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: no major asset class has been spared in the market tumult witnessed since the start of the year. Volatility has also risen notably. Many factors concern us, ranging from still-elevated investor expectations to the vicious circle of energy/commodity weakness and Dollar strength. Furthermore, we believe things can get notably worse, in terms of the global economic outlook, the risk to consensus earnings estimates for equities and further widening in credit spreads in particular. Yet there are solutions. Our approach has been to reduce risk by raising cash and to increase diversification, by investing into truly uncorrelated asset classes.

Asset Allocation:
 Equities: Even after the worst start to a year for global equities since 2009, we believe risks remain weighted on the downside, particularly as the current business cycle is showing increasing signs of maturity and consensus estimates are being downgraded globally. Truly active managers investing in high-quality businesses with robust balance sheets and strong cashflow-generating abilities should be able to prosper on a relative basis in the current environment. Regionally, Europe and Japan both look more attractive than the US from a valuation perspective. Emerging markets may represent a longer-term opportunity, as trends begin to stabilise and with valuations now back at 1998 levels.

 Fixed Income: A more cautious general outlook may suggest there are merits in this asset class. However, we note that yields on government bonds in Europe and Japan are negative as far out as seven years’ at present and may trend lower still. Elsewhere, investment grade and high yield debt are under pressure given leverage concerns and hence widening spreads. We therefore favour only very limited allocations, preferably via active and unconstrained strategies.

 Currencies: Central Banks everywhere continue to pursue unconventional policies in an effort to drive growth and influence their currencies. At present, it also looks increasingly less likely that the Federal Reserve will raise rates. This could lead to near-term Dollar weakness and necessary mean reversion, although this trend may not be sustainable.

 Alternative Asset Managers: With broader market uncertainties growing, our conviction in genuinely uncorrelated assets such as catastrophic reinsurance, infrastructure assets, direct-lending products and private equity continues to grow. We also currently advocate the merits of holding some cash and considering this an asset class.

After a start to the year that few investors either foresaw or desired, sentiment is inevitably fragile. The important question to ask is whether such price action (in which few asset classes were spared) constitutes merely a necessary reset of expectations or, more worryingly, a sign of things to come. Our strategy has always been one of rational analysis, seeking and hence also counselling, not to panic. To arrive at a view regarding the above, we believe it is important to address three key and necessarily interlinked matters: what concerns us; how bad can it get; and what might be the solutions?

What concerns us?
Unrealistic expectations, the unsettled scores of the last financial crisis and a maturing economic cycle comprise an unappealing cocktail for investors. Take expectations first, and the context of 15% annualised returns for global equities (and also double-digit returns for US high yield over the same period) since the end of the financial crisis have led some to assume that such returns can continue to be generated going forward. This view has partly been sustained by the erroneous belief that Central Banks have gained the power to eliminate economic cycles, but also ignores the force of history which shows that over long periods such returns are in fact the exception rather than the norm.

Moreover, the problems that led to such unprecedented intervention in the first place have simply not gone away. Indeed, the amount of global debt outstanding is now 2.5 times higher than it was prior to the financial crisis (according to McKinsey). As is well-known, the burden of debt can only be alleviated by three factors: growth, inflation or defaults. Our concern is that there is not enough evidence of any of these at present. Rather than growth, there is deterioration; rather than inflation, there is deflation. What about defaults? The world is necessarily more interconnected than it has ever been in the past and experience tends to suggest that events which are global in nature are inherently more problematic than single-country issues. Declining energy and commodity prices, excess emerging market capacity and a strong US Dollar have combined to create a highly vicious circle from which there currently seems no obvious way out.

For signs of concern, simply look to the credit market. In the emerging world, credit spreads are at their widest since 2009 (per the JP Morgan Emerging Market Bond Index), while Chinese credit spreads are at an all-time high (measured by the differential between BBB and AAA corporate debt, according to Credit Suisse). Meanwhile, in the US, the spread between the yield on US 10-year Treasuries and Investment Grade debt currently stands at over 200 basis points, a level only previously reached in 2008 – at the peak of the financial crisis – and 2011, when US debt was downgraded for the first time in its history. Not only are problems restricted to the energy sector (where the yield on the Bank of America Merrill Lynch energy high yield index is at its highest since creation, currently standing at 19.3%), but increasingly, are spreading across the market. The ratio of S&P credit ratings downgrades relative to upgrades is at its highest since 2009. Everywhere, corporates’ balance sheets have been weakened by the curse of cheap money which has driven M&A and share buy-backs.

