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: many investors tell us they are confused. And with good reason. Recent market action has seen notable gyrations across all asset classes. The nagging question that just refuses to go away is what it will take to puncture the increasingly tired rally in equities and downward trend in bond yields. We do not know the answer, but recognise that the general investing environment is becoming more complex. The longer the current cycle endures, the bigger will be the subsequent problems. It remains important not to lose sight of fundamentals but also to be tactical. Beyond making the case for a growing investment in genuinely uncorrelated assets, we continue to favour selected equity strategies (particularly in Europe and Japan). Riskier assets may continue to rally near-term, but looking ahead, we see the merits of derisking portfolios somewhat heading into 2016.
Equities: For us, the default asset class, as much as anything because there are few better places to go. Earnings trends in the US have generally been disappointing with EPS improvements masking weaker revenue and margin performance. Given current valuation levels, there is no scope for complacency and we see better relative opportunities in Europe and Japan. Emerging markets may continue to benefit from a near-term tactical bounce, particularly if the Fed raises rates and seemingly removes market uncertainty.
Fixed Income: The imminent end of loose monetary policy in the US (regardless of whether this is the right strategy) means that government bond yields could slowly begin to move up. Elsewhere, for as long as inflation is absent and monetary policy remains accommodative, they may trend lower. That said, it seems evident to us that the risk-return profile of this asset class is highly asymmetric. Investment grade and high yield debt also look challenged, given widening spreads and higher leverage. We hence favour only limited allocations, via unconstrained strategies.
Currencies: The likely divergence in major Central Bank policies, with relative US (and possibly UK) tightening against still-loose policy in Europe and Japan would be suggestive of further relative US Dollar strength in particular.
Alternative Asset Managers: With broader market uncertainties growing, we continue to favour investments to genuinely uncorrelated assets such as catastrophic reinsurance, MLP infrastructure assets and private equity.
Many investors appear to be in a state of limbo, expectant for, yet paralysed by, the actions that Central Banks may or may not undertake. This view was endorsed among the 60 or so clients with whom we have met across 4 continents in the last 7 weeks. As a consequence, it is easy to conflate and hence confuse momentum with fundamentals, as recent price action has shown. Admittedly, decisive Central Bank policy actions can help remove uncertainty, but when assessed more rigorously, such an approach may simply just be creating additional problems that will ultimately have to be addressed.
However, in the absence of such policy developments, it is not necessarily clear to us what may drive the directional impulse for investment strategies. Such a consideration is particularly pertinent given the increasingly lengthy and tired rally
witnessed in equities (which will market its 7th anniversary in March) and the fact that yields on government bonds are at close to all-time lows. Against this background, the correct response seems to us to be one of remaining nimble and flexible, being willing to look beyond the conventional and recognising that the current bubble will almost certainly burst before not too long – just knowing when is a lot harder.
Is raising rates in the US the right thing to do?
Who are we to second-guess Janet Yellen or to suggest that we are in possession of superior information to the Federal Reserve, but the well-flagged intention to raise rates before the year-end seems at best inconsistent and at worst wrong. We cannot help but wonder whether the Fed’s decision may be aimed simply at appeasing investors and removing some of the Godot-like uncertainty that has plagued markets in recent months rather than addressing the fundamentals.
At the least, should the Fed go down the path of raising rates, even if very slowly and gradually, it will mark a clear departure and hence divergence from the de facto strategy of globally loose monetary policy. In other words, as the Fed stands to tighten, the European Central Bank, the Bank of Japan and also the People’s Bank of China remain clearly committed to further accommodation as required. The corollary is that with the Euro, Yen, Yuan (and others), in an effective ‘race to the bottom’, and the Dollar correspondingly strengthening, the US economy may stand to lose on a relative basis given a less competitive currency.
The fact that the Dollar Index has appreciated by more than 20% since the Fed commenced the tapering of its third round of quantitative easing has already led to a tightening in financial conditions even without interest rates having shifted. Such an outcome, as we have discussed in previous editions of this newsletter, has already caused significant issues, particularly in emerging markets, but also for US Dollar-denominated debt globally. Junk bond spreads over Treasuries are now 100 basis points higher than at the start of 2015 while the spread between 3-month financial commercial paper and 3- month Treasuries is currently 50 basis points above January’s levels.
