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: Are we in the calm before the storm? It is testament to the robustness of this market cycle that the bubble has yet to burst. Our reasoned assessment of current valuation levels, macro prospects and the potential for more stimulus (either fiscal or monetary) suggests that there is little scope for complacency. Combine the above with an autumn fraught in political risk, and there is indeed a strong case for caution. Our prudent stance has remained unchanged since at least the start of 2016 and we continue to make the case for increasing allocations to uncorrelated alternative assets, favouring equity over fixed income elsewhere.

Asset Allocation:

 Equities: On all conventional valuation metrics developed world equities do not look cheap and earnings expectations for 2017 look too optimistic, even if the current earnings season has not disappointed. By region, our preference is for emerging markets (and Europe), where valuation and growth prospects look considerably more reasonable. At this stage of the cycle, there is a strong case for active and high-conviction global managers also to outperform.

 Fixed Income: Yields on conventional fixed income may have moved off their recent lows, but it remains the case that some 80% of all German and Japanese government debt offers negative yield, while investors in Swiss government debt have to go beyond 48 years to find positive returns. Such an outcome appears fundamentally unattractive in our eyes, as are prospects for much Investment Grade. Some opportunities exist in local-currency emerging market debt.

 Currencies: This asset class continues to exhibit more volatility than many others as recent events such as Brexit and sentiment around proposed fiscal stimulus campaigns demonstrate. We do not expect such trends to abate any time soon, but believe there is a case for considering some safer-haven currencies such as the Swiss Franc (or the Japanese Yen), as much as anything as a diversifier relative to equities.

 Alternative Asset Managers: Our conviction in this asset class continues only to grow. We actively continue to favour investments in genuinely uncorrelated strategies and private asset classes in particular. Within this universe, we consider investments in catastrophic reinsurance, infrastructure assets, direct lending and private equity to be attractive. There is also logic in holding some cash (as an asset class), preserving it for now to deploy for future opportunities later.

The Panglossian summer

The phrase ‘cruel summer’ first appeared in our View From the Top commentary exactly five years’ ago, a homage not only to one of the finest songs recorded by the 1980s UK pop-act, Bananarama, but also a recognition of the profound challenges then facing investors, characterised by the Greek debt crisis and fiscal stasis in the US. It has been an apt turn-of-phrase in many subsequent years, describing an increase in risk-aversion levels and, typically, a sell-off in equities.

2016 had all the hallmarks of another potentially cruel summer, yet writing this commentary in the closing moments of July, the S&P US equity market stands at an all-time nominal high and the VIX (the best metric of risk elevation) at a 12-month low. It is almost as if Brexit never happened. Rather than the cruel summer, 2016 may end up being characterised as the Panglossian summer. For the unaware, Doctor Pangloss is one of the leading characters in Voltaire’s 1759 satire, Candide. Hence, the dictionary describes a Panglossian state as “one characterised by or given to extreme optimism, especially in the face of unrelieved hardship or adversity.”

Our contention is that we may well look back on the summer of 2016 as being the calm before the storm. Looking ahead through to the end of the year and investors will have, at the least, to contend with a US Presidential Election, an important vote on Italian constitutional reform and the UK’s first post-Brexit budget, not to mention any number of possible random acts of terrorism. Even if markets continue to show a sustained robustness in shrugging off perceived bad news (as has been the case year-to-date), it remains the case that the ideas of ‘all-time highs’ and ‘uncertainty’ don’t sit comfortably together as concepts. Thought of another way, it is rarely an attractive situation when many of the outperforming and expensive parts of the investment universe have only continued to get more expensive.

We have counselled caution in our commentaries for some time. In order to debate the notion of what can drive (equity) markets higher and to reinforce our conviction in our current stance, let us now assess the current landscape. Without wanting to spoil the subsequent paragraphs for readers, it doesn’t look too encouraging.

Valuation

Just as US equity markets are testing new highs, yields on 10-year US Treasuries are close to 50-year lows. For investors, it is like navigating between Scylla and Charybdis, a rock and a hard place. Take government debt first: how can this asset class be in a secular bull market when losses are guaranteed on some $11.7trillion of state-backed fixed income and $465billion of Investment-Grade paper, all now carrying negative yield? But are equities any more attractive? Well admittedly their yield is vastly superior to that offered by conventional fixed income (2.1% for the S&P and 2.6% for the MSCI World), but as Goldman Sachs eloquently highlights in a recent research note, on all valuation metrics, US equities are now trading close to the 90th percentile of their history over the last 40 years. In other words, rarely have equities been more expensive.

