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.
The labours of Sisyphus, a king in Greek mythology, seem a topical starting point with which to begin this month’s View From The Top, especially since the fate of Greece continues to dominate headlines and enthral/enrage investors. Sisyphus was punished by being forced to roll an immense boulder up a hill, only to watch it roll back down again. Investors in most asset classes have become all-too-familiar with this sensation as 2011 has developed. While there are causes for optimism and some compelling investment opportunities, which we discuss in more detail below, we remain deeply cognisant of the bigger picture, namely that some form of recession looks increasingly likely for 2012.
From Heptagon’s perspective, our favoured investment strategies relate to fixed income (long-dated government bonds, high yield, Asian fixed income and emerging market corporate bonds) over equities with a stable allocation to alternative managers. Within equities, the US (particularly large cap, dividend- payers) remains preferred over Europe, while selective emerging markets are beginning to become more interesting.
What appears clearer to us than anything else in these still highly uncertain times is that global GDP growth is slowing and could slow further. For policy-makers globally, the key challenge is how to arrive at the appropriate combination of cyclical stimulus and long-term adjustment (Western deleveraging combined with rebalancing in the emerging world). As a consequence, short-term policy has become more closely tied to structural decision making. Moreover, given the seeming inability for politicians to act in a timeous fashion, it suggests that the bottom of this current cycle may likely be characterised by more of a potentially drawn-out process rather than a specific event.
Indeed, this latter point is crucial. For Europe, we are agnostic over whether policy decisions lead finally to greater union (perhaps more likely) or disintegration, but recognise that the journey there will likely be long and painful, particularly given that any major change could require legislative approval in each Member State, many of whom are showing increasingly vocal reluctance towards the whole European project. Furthermore, either outcome would also likely fail to resolve fully the structurally uncompetitive nature of several of the continent’s economies or the risks inherent in its banking system. According to data from the Federal Reserve and the European Central Bank, banking liabilities as a multiple of GDP exceed two times in both France and Germany and average 3.5 times across the Eurozone (reaching almost six in the UK) relative to levels of below one in the US.
Europe’s problems should not leave policy-makers (and investors) in other regions feeling complacent. One factor that ironically seems to be in Europe’s favour is that the ECB still has scope to cut interest
rates and a decision on this looks increasingly likely before the year-end. However, such a reduction would serve only to confirm an inexorable trend, namely, that the western world – whether we like it or not – is ‘turning Japanese.’ The Fed Funds Target Rate is already remarkably close to the Bank of Japan’s discount rate. Other macro indicators suggest that deflation seems much more likely in all these economies in the very near-term than the inverse (although we are mindful of currently rising inflation in the UK). In addition, the Fed’s recently announced ‘Operation Twist’ also supports this thesis, when viewed as another increasingly desperate act, aimed at lowering long-term yields; the benchmark for how low they can go is constituted by the Japanese market.
The Japanese experience of almost two ‘lost decades’ of economic growth is sobering one for investors across most asset classes and has been discussed at length elsewhere. Nonetheless, an interesting recent study by the San Francisco Fed1 makes for further disquieting reading on this topic. It links demographic trends with market P/E ratios and demonstrates that given typical investment patterns by individuals (i.e. accumulation of financial assets in working life and reduction in these as retirement approaches), there is a high correlation between such behaviour and earnings ratios. In other words, deteriorating demographics (a highly pronounced phenomenon in Japan and an emerging one in the west) could imply that equity multiples trend markedly lower from current levels.
This leads us on to a point that we have highlighted before. Even accepting valuation as just a necessary rather than a sufficient criteria for investing (in equities), we believe there are good reasons why multiples can compress further downwards. On a Shiller P/E basis, fair value for the S&P is 950, some 15% below current levels. Axiomatically, equities would have to fall even further than this before they were ostensibly ‘cheap.’ The implication from the arguments developed is that the recent ‘cult of equity’ may just be a chimera, a fleeting phenomenon when viewed in a broader historic context. Data from Bloomberg going back to 1700 for the UK economy (which has the longest available series) shows that the period from 1980-1999 was the only 20-year period over this 300-year scale when equities delivered annualised real returns of 8-10%. The norm was annualised real returns of between -2% and 4%.
