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: Future returns for investors have been constrained by financial repression; now there is a risk that they may be consumed by inflation. With policy effectiveness at its limits and sustained economic growth stubbornly elusive, the next roll of the dice looks to be one of engineered inflation. Whether efforts prove effective (and stagflation avoided) remains unclear, but at the least, it provides a coherent explanation for why bond yields have begun to rise so abruptly. Such a scenario reinforces the logic of avoiding conventional fixed income assets. However, equities (in general) are hardly an attractive option at current valuation levels. With asset-class correlations rising, the logic of increasing allocations to truly diversified alternatives only grows.

Asset Allocation:

 Equities: Valuation caps upside for equities in general, but a lack of better liquid options also creates a floor on the downside. The recent reporting season has shown a highly mixed picture; even if earnings have generally beaten, growth has disappointed. We see the most attractive combination of growth and value currently in emerging markets, which have continued to perform well, despite a rising Dollar. China (and Japan) stand-out as being anti-consensus ideas.

 Fixed Income: Bonds have had their worst month since the ‘tapertantrum’ of May 2013 and yet more downside seems likely. Conventional fixed income has clearly been underperforming on concerns over higher rates. However, it is worth bearing in mind that there is still over $10trillion of negative yielding debt globally. Return-less risk is not an attractive proposition in our view. Nonetheless, we see a case for local currency emerging market debt on valuation grounds.

 Currencies: The US Dollar has strengthened notably in the past month (on the prospect of higher interest rates), but as we have observed previously, currency investing is not a zero-sum game. The corollary of Dollar strength is weakness elsewhere. Both the Euro and the Yen have fallen, as have most emerging market currencies. Near-term, there are good reasons to believe that the Dollar will remain elevated. As elsewhere, however, we see most value in EM currencies.

 Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies and private asset classes in particular. Within this universe, we consider investments in catastrophic reinsurance, infrastructure assets, direct lending and private equity to be attractive. We also believe there is some logic attached to having exposure to gold, both as a defensive strategy and as an inflation-related hedge.

The biggest ‘what if’ on investors’ minds

One statistic stands out more than any other from October: world bonds have had their worst month in performance terms since May 2013, down 2.8%, as measured by the Barclays Global Aggregate Bond Index. What compounds the problem for many investors is that at the same time, world equities also underperformed last month. We have said before that there are increasingly few places for investors to hide. Correlations between asset classes have been rising for some time.

Now consider if the whole premise that has helped underpin both fixed income and equity markets for the last few years is challenged. Just imagine, what if bond yields were to stop going down? This would have severely negative consequences for many, particularly since valuation levels for conventional assets in general terms are at extremes. The most recent long- term returns study published annually by Deutsche Bank shows that aggregated developed market average nominal bond yields and equity percentile valuations are at their most expensive in 200 years. At the least, we see little room for complacency, particularly as rising political uncertainty (a US Presidential Election, the UK’s first post-Brexit budget and a vote on Italian constitutional reform all due before the year-end) could exacerbate an already challenged environment.

Why are bond yields rising?
Beyond valuation (about which we have written extensively in the past), we think there is simply more evidence to point to the emergence of inflation rather than the global economy returning to sustained economic growth. Admittedly the most recent purchasing manager survey data points to an improving manufacturing outlook across the developed world, while growth in services activity stands at a current 11-month high in the US. However, global growth estimates continue to be revised down.

The IMF, for example, pruned last month its 2016 forecast for world GDP to just 1.6% relative to its 2.2% estimate made only as recently as July. Furthermore, it is sobering to think that 2016 will mark the fifth consecutive year in which global GDP will have grown at below 3.7%, the average it achieved in the 20 years prior to the great financial crisis (based on IMF data). Elsewhere, the Federal Reserve now believes US long-term GDP to be just 1.8-2.1% (versus a prediction as optimistic as 3.5% just five years ago). With protectionism increasingly informing the political narrative, moves in this direction would be additionally deleterious to growth prospects.

