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: Risky assets seem to be back in vogue, at least if recent price action is to be believed. Our more reasoned assessment highlights a world where economic growth and inflation forecasts continue to be scaled back and earnings estimates for equities are falling. At the same time, Central Bank policy actions are having diminishing (or negative) returns, thereby failing both to resolve the problems they intend to fix and also potentially creating other concerns for the longer-term. Further abrupt price moves in both directions and across all asset classes therefore seem likely. Against this background, we stick to fundamentals, preferring to invest where we see genuine value (emerging markets, for the long-term) or in alternative and truly uncorrelated assets.

Asset Allocation:

 Equities: Despite continued downward revisions to earnings globally, equities experienced their third strongest month over the last five years during March. A combination of downgrades and recent price action imply elevated multiples and hence the need for caution. Our emphasis is on value over growth, emerging over developed markets and on active relative to passive strategies. Listed businesses with pricing power and strong capital discipline look best placed globally.

 Fixed Income: Government debt offers negative yields out to at least seven years in Germany, Switzerland and Japan and yields may go more negative as Central Banks reach the limits of their policy effectiveness, implying an unattractive source of potential returns. Similarly, although spreads have narrowed in both Investment Grade and High Yield, they remain wide relative to history, and liquidity in these markets is still poor. We see most potential upside over the long- term in local currency emerging market debt, again on a valuation basis, with this asset cheap relative to its history.

 Currencies: We have no active currency positions and expect the currency environment to remain highly volatile. It seems increasingly clear to us that in the absence of sustainable economic growth or inflation most Central Banks are in a tacit ‘race to the bottom’, seeking weaker currencies. Long Dollar positions are likely to continue to unwind.

 Alternative Asset Managers: With broader market uncertainties growing, we continue to favour investments in uncorrelated strategies such as equity long-short investments, catastrophic reinsurance, infrastructure assets, direct lending and private equity. We also see a logic in holding some cash positions to preserve for future opportunities.

An appropriate place with which to begin this month’s View is to quote directly from a speech given by Janet Yellen to the Economic Club of New York on 29 March. Here, Ms. Yellen states that “economic and financial conditions remain less favourable than they did back at the time of the December FOMC meeting. In particular, foreign economic growth now seems likely to be weaker this year and earnings expectations have declined” (our emphasis in bold). If Ms. Yellen’s assessment is an accurate one – and we concur – then it seems reasonable to ask why almost all asset classes have rallied strongly since their mid-February trough. From here through to the end of March, oil has gained close to 50%, the VIX Index (of volatility) has fallen by almost the same amount, credit spreads have narrowed by around 25% and global equities are up close to 10%.

Our simple assessment is that recent price action forms part of the broader narrative that has characterised the investing environment for some time, namely, that investors should get more accustomed to wild and uncertain price moves in all asset classes in both directions. Although it might be easy to claim otherwise, none of the problems alluded to by Ms. Yellen has gone away. In other words, there is not enough growth or inflation in the world economy, and in the absence of these, the global debt mountain is only going to continue to grow. After seven years’ of asset price inflation (and the third longest bull market in equities since the beginning of the 20th Century), we think it clearly behoves us at the very least to be highlighting what we see as being the key areas of risk and uncertainty.

Investors are, understandably, confused at present. Most economic data points appear highly contradictory and the recent actions on the part of Central Banks have created a sense of obfuscation rather than clarity. We prefer to stick to the fundamentals and these drive our investment conclusions. Our focus is on valuation and our broad emphasis on uncorrelated assets classes, those that are potentially least exposed to current market dislocation. Our conviction is driven by an analysis of two key issues, discussed in more detail below.

1: Have Central Banks lost their credibility? And, does it matter?

We do not doubt the resolve of Central Banks to ‘do what it takes’, but this is very different to lauding the effectiveness of their policy actions. Clearly the world is no longer in the sort of crisis witnessed in 2008/9 and hence its problems may now be of a kind that are simply less responsive to monetary easing. Indeed, given how low bond yields are, lowering rates beyond the zero-bound may indeed be counter-productive. At the very least, there seem to be diminishing returns from Central Bank actions. Gone are the days of old, of ‘shock and awe.’ The statistics back this assertion up: since the Fed’s third round of quantitative easing ended, annualised returns have been negative for both global equities and fixed income (-2.5% and -1.1%, based on data from Bank of America Merrill Lynch).

