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: Heightened political uncertainty now joins the list of worries with which investors have to contend. Additionally, an ageing business cycle, stretched equity and fixed income valuation levels, and policy effectiveness at its limits create an exceptionally challenging investing environment. We do not expect this to change any time soon. We have been (rightly) prudent since at least the start of 2016 and continue to make the case for increasing allocations to uncorrelated alternative assets, favouring equity over fixed income elsewhere.

04 July 2016

Asset Allocation:
 Equities: Global equities are broadly flat year-to-date, despite no evidence of earnings upgrades. Yet this masks major disparities across regions and sectors. US markets continue to outperform despite valuation levels being well-above historical averages. Europe and Japan have underperformed despite offering better value. Our preference is for selected global managers and also for Emerging Markets (which have outperformed) where valuation looks most compelling.

 Fixed Income: Despite the out performance of conventional fixed income relative to equities, we continue to see limited merits in this asset class and favour only highly selective allocations. Some $11trillion of government debt now offers negative yield, implying guaranteed losses through to maturity. With Central Banks at their limits, it is also hard to see how much further yields can fall. Investment Grade and some High Yield look unattractive near-term as investors de-risk.

 Currencies: We have no active currency positions and expect the currency environment to remain highly volatile, as evidenced by the recent moves in all major crosses sparked by the UK’s Brexit decision. While the Dollar may strengthen as investors seek assets that constitute relative safety, the logic remains for all economies to seek weaker currencies.

 Alternative Asset Managers: With broader market uncertainties only growing, we actively continue to favour investments in uncorrelated strategies such as equity long-short investments, catastrophic reinsurance, infrastructure assets, direct lending and private equity. Although increasingly consensual, we also continue to see a logic in holding cash (as an asset class), preserving it for now to deploy for future opportunities later.

An extraordinary month

In what has been an extraordinary month from both a market and geopolitical point of view, context is always important. Perhaps more notable than the countless headlines relating to Brexit and the many potential future permutations that the UK’s relationship with the EU could assume, is what has been happening in equity and sovereign debt markets. As recently as 8 June, the S&P stood within 1% of its all-time nominal high. Meanwhile, in the same week, the yield on 10-year German Government debt turned negative for the first time ever, as did yields on 15-year Japanese debt and 30-year Swiss debt. These yields all remain in negative territory at the time of writing and yet, despite Brexit, global equities have also held up.

How to resolve this apparent contradiction? Logically, the case for owning sovereign debt (and hence an explanation for declining yields) is premised on growing risk aversion. However, as plausible as this may sound, the reality is that holders of this (negative yielding) debt are now guaranteed to lose money from here until the maturity of their outstanding bonds, at

least in nominal terms. On an inflation-adjusted basis, losses could be even higher. Yet this also explains the seemingly relentless progress in equities. In a world where interest rates are at record lows and Central Banks are buying large chunks of the bond market, the central dilemma for investors is to find yield in a world where uncertainties are only growing.

Such a conundrum helps explain the dangerous lurches from ‘risk-off’ to ‘risk-on’ mentality that increasingly seems to characterise markets. Our contention is simple: we have advocated the case for equities over fixed income for some time, mostly clearly from a valuation perspective. However, for investors in search of yield and genuinely uncorrelated assets, then it is again worth reiterating the case for private assets such as catastrophic insurance, direct lending and the like.

What’s changed?

Our previously outlined view is not a novel one and we have indeed been advocating such positioning for over a year. However, recent events have served only to reinforce our conviction in this respect. The most notable conclusion we draw from the UK’s apparent decision to leave the European Union is that markets have moved into a post-Central Bank phase. In other words, going forward, politics will likely play a more important role than previously in helping determine market direction. Easy (Central Bank-provided) money cannot, and will not, solve all problems. Indeed, the pursuit of such policy to the bounds of its conventional limits is no longer uniformly virtuous for all risk assets.

The growing institutionalisation of political risk speaks to a broader and more deep-seated disillusionment with established politicians. As such, another cruel summer for investors potentially lies ahead. At the least, there will remain for quite some time considerable uncertainty over how the UK’s negotiations with the European Union will evolve. It should not be forgotten that some 80,000 pages of trade agreement between these two blocs exist and hence any revision to these will be neither a quick nor a trivial matter.