Many weaker corporates (particularly in the energy and commodity space) have already felt the consequences of such effective tightening. But thought of another way, while quantitative easing has helped keep many businesses afloat, at higher rates, not all will likely remain profitable. Even if the headline economic data (initial jobless claims at their lowest since 1973, existing home sales at their highest in ten years and companies from Wal-Mart to McDonalds citing wage pressures) may provide the Federal Reserve with the ‘excuse’ for a rate hike, the underlying health of corporate America tells another story. Data from Morgan Stanley shows that with more than 50% of S&P listed businesses having released results for the third quarter of 2015, revenue growth has consistently missed expectations while 64% of corporates have reported margins down year-on-year. This is set to be the weakest earnings season in the US since early 2009.
It therefore behoves us to consider whether rather than the US being in a position of relative economic strength, it may be closer to recession than many would be willing to consider. The problem, of course, both for forecasters (including the Fed) and investors is that if growth really is turning down, then the classic signal for a recession – namely an inverted yield curve – simply can’t manifest itself, as such an outcome is clearly impossible in a manipulated zero-rate regime. Even if recession may be too strong a word, then do not rule out the risk of a possible bear market for equities. We state the facts very simply: recessions generally occur once in each decade (and we have not had ours yet in the 2010s); widening corporate spreads (as is the case) are often a precursor to a downturn in equities as is narrowing equity market breadth (fewer sectors and businesses being responsible for market leadership, again the case currently). We think it is still possible to be constructive on selected asset classes, but we see growing signs that do concern us. Should the Fed raise rates, it may spark a relief rally in risk assets (such as emerging markets and commodities) on the removal of uncertainty over action, but such a decision will almost certainly create more significant problems further down the line.
Why we are still optimistic on prospects in Europe and Japan
While recognising that the world is increasingly interconnected and so what happens in the US will undoubtedly affect other regions, we believe that (equity) investors can continue to enjoy upside potential in both Europe and Japan. As the recent rhetoric of Mario Draghi and Haruhiko Kuroda shows, the old tricks still seem to work – at least for now. It seems likely to us that there will be further printing of money in these two regions as even if growth is beginning to improve, it is still lacklustre, while inflation continues to be stubbornly elusive.
The fundamental case for Europe is buttressed by spare capacity and operating leverage. In other words, with region-wide unemployment at around 11%, broad wage pressures are unlikely to be an issue any time soon. Moreover, with almost no GDP-growth since 2007, most businesses have developed exceptionally lean cost structures implying that when demand comes back, the upside to profitability should be significant. Probably the most encouraging recent indicator has been over 10% year-on-year growth in money supply (M1), a good precursor to future demand.
For Japan, there is also a strong structural argument to be made above and beyond any benefits that may accrue from loose monetary policy. Prime Minister Abe has passed 1,000 days in office now and progress across many areas is evident, yet it is clear that there is still a lot more to do. At a broad level, the government continues to implement policies aimed at improving competitiveness, introducing more flexible working practices (particularly for women), liberalising agriculture and increasing fiscal flexibility. For corporates, there has been a notable shift in terms of better governance combined with a greater focus on profitability. Profits as a percentage of GDP (at 15.6%) are the highest on record, while forecast return on equity of 10% will be at its best since 1981, although still around 5 points below US levels (source: Morgan Stanley).
Final word: what about emerging markets?
Emerging market equities have suffered from four consecutive years of negative earnings revisions and hence the index (MXEF) is some 45% below its May 2011 peak. The problems (in general terms) seem well understood with many businesses and economies affected by a combination of Dollar strength, commodity weakness and political challenges. While none of these issues look likely to dissipate any time soon, we make three observations. First, current data are pointing at least to a stabilisation in macro trends. A hard-landing scenario for China seems increasingly less likely. Second, we have never been in doubt about the longer-term case for this asset class, particularly given superior demographics. For China in particular, the recent abandonment of the one-child policy could be significant. Third, we see a near-term tactical argument to favour emerging markets should the Fed move towards its inevitable tightening.
Alexander Gunz, Fund Manager, Heptagon Capital
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