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: the reluctant rally continues. A combination of generally dovish Central Banks and a weaker Dollar has sent volatility to its lowest level since July 2015 and seen risky assets generally outperform. However, markets continue to elicit frustration more than enthusiasm. The reality is a decidedly mixed macro landscape where valuations for many conventional asset classes continue to look unattractive. We worry about near-term complacency and focus our efforts on the longer-term. The most appropriate strategy for generating returns in a low-return world seems to be one of increasing the focus on alternative and truly uncorrelated assets.

03 May 2016

Asset Allocation:
 Equities: Global markets have now climbed 14% from their February lows and are just 7% off their all-time highs. However, these gains have been accompanied by deteriorating earnings growth. For the S&P, earnings estimates are currently down 8% year-on-year, their biggest fall since 2009. Furthermore, global sector and regional dispersion between winners and losers continues to widen. Our strategy is focused on active managers and we currently prefer value over growth, emerging over developed markets.

 Fixed Income: We continue to see most conventional fixed income categories as unattractive. The issue remains that as yields get pushed further into negative territory, holding government bonds implies a guaranteed loss of purchasing power. We see most potential upside over the long-term in local currency emerging market debt, with this asset cheap relative to its history.

 Currencies: We have no active currency positions and expect the currency environment to remain highly volatile. All countries seem to understand the logic of a weaker currency, but such a strategy is ultimately a zero-sum game. Recent price action (especially in the US Dollar and the Yen) reinforces the idea not only that currencies have a tendency to over-shoot, but also that they do tend to mean-revert over time.

 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 holding some cash positions to preserve for future opportunities.

Four interlinked topics form the core of this month’s View, all of which have clear investment implications –

1: The new reality: implications of a zero-rate world

While a broadly benign set of messages from the Federal Reserve and a correspondingly weaker US Dollar have helped to improve near-term sentiment, they do not alter the more fundamental challenge investors currently face. As a result of interest rates being set at either zero or even negative in most of the developed world, we live in a low-return world. Furthermore, the hunt for yield is becoming harder and harder. Indeed, some 27% of the JP Morgan World Government Bond Index now offers negative yields. Real bond yields are sub-zero out to at least five years in the US, UK and Eurozone, and more than ten years in Japan and Switzerland.

These observations clearly matter. Put starkly, a Central Bank policy of zero/ negative rates constitutes a clear concern – and this matters for investors as well as individuals. If we accept that current yields predict future returns, then zero real (i.e. nominal rates less inflation) interest rates, predict zero real returns; similarly, negative real interest rates predict negative real returns. For individuals, financial repression has not only a damaging effect on retirees – i.e. they have less money – but also on younger workers. They are being forced to defer a great percentage of their current spending in order to set more money aside for the future. This also perhaps explains why the savings rate is rising in the US. We leave investors with one final thought on this topic: how can negative rates be logical? If interest rates are supposed to compensate investors for future risk, then according to current market prices, the future is less risky than the present.

2: Where to invest: at least fixed income is not the only choice
The corollary of the above is that if investors wish to enjoy the levels of returns to which they have been accustomed, then they need to diversify. We have argued for some time in this commentary that increasing allocations to alternative and genuinely uncorrelated asset classes is an appropriate strategy. As the bull market in equities continues to endure, our conviction in this assertion only grows. Despite (or because of) the lengthy rally equities have experienced, they are deeply unloved, even if they remain a more attractive asset relative to fixed income.

Nowhere is this conundrum felt more heavily than in the US market. US equities have outperformed global equities over almost every recent time period, with annualised returns in the last ten years of 7.3%, compared to 5.2% for the MSCI World. To consider the relentless outperformance of the US market from a different perspective, it is worth noting that the market capitalisation to GDP ratio for the S&P is 114% at present. This compares to a ratio of 76% a decade ago and contrasts with current figures of 60% for Europe, 70% for Japan and 13% for emerging markets (all data courtesy of Morgan Stanley). However, at the same time that US equities continue to outperform, their earnings momentum deteriorates further. Corporate profits fell 15% year-on-year during the past quarter, the worst performance since 2008 (according to Société Generale). It seems increasingly hard to justify the case for US equities given current valuation levels in the absence of consistent earnings growth.