Furthermore, there is now clearly a heightened probability of recession, or at least slower growth in both the UK and the Eurozone. The UK is the second largest economy within Europe and also the fifth biggest globally. Economists at Credit Suisse calculate that with around 17% of the Eurozone’s trade going to the UK, the impact to the continent’s GDP growth could be in the region of -0.5%. In addition a stronger US Dollar (the corollary of weaker Sterling, and to extent Euro too) is clearly unhelpful to the US economy. Against this background, it would clearly be naïve to assume that there will be no spillover effects from Brexit risk. We also note that despite the relatively sanguine moves in US volatility metrics (the VIX), European volatility (captured by the VDAX Index) has been on an upwards trajectory since June 2014, having more than doubled over this period.

What’s the problem?
The legacy of the Great Financial Crisis of 2008-9 continues to loom large. Ultimately, the problem remains one of too much debt and not enough evidence of either sustained economic growth or inflation. 2016 will mark the fifth consecutive year of global growth below its thirty-year average (according to Morgan Stanley). Global GDP assumptions continue to be pruned with the World Bank, for example, cutting its 2016 estimate from 2.9% in March to 2.4% in June, even prior to Brexit. Purchasing Manager Indices around the western world are at four-year lows. Inflation expectations also continue to mark new troughs. Meanwhile, challenged demographics in the west make escape velocity even harder.

Such a backdrop is now being compounded by the behaviour of Central Banks. Once the saviours, their credibility is now being increasingly challenged. As has become evident from the continued downward revisions to the Federal Reserve’s ‘dot’ projections for future interest rates, the institution has clearly been too optimistic on growth. Perhaps approaching things purely from an academic perspective (as the Fed does) constitutes a denial of reality. Yet, the Fed will never actually forecast a potential recessionary scenario since not only would this serve to damage their remaining credibility, but also, more practically, it would appear that they lack the necessary tools with which to fight a recession. And similarly, Governor Kuroda continues to talk of 2% inflation in Japan as being a realistic objective.

In fairness, it is perhaps hard to know what more Central Banks can do, especially with so much government debt now offering negative yields and with Japanese/ European equities – where policy experimentation has been most radical – having underperformed in the last year. Indeed, in Japan, all of the benefits of Yen depreciation since the Bank’s second round of quantitative easing have now been unwound, with the Yen back at October 2014 levels. More than 70% of Japanese corporates interviewed in a recent Reuters survey do not expect the country to escape from deflation in the foreseeable future. There are now seemingly diminishing returns attached to the pursuit of further unconventional monetary policy. The fall in sovereign yields and the descent of interest rates into sub-zero territory harms risk sentiment and creates a negative feedback loop with regard to high-street bank lending behaviour.

A western world that is possibly experiencing secular stagnation and where savers, borrowers and lenders are challenged is one characterised by frustration and also, potentially, anger. This hence explains the rise of the populist politician, a phenomenon being witnessed on both sides of the Atlantic. More concerning, the fact that the topic of immigration ranks higher than that of the economy (despite a mixed backdrop) gives important clues not just to voter intentions, but to the tools that the press and politicians use to motivate them. Be aware that in addition to the impending US Presidential Election in November, five Eurozone members (including Germany, France and Holland) hold elections in the next 18 months.

What needs to happen next?

For Europe, a period of calm and reflection is required, most likely resulting ultimately in some form of compromise between the UK and the Eurozone. Recall that a referendum in Britain is only consultative and not legally binding. Moreover, the country also currently lacks a leader with which to negotiate any future terms. There is a persuasive argument to suggest that the UK needs Europe as much as Europe needs the UK, both from a trade and a defence perspective. There are also other precedents for renegotiation and compromise, for example the Danish in 1992 (Maastricht Treaty) and the Irish in both 2001 and 2008 (Nice and Lisbon Treaties). Everyone in Europe also probably wants to stave off the risk of further popularism and potential disintegration of the post-1945 project. Keeping the UK in may help in this respect.

More broadly, there is a clear lesson for all policymakers to learn from the 1930s. For monetary policy to be truly effective, it needs to be combined with fiscal policy. The logic for fiscal stimulus only continues to grow, particularly as Central Banks reach their limits, the current cycle nears its end and large amounts of infrastructure are ageing. In a world looking for solutions other than just populist rhetoric (and where many significant elections are looming), this is certainly one worth considering.

Alexander Gunz, Fund Manager, Heptagon Capital