same as saying that all equity valuations are “quite high.” Indeed, we continue to find good value in many regions (especially in Europe, Japan and some emerging markets).
Furthermore, relative to conventional fixed income, equities continue to look attractive. Many metrics support this contention. Consider, for example, that the equity risk premium (effectively, the excess return that compensates investors for taking on the relatively higher risk of equities) for Europe currently stands at around 8.0%, while the same figure for the US is around 5.0%. When equity markets typically peak (in 2000, 2007), this figure is close to zero. By contrast, even with the abrupt move in government bond yields over the last month, investing in most forms of credit still seems currently more about return-free risk than risk-free return.
Moreover, equity investors need not yet be concerned by recent moves in government bonds. For too long, it has been easy to perpetuate a somewhat cynical argument of secular stagnation and hence perpetual zero interest policy. If this line of thinking were still valid, then bond yields ought still to be falling. Instead, the recent rise in bond yields reflects a much healthier world view, namely that inflation is stabilising, (global inflation expectations are at their highest in six months) economic growth is decent enough and policy tightening (in the US at least) will happen. What matters most then is the pace at which yields rise. Most research studies suggest that the valuation case for equities will not be undermined until the yield on 10-year US Treasuries exceeds 3.0%. It is currently 2.2%.
Maybe then, the implication implicit in Yellen’s comment about equity market valuations (in other words, what she meant, rather than what she said), is that investors should prepare themselves for interest rate rises in the US at some stage soon. Clearly the Fed will be at pains to assert that their policy decision will remain data-dependent, but at the very least, the jump in bond yields seen in May has served as a ‘taster’ of what may be to come when rates do rise. Interestingly, the ability for equities to have withstood the relative carnage inflicted on bond investors is perhaps the most telling. Equities may have endured a six-year rally, but credit has been in a thirty-year bull market. It is all about valuation.
How much do politics and reform matter in Europe?
Recent economic data (slowing industrial production, service output and retail sales) perhaps show the limits of a weaker Euro. Put another way, the Eurozone cannot simply depend on a weaker currency to accelerate the recovery. If anything, the argument can be made that the knowledge of quantitative easing (QE) may have induced some complacency on the part of policymakers and delayed the impetus for structural reform. More radically, there may even be a case for the ECB to abandon its QE policy earlier than currently targeted, thereby accelerating this necessary process.
The experience of the UK is perhaps instructive for other European countries. Unemployment in the country is currently 5.6%, the lowest it has been in almost 25 years. The comprehensive victory for the Conservative Party in last month’s election shows that creating the ‘right’ economic conditions will eventually trump complaints over austerity. For mainland Europe, while unemployment may have fallen by more in the first quarter of 2015 than in any previous quarter over the last 8 years, the continent-wide rate remains at 11.3%. Spain is a case in point: industrial production is running at its fastest since 2006 and GDP has risen for 7 consecutive quarters, but unemployment stands at 23%, down only 3 percentage points in the last two years. This explains why Podemos (the anti-austerity party) triumphed in Spain’s recent local elections and also reinforces the need for the incumbent government to accelerate the pace of reform.
As the UK shows, there are benefits from staying the course. With over 35% of Eurozone GDP in France and Italy, reform is a clear necessity in these countries in particular. There is also a lesson for Greece in all of this. Some €1.5bn of loans need to be repaid before the end of June. We have no insight into whether this is achievable, but something will need to give: the ruling party has said it wants to end austerity, yet 75% of the Greek public say they want to remain within the Eurozone. Staying-in would likely imply more austerity, yet if reform is done correctly, then there will be upside over time.
Is now the time to be more constructive on emerging market equities?
It is well-documented that in each of the last five years, emerging market equities have underperformed their developed world peers. Yet look closely, and year-to-date, the MSCI Emerging Market Index has slightly outpaced the MSCI World (4.9% vs. 4.0%). We have long been believers in the idea that it is always best to consider an asset class when consensus is unconvinced, and several arguments can be made to support the case for emerging markets. In valuation terms, emerging markets are trading at a greater than 20% discount relative to their developed peers, despite the fact that 2015 earnings growth will be superior to developed world rates for the first time since 2010 (according to JP Morgan). Meanwhile, local EM currencies are currently the cheapest they have been relative to the Dollar in 12 years.
Despite such a compelling case, there remains scepticism. Beyond the oft-asserted claim that emerging market equities will suffer when the Fed does eventually raise interest rates, many doubts seem to centre on China and the potential risk of a hard-landing for the economy, particularly should the government mishandle its current transition. Our assessment is a simple one – do not underestimate the power of the Chinese government. From what we observe, the transition from a production to service-led economy is deliberately being undertaken at a gradual pace so as to minimise the risk for error. Moreover, there are many available levers to pull: in the near-term, further monetary easing seems probable, while there will also likely be continued deregulation and infrastructure investment projects undertaken.
There is also the longer-term investors’ perspective to consider with regard to China. Despite being the world’s second largest economy with the world’s second largest stock market (the latter accounting for 14% and 12% respectively of global GDP and market capitalisation), the average global asset allocator has just a 2% weighting to Chinese equities (according to Gavekal, a local research boutique). Moreover, with just 16% of Chinese households currently invested in equities, there is clear scope for domestic participation to rise, particularly in the context of other emerging markets having a comparable investment level of around 25%, while the figure for the US is over 40%. The direction of travel is clear. Beyond general emerging market equity valuation levels, China is becoming too big to ignore.
Alexander Gunz, Fund Manager, Heptagon Capital
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