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: confidence is back, it seems. Many of the topics that caused concern (Greece, oil, Ukraine) seem to have settled for now and fears of deflation may be a thing of the past. At this stage, the right things to do are caution against complacency and ask what comes next. If we accept that either government bond yields have to rise or equities fall, then our conviction in the former outcome is higher. An equity market correction may well happen during 2015, but we still prefer to back this asset class (especially in Europe) over bonds. Additionally, we continue to make the case for uncorrelated, alternative investments.
Equities: Global earnings revisions are at three-year lows (according to Credit Suisse) and it is becoming increasingly hard to find value in this asset class, even if it remains easier than in credit. Our preference continues to be for Europe and Japan (and also emerging markets on a longer-term time horizon) since earnings momentum is improving here just as economic recovery is gaining in traction. Relative valuation levels and a stronger Dollar constitute US headwinds.
Fixed Income: Buying sovereign debt today often means locking in a loss at redemption (5-year government debt yields are negative in four European countries and only barely positive in Japan) although this doesn’t mean yields won’t fall further into negative territory. If US interest rates rise and/or European growth surprises on the upside (both outcomes we discuss below), then these outcomes would be very negative for conventional fixed income investors. We favour flexible, ‘go anywhere’ credit approaches.
Currencies: Current Central Bank policy, which will only likely diverge further over the year, supports the case for a weaker Euro (and Yen) and, correspondingly, a stronger Dollar. Although this view may be right, it is also highly consensual and so there is hence some risk of near-term reversal.
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 ($540bn in 2015 so far). 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.
Short memories can be dangerous things. With Central Bank messaging remaining broadly consistent, Greece’s debt problems deferred for several months, the price of crude oil seemingly stabilising and a cease-fire agreed in the Ukraine, it would be easy to suggest that investors can sit back and relax. Equity investors have certainly been able to bask in a global market that continues to make new nominal highs. However, barely a month ago, none of the above was a given and if we can be certain of anything, then it will be that further surprises occur over the remainder of this year.
Against this background, we believe that the most important question to be asking now is what can go wrong? It is also potentially foolhardy to ignore or dismiss some of the warning signs we have observed: widening credit spreads, weakening earnings revisions (at global three-year lows) and increased FX and commodity volatility. Taken together, these factors could be suggestive of tightening liquidity conditions, even in the face of continued global money printing. There remains no room for complacency and we believe having an informed view on the following topics should help frame asset allocation decisions for the months ahead.
Will the Federal Reserve raise rates in 2015 and what will its impact be?
Listen carefully and you will note that the word inflation is increasingly replacing that of deflation in some economic discussions. This is less about what is happening to the price of oil and more about trends in the US labour market. Despite over 1m new jobs created in the US during the past three months (the last time this occurred was in 1997), wage growth is now rising, up 2.2% year-on-year. This may rise further as 2015 develops. Wal-Mart, for example, recently announced that some 500,000 of its employees will see their wages grow to $9/hour from April, more than 20% ahead of the Fed’s minimum rate. Starbucks and GAP have made similar commitments. Falling unemployment and rising wage growth provide the Fed with an eloquent – and justified – argument for raising rates, even in the absence of core inflation.
While the possibility of an interest rate rise during the course of 2015 should not come as a surprise, what could prove to be a major source of dislocation for investors would be a scenario of several hikes, a potential response to labour gaining pricing power more quickly than anticipated and the benign effects of a low oil price wearing off. The yield on the US 10- year has already bounced rapidly off its 1.6% low and is now trading above 2.0% again. The Dollar has also continued to show broad strength against most other global currencies. The prospect of higher rates should only exacerbate these trends. Conclusion: continued upward moves in US Treasuries and the Dollar are invariably negative for investors in conventional government debt and also imply generally tighter global liquidity conditions. Some emerging markets may also inevitably suffer. Furthermore, with 46% of S&P revenues and 50% of profits from outside the US (according to Credit Suisse), the risk of some downside to US equities is also high. Earnings revisions are also at six-year lows.
