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: September should mark a return to reality after what has been an unusually quiet and benign summer for investors. Equity markets may have edged higher and bond yields drifted lower, but none of the major concerns has gone away. Valuations for most conventional asset classes look stretched, while the limits of Central Bank effectiveness have been reached and the positive impact of potential fiscal stimulus may be over- stated. Furthermore, we worry that a scenario of rising bond yields is increasingly possible, but certainly not discounted. Against this background, we continue to position cautiously, favouring increasing exposure to genuinely uncorrelated and alternative assets (and still ranking equities above fixed income at present).
Equities: Most developed world equity markets (and especially the US) do not look cheap relative to their recent history even if earnings revisions have now begun to stabilise. Moreover, the sustainability of positive earnings revisions does not look clear with earnings growth still barely positive year-on-year. Our preference is for relative value within equities, currently preferring emerging markets (where the major macro drivers also look benign) and Europe in particular. At this stage of the cycle, there is a strong case for active and high-conviction global managers also to outperform.
Fixed Income: With effective guaranteed losses on some $13 trillion of negatively yielding government debt, we struggle to see how this asset class can be attractive. Riskless return has become return-less risk. Indeed, when bond yields do start to rise, the impact could be significantly negative. We have had no government bond-based exposure since the end of 2013 and see limited opportunities in the debt universe, perhaps only in local-currency emerging market debt.
Currencies: The relative strength of the Japanese Yen and the Swiss Francis suggestive to us not only of the fact that Central Banks have lost credibility (their currencies have moved higher despite negative interest rates), but also that investors have begun to consider safer-haven currencies. We see some logic in this approach.
Alternative Asset Managers: Our conviction in this asset class continues only to grow. We actively 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 (as an asset class), preserving it for now to deploy for future opportunities later.
Thursday 11 August was an auspicious day for markets, marking the first time this Millennium that the S&P, Dow Jones and NASDAQ equity indices all made new nominal highs simultaneously. While the heady days of the TMT bubble seem a long way from the current era of ongoing austerity and restraint, the mood of late August 2016 is also far from that where we started the year. Cast your mind back to January and equities witnessed their worst start since 2009. Concerns centred then on fears of US recession, excess government debt, low commodity prices and weak China data. And from there, the market seems to have forgotten all this and even got over the Brexit vote, hoping for a re-acceleration in earnings perhaps stimulated by a potential pick up in government spending.
Correspondingly, this has left equities around the world in positive territory with many indices close to year-highs, valuations (at least in the US) showing double-digit premiums to their historic averages, while IBES consensus earnings growth estimates remain anchored close to zero (or, at best, in low single digit territory) across most geographies. Why should this be the case? Simply, most believe there is no alternative to equities, particularly when it comes to searching for yield. Put another way, investors continue to chase yield, resulting in higher asset prices despite what appear to be unsustainable Central Bank policies and major unresolved macro imbalances (excess debt accumulation, anyone?).
Our concern centres not just on the above, but on the return to reality investors will now likely experience after the ‘Panglossian summer’ (i.e. one characterised by or given to extreme optimism, especially in the face of adversity) which we described in last month’s note. Volatility stands at year-lows and there has been an absence of major news with which to crystallise sentiment. The period September through to November will, however, see a series of significant policy events which could likely have a major impact on asset allocation decisions. Even within the next three weeks, the Fed may raise interest rates while the Bank of Japan has said that it will announce a ‘comprehensive review’ of monetary policy at its next meeting (and possibly more easing). We then have a crucial vote on Italian constitutional reform scheduled for late October and the US Presidential Election occurring in November. Current calm or even complacency could be shattered and replaced by significant uncertainty and unpredictability. This has potential ramifications for all asset classes.
Rather than focus exclusively on equities, this piece is also about government bonds and conventional fixed income. Just as equity markets around much of the world have enjoyed positive returns year-to-date, so too have bondholders seen yields extend further into negative territory. We began 2016 with some $10.7trillion of government debt offering negative yield; this figure has now risen by more than 20% to just over $13.0trillion (source: JP Morgan). In other words, choosing to invest in much of the conventional bond universe now guarantees losses out to maturity.
What happens when bond yields reverse and go up?