Beyond this longer-term perspective, the near-term implications for investors in equities are not encouraging, particularly when we return to the well-made observation that corporate profitability does not exist in a vacuum. At present, global economic activity is slowing (in the US the ratio of ISM new orders less inventories is now negative, which is often a recessionary lead-indicator), while consumer confidence is highly depressed. The lack of job creation in western economies is also highly disappointing. Against this background, Heptagon believes there is currently more scope to be constructive on asset classes other than equities. The pending Q3 earnings season will likely provide a useful gauge with which to test this thesis.
In particular, there is a good case for fixed income and cash within investor portfolios at present. Government bonds (particularly US, and long-dated) have retained a ‘safe haven’ status, rightly or wrongly, and should continue to profit from current market turmoil. Outperformance in this asset class looks set to continue at least for as long as inflation remains suppressed. Elsewhere, high yield also seems to represent an attractive opportunity at present, particularly given that the market seems to continue to discount aggressively the risk of default.
Emerging market debt also has clear merits. Asian fixed income should be a clear beneficiary from the significant deceleration in G7 GDP trends. These will likely impact China’s growth and inflation expectations on the downside in the near-term (PMI figures and M2 growth are both contracting), implying a potential end to the current tightening regime and even to the emergence of possibly looser monetary policy going forward, which would be a positive for fixed income in the region. Corporate bonds in emerging markets have also held up well year-to-date, recording low single digit gains.
With regard to alternative investments, our allocation has been stable. Despite the increasing politicisation of key drivers (in other words, the deliberate manipulation of bond yield curves and currencies by major governments), some Macro and CTA (Commodity Trading Adviser) Funds are now looking well-poised to deliver substantial returns, as and when trends do break. In addition, it is also worth considering that opportunities within Merger-Arbitrage Funds are arising; supressed M&A levels notwithstanding, unusually large spreads make the space look now more attractive.
With growing allocations towards fixed income and stable allocations within the alternative space, the implication is a relative underweight for equities within portfolios. Although the spread between US and European equities has narrowed within the last month, on a year-to-date basis, the S&P has outpaced its counterpart in Europe by over 10 percentage points. Some minor relief rallies are likely in the latter region (particularly if interest rates are cut – which would also have implications for the Euro), but the Sisyphean task of righting the region’s economy and financial system remains. Fundamentals are proportionately worse in Europe than the US and so our preference is for large cap US stocks with strong free cashflow generation and attractive dividend yields (McDonalds or IBM, for example). Yield will also matter increasingly in a deflationary environment, with US inflation expectations currently at a 30-year low.
Furthermore, just as emerging market fixed income would be a beneficiary of a looser monetary environment, some developing market equities are also starting to look increasingly attractive. Indonesia, in particular, stands out given its attractive demographic profile, relatively low dependence on exports, scope for fiscal manoeuvre and high currency reserves. By contrast, it is hard to be unequivocally positive on China. In particular, it should not be forgotten that its largest export market is the EU27; and so with European GDP set to turn negative, this will have clear detrimental implications for China.
In conclusion, John Maynard Keynes once famously remarked that markets can remain irrational for a longer time than investors can remain solvent. Bearing this dictum in mind, given its current relevance, there is a clear need for operating with a nimble and proactive approach across all asset classes. The case for pragmatic realism seems much more defensible than one of unbridled optimism. Moreover, the final quarter of 2011 looks likely to be as difficult as those that have preceded it and 2012 may herald global recession. Nonetheless, opportunities will continue to arise, and we remain positioned to move with alacrity.
Alex Gunz, Fund Manager, Heptagon Capital
1 See: www://www.frbsf.org/publications/economics/letter/2011/el2011-26.html. With thanks to RCUBE.
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