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.

Violent oscillations between hope and despair regarding Europe’s future continue to dominate financial markets globally. We have counselled on several previous occasions of the need to divorce emotion from reality: while neither Rome nor Athens is yet burning as policymakers continue to fiddle, what is palpably apparent to us is that global economic growth is clearly slowing. It is this consideration – and how to reverse the mounting decline – that needs addressing above all else. Correspondingly, Heptagon’s current investment strategy is centred on preserving capital in what is likely to become an increasingly problematic environment as 2012 approaches. Fixed income (particularly high yield) remains preferred over equities while the case for allocations towards certain alternative strategies/ asset managers can also be made.

A focus on fundamentals at this time of heightened emotions is crucial. Below is a list of factors that give us cause for concern; not all of these are new or novel observations, but when viewed in aggregate, they constitute a potentially unappealing cocktail:

• The developed world has more than $8 trillion of excess leverage. Structural indebtedness is a not a problem unique to Europe, it is just most pronounced here. High sovereign debt levels act as a barrier to growth. Nations seeking to apply fiscal austerity to reduce their debt burden may actually do more harm than good to their economies. Harm comes in two forms: first, fiscal tightening decreases liquidity within the financial system; second, the irony of greater austerity is that it may actually increase debt should it induce recession (and thereby lower output and tax receipts). It should also not be forgotten that voters, especially in Europe’s peripheral economies, may simply be unwilling to accept further austerity imposed upon them;
• Liquidity is already being sucked dramatically out of the financial system evidenced both by the European Central Bank’s most recent quarterly survey of credit channels and by trends in Chinese M2 growth (also, it is worth recalling that Europe and China are inextricably interconnected with the former being the latter’s largest export market and also responsible for a quarter of the world’s output);
• Reduced liquidity levels are exacerbating already slowing growth. Pick your data points, but we note: purchasing managers surveys continue to struggle to move meaningfully above 50 (implied expansion), while contraction (readings of sub-50) have been reported recently in countries including the UK and China. Unemployment also remains elevated globally (above 9% in the US and now rising – for the first time in two years – in Germany) and consumer confidence looks repressed, currently at a 40-year low in the US, for example. The unemployed or those fearful of job prospects simply are not spending, regardless of low interest rates. Corporates are also clearly cautious. Correspondingly, global GDP growth estimates for 2012 have been markedly scaled back. With regard to Europe, it is also worth bearing in mind that irrespective of the ultimate end-game (break-up or greater fiscal cooperation), much of the continent remains fundamentally uncompetitive; wages need to fall by at least 15% in the periphery; and,
• Sustaining political consensus and creating coherent policy is set to remain difficult: this is an issue not just for Europe’s politicians with differing national agendas (where, in many cases, compromises also need to be struck given the coalition nature of governments), but also in the US and China. 2012 is the first time in twenty years that both these nations may appoint new leaders in the same year.

It will hence be both difficult and painful to delever and improve underlying structural growth at the same time. There is, however, a solution at hand; and, the worse things get, the more likely it is that policymakers will seek to employ it. In three words, inflation is coming. This is most likely to manifest itself in terms of higher prices for goods and services although upward pressure on wages is also possible. Regardless, it is desperation on the part of policymakers that will make the monetization of debt most likely. When defaulting is not a palatable or politically acceptable option, austerity will not work and growth is absent, the option of inflation does remain, and could be stimulated by (even) looser monetary policy. Its effect would be to permit for implicit default with the ‘costs’ being widely spread across the economy. Moreover, banks’ solvency could also be ensured by such an approach.

The legacy of the Great Depression may be enough to sway American policymakers (both present and future) that this is the right approach, while in Germany, pragmatism may ultimately win out. The hyperinflation of the Weimar Republic may be a sore memory, but with European unity currently being tested, inflationary outcomes may be preferable to no growth and a potentially more confrontational political environment across the continent.

A legitimate question may be why bond yields do not currently reflect a possible scenario of higher inflation (or inflationary expectations). With faltering economic growth a central concern, in the nearer- term, deflation may be a more pressing issue with which investors have to contend (and the Japanese experience of the last twenty years constitutes an unfortunate precedent in this respect). Investors in other asset classes also face similar challenges in interpreting near-term price actions. In the space of three months, equities have swung within a range of almost 15% and while the recent earnings season has been generally encouraging (at least 60% of companies globally either met or beat expectations), corporate profitability does not exist in a vacuum. Whether such momentum can be sustained in 2012 remains to be seen, particularly with earnings revisions falling faster than sales revisions, implying a contraction in margins.

A period of economic stagnation would typically imply low equity returns and superior bond returns, although when pronounced inflation does come, diminished returns from equities could be combined with below-average bond returns. In the near-term, the case for credit, and high yield in particular, seems most compelling. It is noteworthy that corporates’ balance sheets and cash holdings are currently

healthy and if margins/ earnings are close to peaking, then there is potentially greater downside risk to equity valuations. Implied default rates also continue to appear abnormally high, while yields look compelling at more than 10%. Record levels of inflows into the high yield asset class were also witnessed in October according to data from several providers.

Elsewhere within the credit space, Asian fixed income looks attractive, particularly should looser monetary policy in the region prevail. This seems likely with overheating concerns being replaced by a need to drive growth, and hence lower interest rates. G7 Government Bonds look less compelling although their ‘safe haven’ status (combined with ongoing quantitative easing) may provide some form of support.

For equities, until there is greater clarity on fiscal and monetary policy, the most likely direction is set to sideways, a repetition of the range-bound pattern witnessed in the late 1970s and early 1980s. Within the asset class, investing in the US (certainly over Europe) remains preferable, with prospects for corporates in this region both less lacklustre and lower risk than elsewhere. Those companies that are internationally diversified, have visible revenue streams and are returning cash to shareholders have the potential to outperform. Pricing power and dividend income will also increasingly come to the fore when inflation starts to rise. Correspondingly, sectors that look most compelling include consumer staples, tech and telecoms.

Alternative asset managers (particularly those pursuing macro and CTA strategies) continue to have a place within Heptagon’s strategic allocation, although performance has been mixed year-to-date. Investing in this space provides an important element of portfolio diversification with these managers’ strategies often being uncorrelated with other asset classes. This would particularly be the case as fundamentals reassert themselves. The Euro, for example, should weaken further from current levels, despite the ECB’s recent interest rate reduction.

We have sometimes been accused of adopting too pessimistic a stance during the course of 2011. However, the rate at which case for global economic recovery has been undermined, often by actions within policymakers’ own control, has given us much cause for caution. A conservative approach has been mostly vindicated year-to-date and until there are signs not only of greater political cohesion but real growth underpinned by a fundamental improvement in liquidity and reduction in leverage, we will continue to pursue such a strategy. Adopting an open-minded and flexible attitude has also been crucial and will remain so, particularly with inflation most likely waiting in the wings.

Alex Gunz, Fund Manager, Heptagon Capital