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: 2016 will provide at least as many challenges for investors as 2015. The debates over valuations, the outlook for rates and for growth, and the ramifications of a deteriorating credit market remain finely balanced. However, at the least, it seems fair to say that late-cycle risks are growing while credit pressures signal the rising chance of a recession. Against this background, we see logic in raising cash and reducing somewhat equity exposure. Opportunities clearly do exist, especially for active equity managers (globally, but particularly in Europe and Japan). We also see a strong case for alternative, non-correlated asset classes.
Asset Allocation: Equities: Our concerns are threefold, centred on valuation, downward margin pressures and the maturity of the current cycle. All are interlinked and mutually reinforcing. Moreover, seven years into a global/ US bull-market, it seems reasonable to assume both volatility and risk dispersion will increase. This implies a strong case for active managers, with alpha up and beta down. 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.
Fixed Income: Although the risk-reward profile for equities looks more challenging than in recent years, risks within credit also seem weighted to the downside. Investment grade and high yield debt are under pressure given leverage concerns and hence widening spreads. Meanwhile, even if US government yields are beginning to steepen at the front- end, yields can still trend lower in Europe and elsewhere. We therefore favour only very limited allocations, preferably via active and unconstrained strategies.
Currencies: Further US Dollar appreciation is currently a highly consensual trade, but needs to be seen in the context of the 2015 move in the Dollar Index being the biggest witnessed for 25 years. A shift of a similar magnitude looks unlikely in 2016. Even if there are good reasons for further Dollar strength, expect also periods of mean reversion.
Alternative Asset Managers: With broader market uncertainties growing, we continue to favour investments in genuinely uncorrelated assets such as catastrophic reinsurance, infrastructure assets (such as energy) and private equity.
2015 was a muted year for returns across almost all major asset classes and 2016 may be similar or worse. This has clear implications for asset allocation strategies. Nonetheless context also matters. Investors should not forget that US equities have delivered 15% annualised returns including dividends during the nine-year period during which the Fed abstained from raising rates while pumping around $4trillion into the financial system via quantitative easing. Comparable annualised returns from US High Yield have been 15%, 7% for Investment Grade and 2.6% for US Treasuries (according to Morgan Stanley). Thought of another way, global equities have outperformed global government bonds by a factor of seven since the end of the financial crisis.
Against this background, it seems clear that the risk-reward profile for equities looks less compelling than in previous years. Moreover, a combination of higher (US) interest rates and reduced liquidity (less aggregate quantitative easing globally) may mean generally lower returns across the board. It seems hard, therefore, to believe that 2016 will not be at least as challenging a year for investors as the one just passed. Furthermore, the trend of divergence viewed in terms of growth, monetary policy and most pertinently relative performance looks set to endure.
Part of the problem for investors is that all the key debates are not only inextricably interlinked, but also that the arguments underpinning them seem finely balanced. Clarity is absent just when investors require it the most. Below follow our key insights into what appear to be the most relevant points of current contention. These help inform our asset allocation decisions:
As we have written on many previous occasions, this consideration trumps almost all others with regard to asset allocation decisions. With multiple-century lows in government bond yields, the decision on whether to invest in conventional equities or credits has been a relatively easy one. However, after seven years’ of rising equity markets – which, additionally, have been driven more by multiple than earnings expansion – the debate is becoming more challenging. Furthermore, US equities comprise almost 60% of the MSCI World Index, and so what happens in the US has clear implications for all investors.
Our primary concern is that profit margins in the US appear to have peaked and could remain under pressure. This has obvious ramifications for earnings and hence for valuations. It seems hard to believe that margins can continue to progress when both US wages and the US Dollar are rising. Wages are rising at 2.3% year-on-year in the US at present and the last Beige Book points to higher labour market pressures than at comparable stages of other previous cycles. More importantly, a strong Dollar, combined with a weaker Chinese currency is fundamentally negative for US profitability.