To return to the idea of counter-productive action, consider the following. Take the Fed first. How can investors ‘trust’ or ‘believe credible’ an organisation that revises its year-end interest rate projections by a factor of 50 basis points in the space of just three months? Yet this is precisely what the Fed did, shifting its December 2016 interest rate ‘dot’ from 1.375% in December 2015 to 0.875% just two weeks’ ago. More concerningly, Fed Committee member James Bullard (who has served since 2011) spoke out publicly after the Fed’s last meeting, stating that he considered abstaining in the belief that the dots only serve to create “confusion” in the market. Now consider, the Bank of Japan (BOJ). Since its negative interest rate policy was embraced at the end of January, the Yen has risen by more than 7% and Japanese government bond yields have tumbled. This constitutes a clear repudiation of Abenomics. That the BOJ has stood by and let the Yen appreciate while also stating its willingness to take interest rates even lower, has served only to create more confusion over which levers it really believes will spur the economy into action.

Even if the recent actions of the European Central Bank (ECB) received greater praise, delivery is a very different matter. Getting corporates to borrow and consumers to spend is somewhat akin to pushing on a string. The issue is less about lack of (credit) supply and more about an absence of demand, in our view. A 10 basis point cut in the ECB’s deposit rate and €20bn extra a month of quantitative easing might do as little to spur growth in Europe as will a shift in Japan from zero to negative rates. Put another way, Central Banks alone can’t create economic growth. And this matters, since global growth is currently at its weakest since September 2012 (based on a monthly worldwide composite index calculated by JP Morgan). The not unreasonable question, therefore, to ask is what Central Banks might do should the world again slip into recession; might they go to further extremes, even if the market continues to object? At the least, it seems fair to recognise that Central Bank actions are not the panacea of old. Furthermore, whether Central Banks like it or not, economic growth remains sluggish and this is clearly manifesting itself in terms of tepid revenue growth and corporate margin pressure.

2: Earnings: how worried should we be, and where are the sources of upside?

Few celebrated the seven-year anniversary of the global bull market in March. The MSCI World may have climbed some 120% since March 2009 and currently sitting just 9% from its all-time high, but most good things do, sadly, have to come to an end. Put another way, how much upside exists for investors in continuing to chase equities (in the broadest sense) after such a long and sustained rally? The evidence against doing so also seems compelling. Global earnings estimates are now 12% lower than six months ago, the biggest negative six-month revision since 2009 (according to data calculated by Société Generale). Given the magnitude of these downgrades, equities are now back to their valuation peak of 2015.

We think a contrast between the US and emerging markets bears valid consideration. From this, investors should be able to draw their own conclusions. Bear in mind also that the US comprises 59% of the MSCI World Index at present. After 81 months’ of economic expansion, corporate profits have probably peaked in the US, but multiples are not close to being below average. The 4.0% year-on-year drop reported in fourth quarter S&P revenues and a 7.8% decline in earnings were the worst figures for the market since 2009. Even if weak oil and a strong Dollar can be blamed as obvious culprits, investors should not forget that consensus earnings estimates for the S&P have been revised down for four consecutive quarters. Looking ahead to the upcoming first quarter reporting season, Factset data shows that consensus now assumes a 7.0% decline in earnings for Q1. Back in December 2015, the street was looking for 5.0% earnings growth. Such downward pressure matters more when valuation offers little support. The US market has traded on an average P/E multiple of 16.9x over the last 80 years (on a cyclically adjusted, CAPE basis). By contrast, the S&P’s current CAPE is 21.5x (data courtesy of Goldman Sachs).

It behoves investors to ask whether it is a more appropriate strategy to pay 21.5x earnings to invest in US equities or around 10.0x currently for emerging markets (again, on a CAPE basis). Such a multiple compares to a range of 10-35x cyclically adjusted earnings recorded for the MSCI Emerging Markets Index since its inception in 1996, and a median multiple of 18x. In other words, investors currently have the opportunity to purchase emerging market equities at trough multiples. We note that emerging market equities have outperformed US/ developed world equities year-to-date. Such outperformance (and also the scope for further gains) can be attributed both to a better external environment (a weaker US Dollar), but also to an improvement in fundamentals (stabilisation in markets such as China, India, Mexico and Russia as well as in underlying commodity market dynamics). However, we also think that EM outperformance speaks to something else, namely, that investors have few choices of what to buy in a low-return world where most asset classes offer little upside. It is also for this reason that we continue to emphasise the need to invest in a creative and pragmatic fashion, according due consideration also to genuinely uncorrelated assets.

Alexander Gunz, Fund Manager, Heptagon Capital