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: and so, the biggest monthly decline in equity markets since May 2012 occurred in August with ramifications felt across all other asset classes too. Volatility is now back to levels last seen in 2011, and questions have been raised over whether this is the beginning of the end for the equity bull market. It is fair to say that imbalances have been building in the financial system for some time and also, that corrections – when they happen – are generally cathartic. A reasoned assessment suggests to us that global recession is not imminent and that Central Banks will be forced to remain accommodative in their policies. Near-term, a flight towards the more defensive seems possible and there will also clearly be a higher volatility regime attached to all riskier assets. Nonetheless, we continue to find relative value in equities versus other asset classes.

Asset Allocation:

• Equities: Global equities are now 5-10% cheaper than a month prior, during which time earnings estimates have risen in every region bar emerging markets. The global equity risk premium (the excess return over the risk-free rate – currently, 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. Emerging market equities should remain under pressure in the near-term given the external environment of weaker domestic currencies and commodity prices.
• Fixed Income: Government bond yields may continue to trend lower in an environment where inflation is absent and monetary policy is likely to remain accommodative for longer than previously anticipated. However, we continue to believe the risk-return profile is highly asymmetric and the general trend will remain towards reflation over time. Investment grade and high yield debt also look challenged, given widening spreads and higher leverage. We hence favour only limited allocation to this asset class, via flexible and unconstrained strategies.
• Currencies: With a US interest rate rise in 2015 now looking less likely, we see some scope for the Dollar to weaken relative to other developed world currencies (Euro, Yen in particular), especially given the move in the opposite direction witnessed during the early part of 2015. Emerging market currencies are likely to remain under pressure.
• Alternative Asset Managers: August’s events rein force the case for allocations towards uncorrelated assets. We have been particularly encouraged by the moves of CTA (Commodity Trading Adviser) strategies. We also favour investments such as catastrophic reinsurance, MLP infrastructure assets and private equity.

Two key questions: why the move; and is it consistent with underlying fundamentals?

No-one ever really knows what constitutes the ultimate trigger point for an abrupt, seemingly unforeseen and undoubtedly significant market correction. Hindsight is a wonderful thing in the sense that it allows commentators to argue incessantly about ‘causes’ and also to find ‘explanations.’ We think, however, that perhaps the fairest analogy for what has occurred is one of a sand pile: imbalances clearly build over time, but ultimately, all it takes is for just one grain of sand to knock the pile over. Put another way, storm clouds have been gathering, for a while; our list of worries has been getting longer, and these concerns have become mutually reinforcing. Just like in the famous behavioural experiment on selective attention where viewers focus on the basketball (i.e. the Fed and its decision on when to raise rates) rather than the gorilla (namely, growing global imbalances), many investors may have arguably been missing the bigger picture.1

It all starts with valuation, and equities do not look cheap per se. One of the clearest consequences of the policies of financial repression followed by Central Banks since 2009 has been to push investors into riskier assets. Equities have correspondingly seen notable asset price inflation (even if inflation has been palpably absent in the real economy – see below). The world’s most important equity market, the S&P, enjoyed 5-year annualised returns of 17% through to 31 July (i.e. the month-end prior to the correction), with remarkably low volatility, of less than 10%. Correspondingly, the market’s cyclically adjusted earnings multiple stands at more than 25x, a level consistent with that seen only in 1929, 2000 and 2007. Moreover, earnings growth has slowed to just 4% annualised in the US, while market breadth (i.e. the number of companies responsible for index gains) has reached its lowest level since 2000. These are all concerning signs.

History is instructive not just when considering multiples and potential market overvaluation, but also when considering the potential complacency that equity investors may be currently experiencing. It is worth recalling that prior to the most recent financial crisis, concerns over sub-prime lending were evidenced by widening credit spreads ahead of an equity market correction. Spreads in both investment grade and high yield debt are now at the widest levels seen since when Bear Stearns sold itself to JP Morgan in March 2008. Moreover, this move has been accompanied by higher levels of financial leverage – another valid alarm signal. Net and gross leverage levels are now higher than they were in 2009 (by around 0.2 percentage points), according to data from Bank of America Merrill Lynch.

