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 appear to be entering a precarious stage in the current cycle with few, if any parallels. Sentiment remains fundamentally cautious and it is seems hard to find obvious sources of upside. The current investing environment will likely continue to be characterised by large and volatile moves in both directions. Yet we believe it is possible to remain constructive in terms of asset allocation, favouring truly active managers within conventional assets classes (equities) and increasing allocations towards alternative and uncorrelated assets.
Asset Allocation: Equities: Although declining global earnings momentum could continue to pressure equities, truly active managers should prosper in an environment which has a notable reversal in sector trends from 2015. Out-of-favour sectors such as utilities and telecoms have outpaced more consensual longs in financials and healthcare. As the long-US Dollar trade continues to unwind, this may play to the benefit of emerging market equities.
Fixed Income: More than 25% of the bonds in the JPMorgan Government Bond Index now have negative yields, constituting a relatively unattractive investment in our view. Yields may also go more negative as Central Banks reach the limits of their policy effectiveness. With investment grade and high yield debt under pressure given leverage concerns and hence widening spreads, we favour only very limited allocations within the credit space, preferably via active and unconstrained strategies.
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. The unwinding of long Dollar positions may persist and further slowing economic growth in the US would also weaken the Dollar.
Alternative Asset Managers: With broader market uncertainties growing, we 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.
Arguably the most significant event of the last month was that the yield on 10-year Japanese Government bonds turned negative for the first time ever. Meanwhile, the Japanese Yen rose by 7.1% (against the US Dollar) in February, its biggest monthly gain since October 2008. These movements matter since, in many ways, Japan is the laboratory for the rest of the world in terms of economic policy. What happens here may be a precursor to developments elsewhere. Already, it seems highly counter-intuitive that across most of the developed world investors are currently paying governments to hold their money. We regard the recent price action in Japan across all asset classes as being one of many reasons for approaching investment decisions with caution at present. We consider below not only the background for such caution, but also what needs to occur in order to avert an even more cautious positioning.
There are, in our view, five interlinked and hence mutually reinforcing reasons for investor nervousness at present. Without doubt, the most significant is the growing loss of Central Bank credibility and the related realisation that the limits of unconventional policy action may have been reached. This issue compounds the next three: that global economic metrics continue to soften while much of the world is in a corporate earnings recession just as conditions in financial markets are tightening further. The obvious concern cited is that if Central Banks can’t solve these aforementioned problems, then who can? If they can’t be solved, axiomatically, they may worsen. Finally, evidence of growing political risks (from possible Trump Presidency and Brexit to the emerging scenario of trade wars) creates an additional level of uncertainty.
To return to the initial source of concern, investors seem (finally) to be waking up to the fact that too much faith has been placed in Central Banks, hence the mistaken belief that they have been able to abolish economic cycles. Markets, clearly, cannot survive on the ammunition of Central Banks alone; the underlying economy of consumers and corporates needs to be able to deliver. Moreover, cycles are not a bad thing: they bring pain, but pain generally brings necessary change.
Despite $12.3 trillion of asset purchases and 637 interest rate cuts around the world since the start of the Global Financial Crisis (data courtesy of Berenberg Bank), no Central Bank globally has achieved either its inflation or growth target established during this time period. Indeed, the latest University of Michigan Survey shows that Americans expect inflation of just 2.4% by the end of this decade, the lowest such expectation five years’ out since 1979. Across the world, Central Banks have also continued to scale back their own near-term targets. Perhaps it is time for Central Banks to admit that they are wrong? Although maybe they don’t need to, since this job has already been performed by Mr Market.
Both Japan and the US provide compelling evidence for such an assertion. But, first a word on negative interest rates: the theory behind them is illogical. Weaker growth would naturally prompt Central Banks to consider a move in this direction. Such a move does, however, put pressure on commercial banks’ net interest margins, which contract. This, in turn, undermines banks’ profits and retained earnings. Banks, therefore, become more risk averse and less willing to lend. Hence, growth weakens and we are back where we started. Put another way, after several decades of interest rates set at zero in Japan, how likely is it that a move to negative rates will really move the needle; or, to what level do rates need to fall in order for there to be growth in the real economy?
