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: Forecasting not just outcomes but also causality has become a lot harder. The extreme moves in all main asset classes in the last month provide evidence for such an assertion and also represent a sign of things to come. Politics has, and will continue to be, a central driver of all asset returns. Clear shifts from left- to-right policies, but also from monetary-to-fiscal expansion tools are underway. The success or otherwise of these experiments will not be known for some time. Moreover, their likely by-product – inflation – will be far from linear. Therefore, when in doubt, focus on two things only: buying assets that are inexpensive and/or uncorrelated.

Asset Allocation:

• Equities: Valuation considerations mean that we favour equities over fixed income in general terms and emerging markets over developed markets. Nonetheless, we continue to see undervalued stocks/ sectors in all geographies. The prospect of higher rates should mean lower correlations, more dispersion and greater alpha opportunities in general. Our strongest conviction is for emerging markets followed by Japan and Europe, with US equities looking least attractive.

• Fixed Income: Over $1.5trillion of value has been eroded from developed world bonds in the past month. The abruptness of this move does argue for some potential mean reversion in the very near-term, but the reality remains that some $10trillion of debt continues to offer negative yield today. The magnitude of guaranteed losses on this debt would also be exacerbated should inflation return. For this reason, we generally continue to avoid fixed income allocations.

• Currencies: Divergence in monetary policy should drive developed world currency movements. Even with the Dollar at a 13-year high it may strengthen further, while the Euro may drift towards parity owing to political uncertainties in the region. Emerging market currencies have suffered from ‘Trump-tantrum’, but offer clear long-term value in our view.
• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies and private asset classes in particular. Within this universe, we consider allocations to catastrophic reinsurance, infrastructure assets, direct lending and niche private equity to be attractive.

The year of the unexpected

Few would have imagined that in a year when the UK voted to leave the European Union and Donald Trump was elected as US President that all four major American equity indices (the Dow Jones, S&P, NASDAQ and Russell 2000) would make nominal highs while the VIX index of volatility would be trading some 30% lower than its 1 January level. However, historians and statisticians would do well to note that in the two years subsequent to the last time such an auspicious moment of new record levels in equity markets occurred, the indices all dropped, by between 21% and 65%.

Meanwhile, in fixed income, the rate at which the yield on US 10-year government debt has moved in the last month (albeit from a low base) constitutes the biggest move witnessed in the last 25 years. Conventional fixed income may have been overvalued for some time and equities may be a relatively more attractive option. From our perspective, however, it remains crucial to focus on the bigger-picture. We see challenging times ahead and counsel two things: first, don’t trust opinion polls or forecasters; and next, when in doubt, return to fundamentals and focus on valuation above all else.

Politics does matter and it’s not all about Trump; look to Europe now…
It has been our contention for some time that politics will be an important driver of all asset returns. The real battle for investors in 2017 is going to be over the soul, or the future of Europe; Brexit and Trump should perhaps be seen as mere skirmishes ahead of the potentially seismic events to come. However shocking (politically, economically, morally) either the events of 23 June or 8 November may have been, the reality is that life will go on. A full and formal UK divorce with Europe may not even happen, while Trump will likely moderate much of his rhetoric when in office. Furthermore, both the UK and the US are independent economies with their own Central Banks and currencies; Italy and France are not.

By the time some may be reading this, Italy will have voted in its 4 December referendum on constitutional reform. Should the vote go against incumbent Prime Minister Matteo Renzi, he may well step down and an election be called in time. Bear in mind that the three major Italian opposition parties (The Five-Star Movement, Forza Italia and Liga Nord) all explicitly favour leaving the Eurozone and abandoning the Euro. Likewise, Marine Le Pen has said that were she to win the French Presidency next May, then she would likely instigate moves to leave Europe. Elections in the Netherlands in March may also see anti-European parties increase their grip on parliament.

After the events of recent months, investors would be brave to discount the impossibility of any of the above scenarios coming to pass. If there has been one political lesson learned in 2016, then it is that parties do not have to be in power to shape the debate. Populism is a good strategy for politicians; whether so for the broader investment universe is less clear. We are forced to wonder in the event of newly installed European politicians setting in train moves for a return to their pre-Euro currencies, whether Angela Merkel (who herself faces an election in October) would be willing to push onward towards full European monetary and fiscal union. Moreover, even if Mario Draghi’s ECB has been able to fend-off market attacks on the Euro, it is powerless to prevent an erosion of political support for the Eurozone.

