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: the reluctant rally in equities continues. It seems that there are few more compelling alternatives for investors at present, evidenced also by recent moves in bond yields and currencies. Even if equities do suffer some form of near-term setback, this asset class should be better-placed to withstand the shifting investment narrative. As disinflation and corresponding Central Bank accommodation begin very gradually to turn, yields on government debt should rise further. By contrast, equities – and especially those in Europe and Japan – continue to benefit from still undemanding valuation levels and upwards revisions to earnings estimates. Diverging global trends should also benefit CTA-style alternative funds.

Asset Allocation:
 Equities: Our near-term regional preference for Europe and Japan remains unchanged. Despite year-to-date strength in both markets, further upside is achievable. Earnings revisions are rising (in Europe, the rate of upgrades exceeds downgrades now for the first time in four years), while valuation levels are still relatively undemanding. Consider that the current European equity risk premium is over 7%, while more than 65% of European stocks offer dividend yields that are in excess of their respective governments’ long-bond yields.

 Fixed Income: The abrupt move in German 10-year debt rein forces our contention that the rally in government debt is unsustainable. Bear in mind that some 25% of all Eurozone government debt now has a negative yield, while a further 50% yield less than 1%. Treasuries do not appear priced for the likely economic and inflation scenario that may develop over 2015. Within credit, our only allocations are in more flexible, ‘go-anywhere’ strategies.

 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 deal-activity. CEO confidence is at its highest in five years and some 60% 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.

Should investors sell in May and go away? However convenient this expression may be, there is in fact very little historic evidence to support its contention. Indeed, as ever, our focus remains on fundamentals. The case for equities remains premised on three broad arguments: an acceleration in the economy, upside potential to earnings estimates and – perhaps most importantly – that there are very few compelling alternative options.

Nonetheless, it is important to be aware that the narrative which has helped underpin how many investors have positioned themselves is subtly, but undoubtedly changing. No longer are we in a world of benign disinflation and tepid growth where the ongoing accommodation of Central Banks is taken almost as a given. Most crucially, the global trend of disinflation seems to be coming to an end, helped largely by the recent rally in the oil price. But even core inflation metrics are stabilising, while the evidence of upward wage pressure is also accumulating. Meanwhile, at the margin, the message from Central Banks, although still broadly very dovish, seems to be shifting somewhat too. The Federal Reserve did not rule out (at its press conference last week) raising rates even as early as June, while the Bank of Japan also did not indicate at its most recent conference that additional quantitative easing would be forthcoming in the near-term.

These developments require careful monitoring, but all asset classes already seem to have been affected. The default strategy of many investors at the start of the year, namely favouring bonds (especially in the Eurozone) and assuming that the Dollar would reign supreme has been called into question. Given that economic growth figures in the US and China have recently underwhelmed while those in the Eurozone have surprised positively (consensus expectations for 2015 GDP have risen by some 30 basis points since the start of the year), the move in Europe has been most dramatic. Yields on the 10-year German Bund were just 7 basis points back on 20 April, yet are now over 50 basis points. While this is still an extremely low figure on an absolute basis, it still constitutes a quite remarkable swing. European yields have served as an effective anchor on borrowing costs in other regions and as such, a clear knock-on effect has been felt in both the US and Japan too, where yields have similarly strengthened.

We have long-argued that the returns available from conventional government debt are unattractive, being at all-time historic lows. Equities, by contrast, offer a markedly more attractive alternative. However ‘reluctant’ this current rally may be, it is important for investors to retain some context. This is not a normal economic/ business cycle and it never has been. The prior recession was deeper than almost any witnessed in history and so the recovery has been necessarily slower, requiring more intervention. Where we currently stand, equities do not appear overvalued in general terms (relative to credit or based on the current equity risk premium). Furthermore, there is little evidence yet of elevated inflation, no sign of indiscriminate credit growth (if anything, the contrary) and certainly no appearance of ‘irrational exuberance.’ In other words, there are few of the signs that might typically characterise the top of the market.

The last time the global equity market fell by more than 5% in a month did happen to be in May (2012) and the argument is often made that ‘the market is due for a correction,’ as much as anything because there hasn’t been one for a long time. We do not totally dispute such an assertion, especially given the nature of the shifting narrative detailed above and given the usual list of concerns (Greece, Russia, Middle East, UK politics). The more important questions, however, are whether there are better alternatives to equities – in our view, broadly no, and they are certainly not to be found in conventional credit; and, how to position within equities – and here, we continue to favour Europe and Japan.

Is it too late to invest in Europe and Japan?

With the MSCI Europe up 16% through to the end of April and Japan’s TOPIX market up 13% over the same period, this is perhaps a fair question to consider, particularly in the context of global equities, which have risen just 4%. However, the simple answer is no. When we return to the parameters of growth, earnings potential and valuation, both these regions continue to look more attractive than others globally in the near-term.

Taking Europe first, there have been broad-based upward revisions to economic growth since the start of the year. It would appear that the effectiveness of Mario Draghi’s monetary policy has been clear, helping improve sentiment and, more importantly, both corporate and consumer behaviour. One of the most important proxies for future GDP growth – the expansion in M1 money supply – is currently running at its fastest pace since early 2007. On other metrics such as consumer and business confidence, figures are also returning towards pre-crisis levels.

Such an improvement has also translated into better earnings with corporates across a variety of industries surprising on the upside. Indeed, for the first time in four years, the rate of earnings upgrades across the Eurozone is now greater than that of downgrades. There are many reasons to believe that this trend can continue, particularly since many corporates have yet to see the full benefits of operating leverage (the consequence of extensive cost-cutting undertaken in the past five years), while analyst expectations also tend to have a bias towards conservatism until there is greater confirmation of a trend. In other words, expectations for Europe still remain relatively low.

Much of the case for investing in Europe can also be extended to Japan, where a combination of macro and micro factors are driving a fundamental improvement in the outlook. Japan currently has the best rate of earnings revisions of any region globally while also trading on a lower multiple of earnings and book value than any other developed world region, according to data from Credit Suisse. There has been a tangible change in corporate culture in the country, helped by Prime Minister Abe’s reforms and the decision of the GIPF state pension fund to increase its allocation to Japanese equities. A virtuous circle effect is being sustained: corporates are reforming in order to qualify for a potential allocation by the GIPF, and both external shareholders and the economy more broadly are benefiting. In particular, the rate of share buy-backs and dividends has improved notably, up 40% year-on-year.

Final word: inflation watch

Although inflation in 16 of the 18 countries where Central Banks have formal targets is running below desired levels, we believe that the rate of change in inflation is one of the most important factors to monitor. Investors have, arguably, placed too much emphasis on the threat of deflation and not enough on the prospect of inflation. However, both trends in wages and in the oil price suggest that inflation may become more of a threat as 2015 develops.

Taking wages first, the number of US corporates raising salaries for base workers continues to grow (McDonalds being the latest high-profile name); in Japan, the largest trade union confederation (Rengo) is pushing for a 0.8% salary increase for its workers, double the level of a year ago; and, in Germany, the major union IG Metall has just secured a 3.4% annual salary increase for its members. Meanwhile, the oil price has moved some 40% from its mid-March low, rising from $43/barrel to over $60/barrel. Analysis from UBS suggests that every $15 move in the price/barrel of oil can add 60 basis points to inflation one year out. In other words, while inflation may not appear overnight, expectations are already beginning to rise. This has marked implications for all asset classes, but in the near-term, only serves to reinforce our preference for equities over credit.

Alexander Gunz, Fund Manager, Heptagon Capital