Such considerations matter even more when considering that the external environment has become more challenging. Global economic growth trends are diverging. With this, comes a corresponding likely divergence in Central Bank policy and also a growing risk of potential policy error. The equity bull market of the last six years has been premised on Central Bank credibility, ‘doing what it takes’ to get the economy into growth mode. Whether policy has worked remains debatable. Credibility is also a major issue, seen most clearly via recent developments in China. Investors may fret rightly about the lack of visibility behind policy decisions and whether recent actions are part of a broader plan or a hasty reaction to a markedly slowing economy. Nonetheless, the Yuan devaluation – however logical – compounds the perfect storm facing emerging economies. Weaker EM currencies, combined with lower commodity and oil prices creates a vicious circle. Furthermore, in contrast to the Asian currency crisis of 1997/8, the emerging world’s economies now comprise some 40% of global GDP, versus just 15% back then. The ramifications for overall growth prospects are clear.

Now for the better news…

Market volatility should not be a surprise at this stage of the cycle, particularly given its very absence for quite some time. However, the dynamics characterising both the current macro and investing environment look very different both to 2008 and 2011. Tail risks appear lower now than they did then; there is no single event of comparable enormity either to the sub-prime crisis or the potential collapse of the Eurozone that potentially overshadows today’s narrative. This is not the first time (and probably also not the last) that there has been an apparent global growth scare during this economic cycle. While the causes have been different (the US in 2011, the Eurozone in 2012 and emerging markets currently), the effects

have been broadly similar. Viewed from a different perspective, the magnitude of August’s equity market move does not seem justified by the fundamentals. Correspondingly, it may not take much to drive a sharp rebound.

It is fair to recognise that this recovery has been slower than others and needs to be considered differently given the crisis that came before. Currently, the world economy is witnessing a weak and unsynchronised expansion, but an expansion nonetheless, which also has the potential to endure. Manufacturing output (measured by Purchasing Manager Indices) is in expansion (readings greater than 50) in every region of the world excluding China. German manufacturing output is, for example, at its highest in 16 months, while Japan is witnessing an acceleration in output this quarter relative to the previous. Moreover, with regard to China, it is hyperbolic to suggest growth is collapsing. GDP will still growth at 6-7% in 2015 and account for around a third of overall global GDP growth, according to the IMF.

Furthermore, given the repeated disappointments to growth and inflation that have been witnessed in the post-crisis era, policymakers are likely going to (have to) remain accommodative in their stance. In other words, the clear message for the Fed in particular is that there is a bigger risk in tightening too early than too late. History shows that the instances where Central Banks have deliberately sought to slow growth below trend have typically been the death- knell for most post-war cycles. The moves of all asset classes in August should send a pertinent message to the Fed regarding its scope for potential policy error.

Importantly, there is little evidence of inflation in any major developed world market at present. Emerging market currency depreciation and lower commodity prices are indeed inherently deflationary. US 10-year break-evens (the difference between the nominal yield on a fixed rate investment and the real yield on an inflation-linked investment of similar maturity) are at 1.5%, the lowest witnessed since the start of the financial crisis. Meanwhile, in Europe, break-evens are lower than prior to the commencement of quantitative easing. In a ‘normal’ environment, a rising Dollar combined with commodity price declines would logically mean easier money and lower rates. At the least, we should expect an ongoing dovish message from Central Banks around the world. At the more extreme, but far from inconceivable, there may even be a better case for a fourth round of quantitative easing in the US rather than an imminent rate rise.

Conclusion: equity market corrections are necessary and can even be seen as cathartic in the sense that they prompt a more sober reassessment of the investing environment. There are few more obvious places beyond equities (other than cash) where investors may want to allocate assets at present. The reality remains that equities are now, on average, 5-10% cheaper than they were a month prior, a time during which earnings estimates have actually risen. Moreover, August’s developments suggest that the policy environment against which investment decisions need to be made will likely have to remain very loose and accommodative. Inflation may not be evident, but the commitment to generate it remains. Meanwhile, the world is not even yet close to sinking into recession. Expect more volatility, but for the brave, now is the time to invest selectively.2

Alexander Gunz, Fund Manager, Heptagon Capital

1 See the ‘invisible gorilla experiment’ conducted by psychologists Dan Simons and Chris Chabris: https://www.youtube.com/watch?v=vJG698U2Mvo

2 For the record, Heptagon took advantage of equity market weakness on Monday 24 August (‘Black Monday’) to increase equity allocations across private client portfolios and within its European and Global equity funds.