Now consider the evidence for inflation. Context matters here. Cast your mind back to last year, and in the second half, the price of oil fell by 35% and the Chinese Renminbi by 7%. As we now lap these declines, inflation is beginning to appear. Moreover, the oil price is at its highest in 15 months (with the Saudi Arabian government suggesting a $60 price is possible before year-end; it is ~$46 currently) while there are growing signs that the Chinese economy has bottomed. Factory gate prices are rising in the country for the first time since 2012, corroborating growing power consumption and increasing money supply. In the developed world, US inflation currently stands at 1.5% and UK inflation at 1.0%, a 22-month high in the latter, albeit partly Brexit-inspired. Even in Germany, the rate of change in consumer prices is at its fastest in two years.

The politicisation of monetary policy

Given the above, the more important questions to raise are, first, why inflation is coming and, next, what may be its implications. We will tackle the former here and provide one plausible theory, namely that inflation is being ‘engineered’ by Central Banks; or, at the least, they are not standing in the way of it. Central Banks have had an exceptionally poor track record in terms of accurately forecasting the economic outlook. Just consider the rate at which the Federal Reserve’s ‘dots’ (or interest rate projections) have been consistently revised down, and concurrently estimates for GDP. It is, therefore, not unreasonable to wonder why should the Federal Reserve be actively talking about the prospect of higher interest rates, when its own forecasts for growth have been falling? In general terms, we are seeing the gradual politicisation of monetary policy.

As we have known for a long time, Central Bank quantitative easing has increased asset prices without providing scope for high street banks to reflate the real economy. Even asset price inflation hasn’t, however, been universal. Despite a €1.5trillion sum spent on quantitative easing by the European Central Bank since August 2012, its equity markets are barely unchanged. A similar challenge could be levelled at the Bank of Japan. Additionally, debt is now higher than it was before the world began on its uncharted path of unconventional policy. Indeed, the IMF highlights that global gross debt (public and private) is $152trillion, two times the size of the global economy. Central Banks, too, have been complicit in the over-accumulation of and deepening addiction to debt. Excess leverage was partially to blame for the last financial crisis, and may well play a role in the next one.

So, after the inability of accommodative monetary policy to generate sustained growth and with austerity at its limits, inflation comes next. Inflation naturally creates the impression of an economy in recovery mode and also clearly helps reduce the sagging debt burden. No surprise then that policymakers are redoubling their efforts to push-up inflation expectations. Federal Reserve Governor Janet Yellen has talked of her comfort with a ‘high-pressure economy,’ a willingness to tolerate faster inflation to drive a more emphatic recovery. Elsewhere, in Japan, Haruhiko Kuroda is perhaps aware that no Bank of Japan Governor has served a second term in this role in over fifty years. His shift to yield curve steepening as a tool to drive inflation is perhaps his last roll to hit the country’s inflation target and so earn a second term.

The approach seems to be working – at least for now. In the US, the market is discounting close to a 70% chance of an interest rate hike before the year-end. In Japan, yields have bounced strongly from their September lows. And, even in Europe, inflation expectations (based on five-year forwards) are at their highest in four months. All good? Well maybe, but what, of course, investors need to watch for is whether these tentative signs of inflation are perhaps stagflation in disguise. As a reminder, stagflation – the blight of the 1970s – is characterised by a period of persistent high inflation combined with stagnant demand. The UK (post-Brexit) could be more at risk than elsewhere, but the implications are almost universally negative.

Can the world cope with a stronger Dollar? Where to hide
Whether the in-(or stag-)flation thesis plays out, one fact that it is hard to deny is that the US Dollar has been rising and may go higher. As the Federal Reserve, in stark contrast to other developed world Central Banks, moves closer to policy normalisation – whatever its reasoning – the Dollar should get stronger. Indeed, it is an eight-month high at present. Investors should take note that during the period from June 2014 to January 2016, when the US Dollar Index rose by more than 20%, not only did US exporters suffer, but also emerging assets underperformed. At least, this has not been the case so far, although it will remain critical to monitor.

Valuation provides the answer. After 40% underperformance in the last five years’ emerging market equities are currently trading on a 20% discount to developed world equities on forward earnings (using Bloomberg consensus data). They also offer markedly better growth prospects. In general terms, high valuations and low profit growth limit upside in the equity markets. Growth and yield have worked well as a strategy for as long as rate and inflation expectations have been falling. Now, as they reverse, so should investors’ strategies. Our preference remains for value in general terms. And, if correlations are also high and rising, then logically too, avoiding related assets and focusing on alternatives makes sense.

Alexander Gunz, Fund Manager, Heptagon Capital