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 believe now is an inopportune time to be increasing risk. Limited upside contrasts with potentially large downside, in our view. There are a combination of concerns on the horizon. These encompass valuations, credit quality, Central Bank credibility, growth and politics. Overall, we conclude that even if developed country interest rates do remain lower for longer, this doesn’t solve all the world’s problems. Sustained economic growth is palpably absent and growing protectionism may become an increasing factor with which to contend. In the near-term, we favour emerging markets (equities, local bonds and local currencies), but our core conviction remains one of actively increasing exposure to genuinely uncorrelated and alternative assets.

Asset Allocation:

• Equities: After a bull market now spanning 90 months, we see relatively limited upside potential for equities in general, and particularly for the US – in its 90th valuation percentile. Our preference is for emerging markets (on valuation grounds and given improving earnings momentum) and for undervalued domestically-oriented businesses in developed markets. While earnings estimates may have stabilised in the developed world, earnings growth is still barely positive.

• Fixed Income: With effective guaranteed losses on more than $12.5trillion of negatively yielding government debt, we struggle to see how this asset class can be attractive, particularly should yields start rising. Riskless return has become return-less risk. Nonetheless, we see a case for local currency emerging market debt, especially if US rates are now likely to stay lower for longer.
• Currencies: Our conviction in emerging markets also extends to local currencies, which are c.20% undervalued on a relative trade-weighted basis (ex-the Renminbi, and according to Credit Suisse). Elsewhere, we expect the Japanese Yen to strengthen further, not only for its defensive safe-haven characteristics, but also as the credibility of the Bank of Japan continues to be eroded further.
• Alternative Assets: The case for this asset class continues only to grow. 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. There is also logic in holding some cash, preserving it for now to deploy for future opportunities later.

What happens when the music stops?

As we have sat watching asset markets in the past weeks, the former Chief Executive of Citigroup, Chuck Prince’s, unfortunate turn of phrase has sprung to mind on several occasions. By way of reminder, according to Prince, when the music stops, “things will get complicated,” but “as long the music is playing you’ve got to get up and dance.” Much of the current investing environment seems to be characterised by a fear of missing out, a perceived cost in not participating in the present rally. 2016 to-date has been a year in which many things have done well (duration, emerging markets, credit, commodities and global equities), but history suggests that this mix of high returns and high correlations is unusual, and hence should not be expected to persist. Our concern remains that the seeds of the next crisis are already being sown, given both the rise in debt and asset prices.

Notwithstanding this fear of missing out, now hardly seems to us like a great time to be increasing risk, given the following unpalatable combination of factors. First, consider valuation. Most metrics suggest equities are in a bubble. This is perhaps not surprising given the fact that the current rally in developed world equities has endured for 90 months now. The S&P, for example, trades on a forward earnings multiple more than one standard deviation above its 60-year average.

Next, credit fundamentals are deteriorating, perhaps pointing increasingly to a late-cycle environment. The most recent US Senior Loan Officer Survey indicates a notable tightening, while in Europe there has been no major pick up in bank lending despite the largesse of the European Central Bank (currently spending €80billion a month to help market liquidity). Meanwhile the Bank for International Settlements highlights in a recent report that banking stress levels in China are at their highest since 1995. Add into this mix the current woes of Deutsche Bank. Additionally, macro surprises have now turned negative again (as measured by an index compiled by Citigroup). Finally, don’t forget about upcoming political uncertainty, with votes on the US presidency and Italian constitutional reform due before the year-end. Bottom line: the investing environment looks highly asymmetric: limited upside contrasts with potentially large downside.

The implications of the failure of unorthodox monetary policy

Lest readers think this piece is all doom and gloom, we can draw some clear conclusions from recent events, and particularly from the behaviour of Central Banks. In summary, we believe, rates will stay lower for longer than many expect. This has notable consequences particularly for emerging markets, which we expect can continue to surprise on the upside. What gives us confidence in such an assertion? Well, first there is the unavoidable. Even prior to the collapse of Lehman Brothers global demographics were deteriorating at the same time as the rate of change in technology (particularly in the context of falling costs) has been accelerating. Taken together, this is an inherently deflationary combination. Moreover, as McKinsey points out in a recent study, global debt levels are now higher (to the tune of some 20%, taking public and private debt together) than they were pre-Lehman. Under this scenario, it is hard to envisage how rates can rise.