How bad can it get?
History suggests to us that contagion will continue to spread until proven otherwise. This is an issue both for the global economy and for the approach investors need to take with regard to their asset allocation decisions. Credit market stress in emerging markets has already begun to manifest itself in developed markets, just as the spillover effects of a slowing Chinese economy are already being felt in the West. China accounts for around 25% of global capital expenditure, but just 15% of global GDP (according to Credit Suisse). Therefore, as China slows and also weakens its currency to avert such a slowdown, it effectively exports its excess capacity and hence deflation.

The impact of such action can be seen already. In the US, much of the industrial economy is already in technical recession, based on falling ISM figures and weakening durable goods orders. As a useful proxy, US railroad operators’ volumes are down over 8% year-on-year. While the US (and global) consumer still looks to be in good health, helped by a combination of low fuel prices, increasing wages and appreciating house prices, this may not continue forever, particularly if the overall macroeconomic backdrop continues to deteriorate.

Furthermore, it remains fair to concede that the outlook on Main Street looks considerably more attractive than that facing Wall Street. Corporate profit margins stand at record levels (7.3% for the S&P against a 5.8% median, according to Morgan Stanley) just as the business cycle is maturing (now at 79 months old versus a median length of 37 months) at the same time as credit quality is deteriorating and currency headwinds are mounting.

In other words, earnings estimates still need to fall. In a sobering piece of analysis by JP Morgan, the investment bank calculates that consensus estimates for the S&P have only fallen around 3% from their recent peak. By contrast, in a typical recession – we are not there yet, but as noted, the probability of such an outcome is mounting – earnings fall some 22% from peak-to-trough. Put another way, the equity market is not yet pricing adequately the risk of a slowdown. Admittedly, the outcome for earnings does not appear so bad in Europe and Japan, but in both these regions, consensus estimates have also fallen since the start of the year. Every region globally is seeing earnings downgrades at present.

One final consideration is the risk of what are increasingly being referred to as ‘grey swan’ events. These relate to outcomes that can be anticipated to a certain extent, are thought of as unlikely, but were they to occur, would have a sizeable adverse impact. The list looking forward for the remainder of 2016 appears somewhat concerning, comprising (but not limited to): a miscalculation by the Chinese in their currency policy actions; an escalation in Middle Eastern instability; a relapse of financial crisis in Greece; a refugee catastrophe in Europe; a British exit from the Eurozone; a Trump Presidency; a new Cold War between Russia and the West potentially prompted by cyber-security concerns; and growing protectionism, driven by further currency depreciations. With sentiment already febrile, any such event could prompt further pressure on both the economy and asset classes.

What might be the solutions?
In order for confidence to return to equity markets, several things need to happen. First, consensus earnings estimates need to stabilise, although as noted earlier, this seems quite some way off. Next, there needs to be some form of stabilisation or normalisation in the commodity and energy sectors which would, in turn, potentially permit for a similar effect to play out in China and across emerging markets. Finally, even if their ability to shock and awe is less than was the case historically, Central Banks still have a valid role to play. Their role, as much as anything is to remain credible and provide reassurance. The Federal Reserve stands committed to its ‘data-dependence’ rhetoric; Mario Draghi at the ECB has said his organisation has the ‘power, willingness and determination’ to act; and Haruhiko Kuroda has said he will ‘do what it takes’, evidenced most recently by the Bank of Japan’s move to negative interest rates.

For investors, the corollary of all of the above is to diversify, particularly into less liquid, private market assets. Indeed, it is a fair question to ask: why take undue risks, seven years’ into an equity bull market? We note that the mindset of equity investors seems to have shifted from ‘buying on dips’ to ‘selling on rallies’ (and it is also remarkable to note that a number of leading investment banks including Credit Suisse and JP Morgan have advocated such a strategy in a recent research piece to its clients). Beyond true diversification (catastrophic reassurance, direct-lending, infrastructure assets etc.), we conclude on a more optimistic note: out of every crisis arises opportunities. For the very long-term investor, it may be soon time to consider the merits of the likes of emerging markets or energy assets.

Alexander Gunz, Fund Manager, Heptagon Capital