The Yuan-Dollar exchange rate currently stands at a four-year low. This is arguably the most important rate to monitor. This dynamic negatively impacts US profit margins in general, US exporters in particular and is also inherently deflationary. Whereas China historically consumed a significant portion of what it produced domestically, this is no longer the case. Chinese companies across a variety of industries are now competing aggressively on price in global markets. Factory-gate prices have fallen for 45 consecutive months in China. Even if margins and valuation levels do not appear as extended in regions other than the US (such as Japan and Europe), we see global risks as weighted to the downside.
Historically, when the Federal Reserve has raised interest rates, this has – at the least – provoked a mid-cycle correction in equities. Furthermore, never have US rates initially gone up so late in a profit cycle when the Dollar has been so strong, oil so weak and credit spreads so wide. While the Federal Reserve says that its future policy will remain data-dependent, not only do its projections (‘dots’) suggest a relatively more hawkish outcome than investors are willing to discount, but also most tend to under-estimate the pace at which rates do rise from initial lift-off levels. The pending US Presidential Election also introduces further complexity into the equation.
Admittedly, this cycle is clearly different to previous ones given the depth of the crisis that preceded it. However, the Fed faces two main challenges. First, in contrast to the ‘Bernanke put’ of the recent past, the new normal resembles more a
‘Yellen call’ where ‘good’ economic news increases the likelihood of future rate rises. By contrast, yet equally as problematic, should the Fed be forced to reverse its path of rate rises in the face of adverse economic data, then this could pose a major blow to its credibility. Indeed, credibility is perhaps the biggest issue facing Central Banks globally. Even if the European Central Bank and the Bank of Japan are continuing to buy cumulatively $120bn of bonds every month, the limits of monetary policy and its effectiveness are being increasingly called into question. Actions matter more than words.
A combination of peaking profit margins, deflationary pressures and incrementally tighter monetary policy does not seem naturally conducive to global economic growth. Beyond developed world problems (US industrial production at its lowest in three years with non-manufacturing ISM data also pointing to decline), what happens in China clearly matters. China has accounted for c40% of global GDP in the last five years, according to Credit Suisse. It seems difficult to believe that the country will be able to deliver a comparable contribution over the next five years in the face of an economy in transition. Even if recent data points suggest some relative stabilisation in the Chinese economy, official industrial production figures stand at three-year lows, while bubbles remain within both property and credit.
On the positive side, not only can investors draw some comfort from ongoing monetary stimulus in both developed (Europe, Japan) and emerging (China, India, South Korea) markets, but also from likely easier fiscal policy across the globe, in Australia, Canada, China, the Eurozone, Japan and the US. In addition, the fact that the oil price has fallen by some 30% in the last year should have positive lag impact on economic growth over the coming six-twelve months. However, whether these benefits prove sufficient to offset the other headwinds previously characterised remains to be seen. Additionally, weaker oil has also had negative unintended consequences elsewhere.
With over $2.2trillion of junk bonds issued in the last seven years and the Bank of America Merrill Lynch high yield index at its lowest since March 2009, there are good reasons to be concerned about credit. Much of the issuance and recent underperformance has been localised in the energy, metals and mining sectors, with these three comprising close to one- third of the index. A c3% default rate in these sectors also notably contrasts with a sub-1% rate across the broader universe.
However, what starts/ has started in energy may spread elsewhere. History tends to suggest that contagion will continue until proven otherwise. We note that there has been a 70%+ increase in the number of bonds on which S&P cut its ratings in 2015 relative to 2014 across the broader market. Meanwhile, many commentaries suggest that overall market liquidity is beginning to dry up. Widening credit spreads are indicative as a warning sign, a necessary but not a sufficient condition for a potential bear market in equities.
At the least, it seems fair to highlight that late-cycle risks are growing (especially given high valuations and decelerating earnings), while credit pressures also signal the rising chances of a recession.
Alexander Gunz, Fund Manager, Heptagon Capital
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