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: We approach the summer with investors in a cautious and uncertain mood. The memory of recent painful bumps on the road to recovery has left many without a clear path. We see multiple contradictions and concerns on the horizon, yet continue to wonder what will be the event that might finally burst the equity bubble. Our strategy is hence one of prudence, particularly with regard to equity market exposure and even more so with regard to conventional fixed income. The case for uncorrelated alternative assets only continues to grow.

Asset Allocation:
 Equities: Valuation levels and the outlook for earnings have made us turn less positive on equities. Meanwhile, longer-term lead indicators (such as default rates and M&A activity) also give us cause for concern. Unsurprisingly, perhaps, outflows are at five-year highs (according to BofAML). We prefer value over growth at this stage of the cycle and like emerging markets for the longer-term, although note that these equities could underperform if US rates rise near-term.

 Fixed Income: We see an even less compelling case for fixed income, particularly given recent out performance relative to equities and with some 25% of the bonds in the JP Morgan Government Bond Index now offering negative yields. We note that the last time spreads between US 2-year and 10-year Treasuries were at current levels was at the time of the 2008 financial crisis. Junk has also rallied despite growing default rates. We hence favour only very limited allocations.

 Currencies: We have no active currency positions and expect the currency environment to remain highly volatile, exacerbated by Central Bank policy action, potentially competitive devaluations and political activity. If, as seems likely, the US does move to a policy of interest rate normalisation, then expect a higher Dollar and corresponding EM pressure.

 Alternative Asset Managers: With broader market uncertainties 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. We also see a logic in building cash positions to preserve for future opportunities.

Investors are beset by many contradictions

One of the most profound indicators of the current broad antipathy and confusion that appears to be felt towards the investing environment is the high number of contradictions or confusing data points with which investors are forced to deal. We can think of at least five that we list below, all of which are necessarily interlinked:

• It feels as if equities continue their relentless march upwards. Yet in reality, they have done nothing in the last two years. The MSCI World has not made a new high since May 2015. Earnings estimates continue to fall, and are averaging down 10% year-on-year at present. Since the start of 2016, conventional fixed income has outperformed equities, despite over $10trillion of government debt in the developed world offering negative yield.
• Economic data around the world is decidedly mixed. Global industrial production is at its weakest in three years (according to Credit Suisse), yet consumer confidence in the world’s biggest economy (the US) is close to record levels. When there are good reported trends, investors cheer initially. However, as concerns over global recession risk recede, these worries tend to be replaced by fears of higher interest rates in the US, and hence also the negative consequences these may have on the developing world. This is a vicious circle dilemma from which there is no obvious escape.

• The negative interest rate policy (NIRP) implemented by the Bank of Japan and much of western Europe was supposed to be a growth stimulus, but currencies operating under some form of NIRP have strengthened rather than weakened. This may lead to further pursuit of such policy even if it is, seemingly, a drag on growth.
• There are growing signs of inflation in the US. However, there is little evidence of this trend elsewhere. The oil price appears also to have troughed (reaching $50 for the first time in a year, as surpluses come to an end). Such a move has positive implications for banks and their credit quality (if the risk of corporate defaults are now lower), but longer-term, a higher oil price is clearly inflationary. Set against this trend, much of the emerging world remains on a multi-year deleveraging cycle, which is long-term more deflationary in nature.
• Even if it remains hard to resolve the cross-currents of deflation relative to inflation, it seems clear that developed world monetary policy will continue to diverge. The Federal Reserve looks set on a tightening path (perhaps as early as this month), while the ECB and BOJ remains as committed as ever to the pursuit of unconventional policy.
• Market volatility is very low despite a horizon clouded by major political uncertainty. We note that the VIX volatility measure stands at 14.2, relative to a five-year average of 17.4. Before the end of the year, Britain will confirm whether or not it wishes to remain in Europe and the US will elect a new President. In addition, Spain and Australia hold elections, the Greek debt situation has yet to be fully resolved and the Middle East remains fraught with danger.