Moreover, there has been no evidence in the last eight years that Central Banks have been able to stimulate any form of meaningful and consistent inflation. Core consumer price inflation is currently 1.2% in the US, 0.5% in Japan and 0.3% in the Eurozone. Indeed, we could go further and assert that Central Banks are becoming increasingly divorced from reality. At the least, each set of actions initiated serves further to diminish their credibility.

Take Japan first and the recent fall back in Japanese Government Bonds combined with the ongoing rise in the Yen speaks to an explicit repudiation of the Bank of Japan’s (BOJ’s) strategy. A lack of NIRP (negative interest rate) intensification and a shift to yield targeting is perhaps a tacit admission of defeat on the part of Governor Kuroda. Moreover, the biggest problem with the BOJ’s policy is that it is now effectively a hostage to fortune. It is almost impossible to target both bond yields and balance sheet expansion simultaneously. Yield targeting has a very poor track record of success.

Next, let’s consider the Federal Reserve. A divided Board of Governors (with 3 of the 10 members voting against Chair Yellen at the last meeting) is hardly good for presenting a unified front. What intrigues us more though is that despite dissent on the near-term, with regard to the longer-term, there is clear accord. Here, the ‘dots’ (i.e. the Fed’s projections for interest rates) continue to be pushed out. They have fallen by 25, 40 and 50 basis points respectively for the next three years. In other words, by the end of 2018, the Fed now projects an interest rate of just 1.875% for the US economy, compared to 3.225% one year ago. Credibility issue? No doubt. Lower-for-longer: yes.

The growing case for emerging markets

A combination of factors mutually reinforce the case for emerging markets, one of our highest conviction views at present. Valuation provides a crucial underpinning. Emerging markets currently trade at a 25% discount to their developed world peers on a metric of forward earnings using consensus Bloomberg data, while they also offer a superior dividend yield (2.6% vs. 2.3% at present). It is also notable that earnings estimates bottomed in the region in February (according to Morgan Stanley), while the most recent quarter was the first in seven where consensus expectations were exceeded.

This momentum has the potential to continue, helped by more than just the tailwinds of lower rates and more favourable currencies. Economic activity has picked up in almost every geography (with the exception of South Africa), while positive structural reform, particularly of labour markets, is helping in Brazil, India, Indonesia and Mexico. Furthermore, inflation remains under control in most emerging markets while governments also have significant potential policy flexibility, with government debt to GDP ratios typically one-third the level averaged in developed markets. There are many positives.

A final consideration: globalisation in reverse?

2016 will almost certainly mark the fifth consecutive year in which global GDP growth will be below 3.7%, the average level it tracked for the 20 years prior to the Great Financial Crisis (data courtesy of IMF). The 673 interest rate cuts perpetrated by the Central Banks of the G20 since then may have helped avert an even-worse crisis, but it remains the case that the growth simply hasn’t arrived in any meaningful fashion. Some of this may not be the fault of the Central Bankers and, as discussed previously, it is hard to fight a tide of negative demographics and successive waves of technological disruption. It is also increasingly evident that Central Bankers are running out of ‘new’ ideas, hence the increasing expectation of the role that fiscal policy may have to play.

Whether cause or effect, international trade flows have been clearly decelerating in the recent past. Our concern is that this trend may only become more pronounced going forward. We cannot help but note the growing apparent momentum in populist (and often nationalist) political dynamics, whether it be Donald Trump in the US or the AfD in Germany, the Front National in France, Italy’s 5-Star movement and so on. At the least, such politicians are helping to shape or inform the metrics of the current debate, promising the prospect of change, even if it is not clear exactly what that change constitutes. This matters, given a large number of important elections due before the end of 2017. In an era of low- growth, the risk remains that protectionism becomes a bigger part of the political narrative. Logically this would support the case for owning domestically-biased businesses in both developed and emerging markets.

Against this background, we are again confronted with the fact that risks continue to grow. There is a need to proceed with caution. Our conviction in alternative and uncorrelated assets hence continues to grow.

Alexander Gunz, Fund Manager, Heptagon Capital