Donald Trump: hype, and then reality
Based on the reaction of the markets, investors appear to be giving Trump the benefit of the doubt. In doing so, they are of course dismissing many of the reasons why the prospect of a Trump Presidency elicited so much consternation in the first place – namely, political inexperience, foreign policy risk and trade/immigration policies that may be harmful to GDP . Investors starved of growth and fed up with Central Banks being the only game in town have latched onto the prospect of a major reset, an abandonment of Obama’s/ the Fed’s cautious incrementalism and the return of economic expansion.

However, what all the excitement about the prospect of reflation seems to dismiss are the twin threats of debt (there is a lot) and demographics (which are very negative). Both these trends are inherently deflationary. It also won’t be easy for Trump. The playbook that worked so well for Ronald Reagan in 1980 simply isn’t relevant as a comparison today. Indeed, Donald Trump enters the White House with America’s government debt/GDP ratio more than 2.5 times higher than was the case 36 years’ ago, while unemployment is around 2 times lower now. The Republican party has also tended to be fiscally more conservative than the Democrats. It may therefore be harder to implement in practice what has been promised.

There are also many apparent flaws and contradictions for investors to consider. For sure, we have argued for some time that government debt has been overvalued and that yields should clearly move higher over time, but there are good arguments for expecting yields to reverse in the near-term. This belief is not based simply on the magnitude of the recent move (equivalent to 2 standard deviations), but also should either US growth disappoint or there be delays to Trump policy implementation – both far from inconceivable – then yields may drift lower again. Moreover, there is also logic for the Dollar to weaken; it increases export competitiveness and would allow Trump to negotiate better trade deals.

Expansions don’t die of old age; but from unbalanced excesses

We see much evidence to suggest that the current cycle is getting to an increasingly advanced, or late stage. This is less about its length, but more based on the growing evidence we see for imbalances building. Recessions are necessarily needed to purge such excesses. The big question is not whether the Federal Reserve raises rates on 14 December, but how quickly rates need to rise (or its ‘dot’ projections for rates in the future move upwards) going forward.

Even in the absence of fiscal stimulus, current wage growth (as measured by the Atlanta Fed) is running at 4.2% annualised in the US. Inflation expectations are also rising. The 5-year forward break-even inflation rate is currently at 1.9%, up from 1.6% a month ago. In Europe, it is moving higher too. Inflation (whether actual or just its prospect) has clear ramifications and exacerbates imbalances. Peak profit margins may be eroded by upward wage pressure; tightening rates have a clear negative impact on bond yields; and higher bond yields are by no means an unambiguous positive for equities, given an implied higher cost of capital and already-elevated valuation levels.

When in doubt, look to valuation

Perhaps the starkest difference between the impending Trump-era and that of Reagan can be found when considering the Shiller (long-term) price-to-earnings ratio of the US equity market. In 1980, the S&P traded on a Shiller P/E of 6.5x; today it is 27x, four times higher. In other words, it is hard to explain why US equities should rerate to meaningfully higher than current levels, even if they do remain more attractive for now than government bonds. When it comes to equity investing, we see better value in almost every region other than the US. Europe is inexpensive, but beset with near-term political risk as previously characterised; Japan also trades below the US on all key valuation metrics and is making tangible progress in implementing supply-side reforms and improving corporate governance; but, it is in emerging markets where we have strongest current conviction.

The ‘Trump tantrum’ has pushed US bond yields and the Dollar up, and correspondingly emerging markets down. However, as outlined previously, prospects for both Treasuries and the US currency are significantly more complex. What reassures us more are not just the positive arguments about longer-term demographics and growth prospects, but valuation. The MSCI Emerging Markets Index trades at more than a 20% discount to its Developed World analogue on metrics of both price-earnings and price-to-book. Many countries trade on Shiller P/E’s of 10x or lower. In a world of uncertainty, a focus on valuation (and an approach that advocates investing in uncorrelated assets) provides a path to navigate.

Alexander Gunz, Fund Manager, Heptagon Capital