Bottom-line: there is little margin for error

This seems the obvious conclusion from the above and nowhere do we feel this is the case more than with regard to equities. We have been negative on conventional fixed income for over two years, turned more cautious on equities at the start of 2016 and have been making the increasingly vocal case for growing allocations to alternative investments since then. Now consider the following four observations, particularly in the context of an ageing economics/earnings cycle:

• Valuation is elevated: US equities (which comprise c60% of global equities – a record in itself) have gone seven years without a bear market. This is the second longest in recent history. Correspondingly, valuations are among their highest in recent times. The Shiller price-earnings multiple for the S&P of 26x is 30% above its post-War median, while on a price-to-sales metrics, US levels are at all-time highs. In mitigation, valuations in other markets are less demanding.
• Corporate sales and earnings are declining: During the first quarter, reported earnings were down 8% year-on-year in the US, 12% in Europe and 23% in Japan (according to JP Morgan). Moreover, two-thirds of S&P companies that issued guidance in April for their forthcoming reported quarter lowered their outlook. Even if estimates are now stabilising, the beneficial effect of a weaker Dollar may only be temporary, while fundamentals look more challenged. Elsewhere, in Europe, 10-year rolling annual earnings growth has now turned negative for the first time since 2011 (based on data from Goldman Sachs), while Japanese earnings growth is at its worst in four years.
• Corporate defaults are rising at their fastest pace since 2009: More than 70 businesses have defaulted year-to-date, according to S&P, which compares to a total of 113 defaults last year. Indeed, the 12-month trailing default rate of 3.9% is close to its long-term average of 4.0%. We also note that this trend may accelerate given that the Federal Reserve’s Senior Loan Officer Survey has pointed clearly to tightening in its last three surveys. This is negative both for the health of challenged corporates, but also since trends here typically serve as around a one-year lead indicator for corporate profitability.
• Deals are declining: M&A activity often also precedes equity market trends and the number of deals has fallen off recently. Global M&A is down 12% year-to-date, and in the US, it has fallen more than 22% since the start of 2016 (according to Berenberg Bank). The number of deals pulled stands at its highest since 2007.

Central Banks are no longer helping in this upside-down world of monetary policy

We live in a world where borrowers are getting paid and savers penalised. Around 500m people in a quarter of the world economy now reside in countries where interest rates measure less than zero. Danish citizens are receiving interest on some mortgage products, Swiss residents in certain cantons are being told not to pay tax, and Tokyo-based safe manufacturer, Eiko, says its shipments have doubled in the last year. The bizarre and unintended consequence of NIRP is that those currencies operating under such a regime have strengthened rather than weakened. Nonetheless, the ECB and BOJ may end up going further into negative territory, based on recent policy comments and the fact that inflation remains resolutely stuck in negative or close-to-negative territory in both these regions.

Now contrast this situation with that of the Federal Reserve, where the default position of officials is that investors should assume two or three further hikes as possible this year. The next may come as early as June or July. It is probably up to the data (or events, such as possible Brexit) to prevent this from happening. Regardless of timing, the reality is that core CPI inflation is now averaging 3.0% in the US on a 3-month rolling annualised basis, while unemployment is at 5.0% relative to the Fed’s ‘natural’ rate of 4.8%. Meanwhile, job openings are at record highs and the quit-rate is above pre-recession levels. What are the implications? Well, if US rates do rise, then this probably means a higher US Dollar, and pressure on emerging markets and commodity markets, an effective rerun of the market tumult investors experienced not so long ago.

Where does it all end?

It is hard to know, but at least, we will leave investors with two plausible scenarios to consider:

• There is some logic in Central Banks seeking to induce a mild recession in order to normalise policy and purge previous excesses. However, this seems unlikely, particularly since there is currently such wide Central Bank divergence. More likely, the pursuit of the unconventional will continue, at least until there is a more significant collapse in the financial system. We note how calls for ‘helicopter money’ or OMF (a new on-trend acronym, for ‘Overt Monetary Finance’) continue to grow in various quarters. However, investors should be mindful that the President of the Reichsbank at the time of Germany’s hyper-inflation (Rudolph von Havenstein) reportedly justified his policy of continued money printing by asserting that “to not done so would have been even worse.”
• Alternatively, given the growing loss of Central Bank credibility and their seeming in ability to weaken their currencies, expect fiscal policy to play a more active role in driving the economy. Both the IMF and the OECD have discussed vocally the case for more state expenditure and an argument can certainly be made that fiscal stimulus is needed in order to bridge the gap from the last debt cycle. McKinsey, for example, says that the G20 needs to spend $60trillion on infrastructure over the next 15 years. China and Canada have already publicly committed to new such projects and the topic is receiving increasing discussion in Japan, France, Australia, and the UK. It also seems to accord well with populists such as the presumptive Republican Presidential candidate, Donald Trump. Welcome to the uncertain summer.

Alexander Gunz, Fund Manager, Heptagon Capital