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 abrupt and profound moves in all asset classes over the last month suggest to us that imbalances are clearly building within the financial system. At the same time, the effectiveness and credibility of Central Bank policy is being increasingly questioned. There seems to be a growing realisation that there is too much debt and not enough growth/inflation globally. More money printing seems likely, and can help extend the current cycle, but may not be enough to solve the more profound underlying challenges facing the world. All of the above suggests a clear need for caution and prudence, emphasising a focus on fundamentals and on valuation. Selected equities (particularly in Europe and Japan) remain the best relative option for now.
Equities: Q3 marks the worst quarter of performance for global equities in four years, although such a correction needs to be seen in the context of a broad six-year rally in this asset class. We note that the global equity risk premium (the excess return over the risk-free rate – currently at 6.0%) remains well above levels witnessed at previous market peaks. Our preference is for relatively undervalued markets with attractive fundamentals, namely Europe and Japan.
Fixed Income: Government bond yields are at all-time lows in many developed markets. They may trend lower in an environment where inflation is absent and monetary policy remains accommodative for longer than previously anticipated. However, we continue to believe 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 flexible and unconstrained strategies.
Currencies: Central Bank policy will likely continue to dictate the relative performance of currencies. Further easing on the part of the European Central Bank and/or the Bank of Japan would result in US Dollar strength relative to the Euro/Yen, compounding many of the problems currently faced in emerging markets.
Alternative Asset Managers: Recent market price action reinforces the case for allocations towards uncorrelated assets. We have been particularly encouraged by the performance of some CTA (Commodity Trading Adviser) strategies. We also favour investments such as catastrophic reinsurance, MLP infrastructure assets and private equity.
How worried should investors be?
The abrupt drop in global equities witnessed since mid-August has inevitably prompted a re-assessment of the investment landscape. The recent actions (or inactions) on the part of the Federal Reserve have compounded the need for this exercise. A sober and reasoned analysis suggests the following somewhat concerning three conclusions: first, recent Central Bank policy may not have been effective in achieving its goals; next, the seeds of the next financial crisis may already have been sown; and finally, equities remain the default asset class for now only because there is no better place to go. We will consider all these topics in more detail, but put simply, market volatility constitutes the failure to remove uncertainty. Such uncertainty manifests itself in three interlinked forms: near-term policy decisions, the broader debate over policy effectiveness and, the amount of debt within the financial system – the metaphorical elephant in the room.
It is now some six years since the Federal Reserve embarked on its massive – and previously untested – programme of unconventional money printing. At one level the policy has proven effective in the sense that it has generated tangible asset price inflation, with US equities up more than 150% since their March 2009 low and global equities some 100% higher. Meanwhile, globally, yields on government bonds have been depressed to levels not seen in over two centuries. However, while the financial distortions provoked by quantitative easing are apparent, these have occurred without the benefits of either consistent economic growth or inflation. Guidance from the world’s major central banks (the Fed, the ECB and the Bank of Japan) suggests that inflation in their respective countries will not exceed 2% for at least the next two years, implying that it will have remained below target for a decade.
Herein lies the major paradox. Should – as seems increasingly likely – Central Banks still pursue their policy of loose money, this will de facto extend the current cycle for longer, even if it means the current imbalances within the financial system grow further. These two factors are, unfortunately, inextricably interconnected and hence mutually reinforcing. Such is the fragility of the financial system and the lethargy of the global economy that Central Banks are near forced to continue feeding the current addiction. As a consequence, we are now in an unprecedented situation where never has so much money been printed (US$8 trillion since the start of the 2009) nor have base rates been so low.
Perhaps the biggest myth of the current cycle has been that of deleveraging. On the contrary, record low interest rates have encouraged the creation of debt. Global debt is now equivalent to 2.5x global GDP and has expanded by 20% since the end of the financial crisis (according to data from McKinsey). Debt can only decrease in one of three ways: via growth, inflation or default. In the current absence of either of the former two factors, investors are perhaps entitled to entertain the plausibility of the third scenario, namely the potential risk of default.