Perhaps this might not matter so much if there were sufficient earnings growth to drive equity multiples higher. While the current reporting season is not yet over, thus far c70% of US businesses have exceeded consensus expectations. However, despite this performance, earnings growth is still tracking -1% year-on-year, or +1% on the same basis were the energy sector to be excluded (source: JP Morgan). This is hardly what can be considered attractive or sufficient to prompt upgrades to current valuation levels. Herein lies a problem. Using IBES consensus data, developed world equities may see their price/earnings ratio drop from 17.3x for 2016 to 15.3x for 2017, but this assumes that corporates are able to post average earnings growth over the next 12 months of 13.3%. As our findings on the economy below might reinforce, this figure looks highly optimistic.

One final observation on valuation worth considering is the state of emerging markets. Equities markets across this region have outperformed their more developed peers year-to-date (currently standing at an 11-month relative high) and remain markedly less expensive. Using IBES estimates again, it would seem that a persuasive case could be made for further outperformance based simply on valuation alone. Investors here have the opportunity to pay a multiple of just 13.4x 2016 earnings or 11.7x for 2017.

The Economy

Even if we know that there is a close to zero correlation between GDP growth and the performance of many asset classes (particularly equities), the macro outlook still matters, both for gauging corporate demand patterns and for informing near- term sentiment. In summary, it is a mixed picture. The IMF captures this well, having cut its 2016 forecast again in July, now effectively assuming that the world economy grows no more quickly this year than it did in 2015.

The US stands out as a relative bright spot, even if the dynamics suggest that the current business cycle is moving into its later stages. Non-farm payrolls (employment growth) remain robust, although this is also creating upward wage pressure, with the latter rising 2.9% year-on-year in July. Moreover, the latest flash report on industrial production highlighted not only a ‘robust expansion of incoming new work’, but also input cost inflation at its strongest since November 2014.

Whether the US economy is strong enough to carry the rest of the world remains to be seen, particularly if the scenario of a Trump Presidency results in a significant shift in policy and business sentiment. We will be exploring this issue in more detail in a pending research note. Brexit perhaps provides a useful case study in this respect. The Deloitte UK CFO survey published a month after 23 June showed that the hiring intentions of Finance Directors stood at their lowest since 2007, with some 74% signalling that they plan to cut discretionary spending in the next 12 months. Meanwhile, 66 UK businesses warned on profits in the past quarter, the highest since 2008. Elsewhere, in Germany, the significant ZEW investor survey (of business investment intentions) showed its biggest-ever one-month drop in confidence post-Brexit. These are perhaps valid harbingers. Do not forget, the UK is Europe’s second-biggest and the world’s fifth-largest economy.

Fiscal and monetary stimulus

We have yet to mention the Japanese economy, where the government recently has again cut its 2016 GDP forecast to 0.9% (from 1.7% at the start of the year), exports have fallen for 9 consecutive months and wage growth is now negative for the first time in a year. Little wonder perhaps then that the government is contemplating fiscal stimulus. Japan remains the laboratory for financial experiments. And, if we have learned anything since the Great Financial Crisis, then it is that radical policy begets more radical policy, regardless of the longer-term consequences.

So, will fiscal policy provide the much-needed solution for absent economic growth, particularly when combined with ongoing monetary easing efforts? At this stage, it is hard to know, but we would express some caution, noting the following. First, there is a big difference between rhetoric and reality. Headline figures from newly announced stimulus programmes typically tend to contain some spend from already-existing programmes, which are just renamed in order to impress. Next, announcement and implementation are two very different things. Before actual spending can take place, plans generally need to be modified, then approved by parliamentary vote. This can take time. Even if Japan gets things going, the results could be several quarters away. Furthermore, it will be harder elsewhere. Regardless of who wins the US Presidency, he/she may still have to contend with a gridlocked Senate and Congress. Meanwhile, Europe lacks any form of coordinated mechanism on fiscal planning and policy effort may be arguably better spent on labour market and trade reform.

We conclude that it is hard to get excited about near-term prospects and prefer to remain defensively positioned.

Alexander Gunz, Fund Manager, Heptagon Capital