This is perhaps the most important question investors need to ask themselves, the metaphorical elephant in the room and the scenario for which much of the market is, arguably, not prepared. This question matters especially since it is being asked in the context of the biggest ever bond bull market in recent history. Given the magnitude of the guaranteed losses, the consequences could also be significant, especially for the global pension industry. So-called riskless return has, in our view, become return-less risk.
There are three good reasons as to why yields may increase: valuation, loss of central bank credibility and an associated shift in emphasis to fiscal policy. We have already made some observations about valuation and hence concentrate below more on the monetary and fiscal arguments. The recent symposium of central bankers at Jackson Hole seems an appropriate starting point. Rarely has there been more interest in what a gathering has to say, yet rarely have those policymakers been able to do so little. Of course, a worse-than-otherwise crisis was probably avoided by the actions of Central Banks in 2008/9, but there is still little sustainable economic growth or inflation to show for the 673 interest rate cuts that have occurred since the collapse of Lehman (equivalent to one every three trading days spread across the world’s 50 largest Central Banks, according to Bloomberg). Put another way, Central Banks continue to run a fine line between pursuing policies that are creating bubbles in asset prices and also maintaining their credibility.
To follow this line of thinking through to one logical conclusion, if Central Banks have already lost control of some elements of policy, why should they not in other areas too? At the least, there is an argument for diminishing returns. More worryingly, consider what has happened to currencies since ever-more-extreme policies have been pursued: since Japan moved to negative interest rates in January, the Yen has risen by 18%. Similarly, the Canadian Dollar, Danish Kronor and Swedish Kronor have all risen despite lower rates. After the currency markets, why not the bond markets?
Past experience suggests that we can be fairly confident that once bonds yields do begin to reverse their downward trend, it will be very hard to stop this. The periods of 1978-1980 and 1993-1994 both provide useful precedents in this respect. Interestingly, in the prelude to both periods, the Dollar weakened against other major currencies while commodity prices and gold particularly increased. As Mark Twain famously put it, “history doesn’t repeat itself, but it often rhymes.”
Of course, the trend in the US is probably towards higher interest rates. Bondholders clearly suffer under this outcome. The normally conservative Janet Yellen went as far at Jackson Hole as saying that “the case for an increase in Fed fund rates has strengthened in recent months.” Unemployment is at just 4.9% in the US, indicative of a lack of spare capacity in the labour market and while inflation remains below the Fed’s target for now, Credit Suisse notes that some 60% of inflation is derived from the labour market. The Atlanta Fed’s wage tracker for job switchers currently stands at 4.3% year-on-year growth, above pre-crisis highs. The futures market is discounting a 60% probability of a US rate-rise before year-end (up from 50% at the beginning of August). This may prove too cautious an assumption.
Finally, a word on fiscal spending. While it may be good for equity investors, it is much less so for bondholders. In Japan, Shinzo Abe has already committed to the equivalent of $265bn of new government spending over the next two years, while in the US, new capital projects is one of the few areas on which there is accord between Hillary Clinton and Donald Trump. This is hardly surprising given that public investment stands at a 60-year low as a percentage of GDP in the US according to the IMF. UK Chancellor Philip Hammond has also signalled a willingness to use such policy tools when he presents his first post-Brexit budget in November. A cycle of higher government spending implies greater inflation risks, a clearly negative outcome for bondholders. We conclude on one final sobering thought: figures from Goldman Sachs suggest that a 100 basis point increase in US interest rates could erase $1.2-1.4trillion from the US bond market alone. Even if this figure is incorrect, a large and self-perpetuating vicious circle effect would likely play out once rates start to rise.
Where will all the money go?
Equities are probably the most natural beneficiary of higher bond yields, but in general terms, this asset class is far from cheap. Indeed, the Shiller P/E (a cyclically adjusted earnings multiple) for the US market stands at a 33% premium to its 50-year average, according to Credit Suisse. And, US equities comprise almost 60% of the global equity universe based on most recent MSCI World data. Within the equity world, we see most merits for emerging markets, given their relative attractiveness on a valuation basis and the fact that most macro drivers appear quite benign at present. However, we have said it before and will say it again: there is more than just equities and conventional fixed income. Given where we stand in the current market/business cycle, the case for alternative and genuinely uncorrelated assets only continues to grow.
Alexander Gunz, Fund Manager, Heptagon Capital
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