Might Eurozone growth surprise on the upside?
Europe-watchers have grown used to disappointment, but are perhaps now too accustomed to it. A closer look at the data suggests a tangible recovery is occurring and this is even prior to the ECB’s large-scale asset purchase programme. Of most note is the improvement in money supply: January’s reading showed the strongest growth in over five years, while bank lending to the private sector showed its first year-on-year growth since 2013. Meanwhile, consumers are also feeling more confident (the most so in three years in France, and in thirteen in Italy, to take but two examples) and are out spending more (retail sales have risen for three consecutive months). As in the US, listen very carefully and one may even hear the word inflation being occasionally mentioned. Germany’s economy saw 1.6% wage growth during 2014, its highest level in six years, and with the country being close to full employment, the pressure on wages is only likely to be upward.
Taken together, these factors are clearly suggestive of an improvement in economic momentum. Consensus GDP estimates for the Eurozone have moved up slightly since the start of the year (1.1% to 1.3% for 2015, according to Bloomberg), but should move higher. While we have regularly asserted that correlations between GDP growth and equity market performance have limited relevance, a strong case can be made for further European equity market performance, inevitably helped by the benefits brought about from the weaker Euro.
Relative to their US peers, European equities trade on lower multiples, have superior earnings growth (more than double for 2015, according to Morgan Stanley) and have underperformed by 30% on a relative basis since 2008. Conclusion: there is a compelling argument for favouring European equities over the US, particularly as there is greater potential for the economic outlook to surprise on the upside in the former region relative to the latter. Furthermore, should economic growth in Europe gain traction and fears of deflation recede, government bond yields in the Eurozone may also be forced upwards. The caveat, of course, to these arguments remains twofold: first, the need for genuine structural reform in many countries in order to ensure that recovery can become more enduring rather than just temporary; and, the risk of political uncertainty, whether it be in Greece or elsewhere.
Could trends in China destabilise the global growth outlook?
On the surface, falling house prices, declining electricity usage and weaker consumption patterns (a trend noted by a number of corporates including Kraft, Nestlé and Unilever) point to a worsening economic picture in China. In particular, concerns regularly seem to return to the state of the housing market, given that roughly 50% of total Chinese debt is estimated to be exposed to this area. However, these arguments miss the point at two levels. First, as we have argued in previous notes, retaining the same rate of growth given the absolute change in the size of China’s economy in the past ten years is simply not a realistic assumption to expect. Furthermore, some of the slowdown may also be deliberate; in other words, part of a managed strategy of transition, from exporter to consumer.
Second, and related, do not forget that GDP growth does not correlate with stock market returns. Evidence from the last decade in China seems to support this contention and can also partly be explained by the inefficient allocation of resource, particularly to state-favoured businesses. The economy now seems increasingly focused on services and technology (at the expense of traditional export-oriented industry), paving the way for much higher future returns. Furthermore with core inflation in China at its lowest in over four years, the scope for the Central Bank to loosen policy in the near-term in order to stimulate the economy, if needed, is also high. Conclusion: slowing Chinese growth should not be a surprise given the base from which it has come. The authorities look to be managing transition towards a more returns-focused economy. Investing in China for the longer-term also seems the right strategy.
Final word: don’t forget about Japan
Beyond the more ‘obvious’ topics of the US, Europe and China, it should not be forgotten that the Japanese equity market reached a 15-year high in February. The economic outlook is improving, the Bank of Japan is continuing to print money and earnings revisions are higher than in any other global region (according to Credit Suisse). Structural reform is also occurring: corporate governance has been tightened up, corporates are now listening to their investors and share buyback levels are rising. Conclusion: we continue to advocate the case for (currency-hedged) Japanese equities.
Alexander Gunz, Fund Manager, Heptagon Capital
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