Nowhere is this a more profound problem than in emerging markets. Much of the money printed by Central Banks in the last six years flowed here both to fund the expansion of commodity production and because the returns promised to investors appeared higher than in developed markets. These factors gave the appearance of sustainable commodity demand and provided the justification for a continuous positive feedback loop of further investments. However, the evidence of the last twelve months shows what happens when cycles end. Since the Fed’s balance sheet has stopped growing and the US Dollar started rising, a collapse in emerging markets has been precipitated. Some $650bn of emerging market debt needs either to be repaid or rolled over in each of the next three years (according to JP Morgan). This constitutes a clear challenge given higher credit risks, tighter credit channels and the reversal of capital flows.
Past experience suggests that there is a higher opportunity cost attached to raising rates too early than too late. There are clear precedents from across the globe (Australia, Canada, Chile, Japan, South Korea and Sweden) where policymakers have had to reverse rate rises and consequently lost credibility. Moreover, whether Central Bankers like it or not, the global economy is necessarily interconnected. The current fall-out from emerging markets will not only take some time to assess but the excess supply of commodities that is helping to depress developed world inflation will not dissipate quickly.
The above argues for continued loose monetary policy. The debate, of course, is how much looser? Twelve countries around the world already have negative interest rates. New Zealand, Norway and Taiwan all eased their monetary regimes in the past month and the expectation is for more monetary largesse to come. Australia and Canada – given their clear commodity dependencies – seem likely candidates, but the more interesting questions relate to the larger economies of the world, particularly the Eurozone and Japan. Current CPI inflation in these two regions is below zero and both Mario Draghi and Haruhiko Kuroda have hence indicated that they are prepared to embark on further quantitative easing.
However, while investors may react to such policy in an initially positive manner, the best analogy remains that of sustaining an addiction while ignoring the fundamental underlying problem. Should there be more money printing from either the European Central Bank or the Bank of Japan (or both), then the inevitable consequence would be for the Euro and the Yen to weaken further. The corollary of such action would be for the US Dollar to strengthen, thereby compounding the already significant challenge facing emerging markets described earlier. In the absence of defaults, such a vicious circle may be sustained for some time longer. Inadvertently, global policy actions are already leading to actual financial tightening. Moreover, this is clearly occurring at a time when equity valuations are beginning to look relatively stretched on a number of metrics.
Against this background, it behoves us to consider whether the Federal Reserve should have been more aggressive in its monetary stance at an earlier date. Perhaps the time has passed for negative interest rates in the United States, but it certainly does not seem beyond the realms of possibility for a fourth round of quantitative easing (‘QE4’) to be entertained. Whether this would be a step too far in credibility terms remains to be seen.
It’s not all bad out there
To state the obvious, this economic and market cycle is clearly markedly different to previous ones. In the age of financial repression, it perhaps helps to have low expectations. The reality remains that the global economy is still growing. US GDP for the second quarter was revised up to an annualised rate of 3.7%. The US consumer comprises some 70% of the economy. American household debt has fallen by 30% since the financial crisis while the savings ratio has doubled. In Europe, industrial production and money supply are at their highest in four years and unemployment at its lowest in three. Meanwhile, even if China achieves just 5% GDP growth in 2015, given the size of its economy, the contribution of such output to global growth will be more significant than was the 14% GDP expansion achieved a decade ago.
Of course, correlations between GDP and asset class returns (particularly equities) are limited, but the above suggests to us that there is scope for relative outperformance in certain areas particularly against a backdrop of diminished expectations. Even if the seeds of the next crisis are being sown at present, this current cycle can still endure for some time longer. Inflation rather than deflation tends to mark the end of equity bull markets, but the debt just won’t go away.
Alexander Gunz, Fund Manager, Heptagon Capital
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