Against this background, maybe now is a time to consider equity markets other than the US. In particular, for longer- term investors, we believe the case for emerging markets looks increasingly attractive, both from a macro and a valuation perspective. With regard to the former, we note four significant factors. China appears to be stabilising; so too is the oil price. Meanwhile, a weaker US Dollar is certainly helpful, and financial conditions are correspondingly improving. Chinese PMI (a gauge for industrial output) is exhibiting expansionary readings for the first time in six months, while export growth and retail sales have surprised positively relative to expectations. Elsewhere, Goldman Sachs notes that financial conditions (i.e. liquidity with regard to money supply and lending) are currently at their loosest in emerging markets generally since December 2012. Finally, both on a price-to-earnings basis and a price-to-book value, emerging markets are currently trading at least at a 30% discount relative to history (according to Credit Suisse). This contrasts markedly with US equity valuation levels.

3: What will Central Banks do next? The worrying precedents Japan sets

A year ago, China was considered as the epicentre of global market risk. However, as noted above, there are clear signs of stabilisation and improvement in this market. We believe China has now been overtaken by Japan as the primary concern among investors. This is evidenced by the marked underperformance of Japanese equities year-to-date and by the fact that TOPIX volatility indicators are now above those of the Chinese market. This matters since, arguably, Japan is the test- bed for monetary experiment elsewhere. It also potentially represents a sign of things to come for other developed markets given its deflationary and demographic dynamics.

After three months since initiation, it seems clear on any number of metrics that the Bank of Japan’s (BOJ) negative interest rate policy has not succeeded. Consider the following: the total cash stashed in peoples’ houses in Japan has risen 15% over the last year (according to Daichi-Life, an insurer); loan growth is slowing, and has decelerated year-to-date; the economy is shrinking at its fastest pace since the Fukushima nuclear disaster in March 2011; and inflation expectations continue to fall. 5-year inflation expectations are now 1.3% for Japan, versus 1.6% three months prior. The rise in the Yen (at a 19-month high relative to the US Dollar and the best-performing G20 currency year-to-date) also speaks to the market’s response to recent BOJ actions.

Despite such a stark repudiation of policy, the BOJ seems stubbornly committed to its continuation – at least for now. It begs two questions: what comes next, and when will Central Bank credibility finally be eroded? With regard to the former, investors should not rule out the possibility of ‘helicopter money.’ The concept, first popularised by the economist Milton Friedman, relates to Central Banks making direct transfers to the private sector without the involvement of fiscal authorities. If anyone tries it, then the Japanese may well be the first. In terms of credibility, the more it gets undermined, the greater is the risk of loss of Central Bank independence and hence the higher the probability of nationalisation. This would have clearly negative investment ramifications and reinforces the logic of investing in truly uncorrelated assets.

4: What will Central Banks do next, part II: how might they respond to inflation?
Investors do not appear to be discounting a scenario of inflation in the developed world any time soon. Indeed, the market is assuming only one more rate increase from the Federal Reserve over the next 12 months. What if this is wrong? Investors are certainly not positioned for such an outcome, and it would clearly lead to an increase in market dislocation and volatility. Furthermore, a rapid pick-up in inflation combined with still-weak economic growth (we note that the IMF has been forced to cut its global GDP growth forecast four times in the last year) would result in a major erosion of pricing power.

Now consider the facts. Weak oil and food prices have served to camouflage strengthening core inflation. Even if underlying US inflation is still close to zero, 5-year inflation break-evens have increased by 50 basis points in the past quarter to 1.6%. The US job market is close to full employment, with jobless claims at their lowest since 1973, the time needed to fill a job at its highest in 16 years, and the number of people voluntarily leaving their jobs (to take up another) at its most elevated since 2008 (all data provided by the US Conference Board). Correspondingly, according to the Atlanta Fed, wage inflation for male employees is currently running at 3.8% year-on-year, its highest in six years. Investors should also take note that many commodity prices have begun to stabilise, helped by the weaker Dollar. With oil production volumes at their lowest since September 2014 and prices up more than 35% in the last two months (in Dollar terms), it seems only a matter of time before this feeds into inflation data. Our view: be prepared, and again, we cannot emphasise enough, look to diversify.

Alexander Gunz, Fund Manager, Heptagon Capital