Things don’t look good for Japan. GDP has been negative in 5 of the last 12 quarters, exports are at their weakest since 2009, debt to GDP stands at 260% and the Bank of Japan says that 2% inflation won’t be reached until at least mid-2017. If, as cannot be totally ruled out, Japan resumes its deflationary spiral, then this would not only finish off Abenomics but also reinforce global deflationary trends while diminishing (further) the credibility of Central Banks globally. That Japanese Government Bond yields have plunged and the Yen has rallied already constitutes a clear repudiation by the market of Abenomics. A similar story can be seen in the US. The Federal Reserve is currently forecasting a 3.25% interest rate by the end of 2018. Yet the market is discounting a rate of just 1.00% by this time frame and is attributing less than a 50% probability even to another rate hike over the next six months. The concern can, arguably, be levelled at the Fed that it has lost control of the yield curve, an outcome which has clear negative ramifications for investors.
We are now at a crossroads. Either the risks of recession continue grow or someone (Central Banks, Governments) needs to do something to avert such an outcome. And, recession risks are certainly growing. Manufacturing activity (as measured by Purchasing Manager surveys) remains – for now – in positive territory, but has fallen since the start of 2016, with the pace of deceleration quickening in many regions. Consumers are also becoming increasingly gloomy. US consumer confidence has fallen for seven consecutive months, while confidence within the Eurozone is at its lowest since December 2014. In what seems to be a clear sign of caution, consumers do not appear to be reinvesting the benefits accruing from a weaker oil price. Indeed, the US savings rate has moved from its most recent trough of 1.9% in 2005 to a current level of 5.5%. Such a trend undermines overall economic growth. Economies across all of the developed world are currently recording growth rates below long-term trend levels for the first time since 2012, with US trend growth at its weakest since 2009 (according to Goldman Sachs).
Weaker growth trends are already manifesting themselves in corporate data too. Even if manufacturing (where current pressures seem most pronounced) accounts for just 12% of US GDP, manufacturing companies account for c60% of the Dollar profits reported by the S&P (based on Bloomberg data). It is, therefore, not surprising that negative guidance from S&P corporates has exceeded positive guidance by a ratio of 6-to-1 for the quarter ahead, more than double the typical ratio. In Europe, downgrades to consensus earnings estimates are occurring at a pace last witnessed in 2009 (both statistics courtesy of Morgan Stanley). Without an improvement in global growth, sales trends at corporates are unlikely to improve markedly, while margin improvement measures are becoming increasingly exhausted.
Finally, it is evident from a range of indicators (especially within the high yield market) that global financial conditions continue to tighten. Even if commodity prices have not recently marked fresh lows, the entire industry (oil and metals) still faces enormous credit stresses over the coming months, not just in terms of the potential risk of bankruptcies, but also regarding provisions for banks. Credit default swap spreads (effectively the amount of insurance required against the possible default of a credit issuer) initially began to widen in energy, but are now rising in every sector and major region globally. JP Morgan notes that corporate leverage stands at 12-year highs in the developed world. In the absence of consistent economic growth or inflation, the global debt burden can only diminish when companies are forced into default.
What can help improve sentiment?
It’s not all bad out there. Commodity prices are stabilising, the major oil-producing nations seem to have acknowledged the existence of a supply-demand imbalance and the US is not yet in recession. Indeed, several trends in the US point to some underlying health in the economy, be it inter-modal rail volumes, advertising growth and even modest upward wage pressure. Banks globally are also significantly better capitalised than they were during the 2007-2010 period and their exposure to oil is much less than was their exposure to housing in the previous cycle.
Whether these dynamics are robust enough to drive meaningful growth remains unclear. We continue to monitor carefully the extent to which growth indicators evolve. Meanwhile, the role that Central Banks have to play remains crucial. Further moves into negative interest rate territory would be detrimental in our view. Governments have a valid role to play too, and if monetary policy is not working, then the case for more assertive (and/or coordinated) fiscal stimulus needs also to be considered. The probability of effective outcomes being achieved currently seems low, hence our relative caution. In a world of growing uncertainties, investing in truly diversified and uncorrelated asset classes seems the most defensible course of navigation.
Alexander Gunz, Fund Manager, Heptagon Capital
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