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: this is not a normal cycle. Unprecedented crisis and subsequent intervention by stimulus has seen the rally in equities endure for over eight years, during which time bond yields have simultaneously compressed. Yields may have risen somewhat, but remain very low by historic standards. Meanwhile, equities are trading at generally elevated absolute valuation levels and have seen very few meaningful setbacks over this recent period. They may remain the least bad major asset class to own at present, but this clearly doesn’t mean they are without risks. Calling when the next major correction will occur is hard, but we do highlight in more detail below several areas of concern and complacency. Our conclusions: think long-term, look for value, and diversification.

Asset Allocation:

• Equities: This constitutes the least bad place to be. It is also the least expensive of the major asset classes. Equities in most regions are also continuing to benefit from earnings upgrades. The current environment continues to be supportive to stock pickers with correlations at their lowest level in over two years. We see most relative value in emerging markets, Japan and Europe and emphasise focusing on secular themes (look to own plays on localisation, deregulation and ageing) across all regions. Watch for a major drawdown, though. There hasn’t been one for a very long time.

• Fixed Income: The asset class remains unattractive in general terms. Developed world government bond yields may be markedly higher than a year ago, but have remained in a tight range year-to-date, reflecting a combination of continued dovish Central Bank policies and still-elevated levels of political uncertainty. From a fundamental perspective, after a 30- year bull market in bonds, it is hard to make a compelling case on valuation grounds. At notably more elevated levels of yield than currently (at least 3.0% for the US 10-year), Treasuries and other comparable debt may become attractive.
• FX: We have no active views in this space at present. Despite downward pressure in the last month, a strong Dollar remains a highly consensual stance, yet stands in contradiction to some of Trump’s desired policy outcomes, particularly on trade. Meanwhile, the fate of the Euro (and Sterling) will likely be influenced by near-term political outcomes.
• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies, and private asset classes in particular. This is one of our highest conviction views at present. Within this universe, we consider allocations to catastrophic reinsurance, infrastructure assets, direct lending and niche private equity to be attractive.

All good things must come to an end…

… although being able to judge when this comes is much harder. Price action across most asset classes in the last month (falling bond yields, underperforming banking and small cap equities) is, at the very least, suggestive of the fact that a more sober reassessment of the recently-popular reflation narrative is perhaps underway. The more fundamental issue is that no-one really knows where we are in this current cycle. Of course, eight years does seem like a long time. Cast your mind back to March 2009 and the S&P stood at 676 at its trough; today, it is some 250% higher. However, we see little point in trying to compare this cycle with others, simply because of the abnormal crash that preceded it and then the exceptional stimulus that followed. The massive metaphorical elephant in the room that continues to lurk is the distortion wrought by Central Banks globally. Together, they currently control some $25 trillion of assets (based on recent IMF data), which at some stage will need to be unwound. This cycle is without precedent, and so comparing it with others may be a flawed exercise.

It behoves us to consider what may bring the cycle to an end. Sadly, we are not in possession of a single, simple answer. Nonetheless, it seems fair to contend that something on which investors are probably not currently focused will be the eventual trigger. It is also both lazy and complacent to think that the market needs some sort of ‘formal’ catalyst to initiate a meaningful drawdown which, in its turn, may spark a correction and then a potential bear market and/or recession. Rather, the analogy of grains of sand seems an appropriate one; namely, it is impossible to know which one may eventually cause the whole heap to collapse. What is certainly worrying to us is that we haven’t had a meaningful market setback for a very long time (indeed, there have been only three monthly drawdowns of more than 5% for global equities in the last five years). We also note just how bullish investors seem to be. In a recent survey (carried out by Deutsche Bank), the percentage of those polled predicting a US recession in either the next six or twelve months was the lowest since 2008. More interesting to us is that the ratio of insider selling relative to buying is now at its highest for a decade (according to Credit Suisse).

Where to invest? Our message on diversification into uncorrelated asset classes has been consistent for some time. It is only reinforced by the above observations. Moreover, it is naïve to assume that the transition from an environment where Central Banks have effectively dictated the investment narrative to one which will (hopefully) be more growth-driven will be seamless. How successful this regime shift proves to be will be crucial to the performance of both fixed income and equity markets going forward. While the US is more advanced in this respect than other regions, we also see it as being the least attractive market in which to invest on a relative basis. From an equity perspective, we currently have higher conviction in almost every other global region.

A deteriorating US picture

We will save analysis of Trump’s failure to reach agreement on healthcare reform for other commentators. All it is worth noting from this recent debacle is that reaching political compromise in the US will be increasingly hard. Some of Trump’s political capital has undoubtedly been eroded and a recalibration of political expectations is now underway. Combined with a dovish message from the Federal Reserve, this helps explain why bond yields retreated in March. We find it intriguing that the Fed has been prepared to raise interest rates, but still sees risks as “roughly balanced.”

We wonder whether the Fed perhaps wants to give itself some headroom to cut again, should the outlook deteriorate. The following data are worrying and supports our contention that the seeds of the next crisis may come from a source other than those which have provoked other previous recent crises. Consider that commercial and industrial lending growth is at a six- year low. In March, it expanded at less than 3%. This compares to growth more than 10% one year ago (data courtesy of the Federal Reserve). On the consumer side, banks are reporting increasing credit card losses and auto delinquencies. Consumer credit defaults in the last month were up by more than 20% from their low recorded in August 2015. Some one million US consumers are currently over two months behind on their car loan repayments, with delinquencies at their highest since 2009, according to TransUnion, a US credit bureau. Similarly worrying is the fact that used car prices have now fallen for eight consecutive months with the 3.8% decline reported in February being the steepest drop since November 2008 (based on data from NADA, an industry body). Combined, with a flattening yield curve, falling lending growth and rising delinquencies do raise valid questions about the strength of the US economy. These trends will require monitoring.

An improving European picture

The region clearly has its problems and the fragility of its political core may again be tested over the coming months, but it might surprise many investors that the European economy is, in aggregate, currently growing at a faster pace than the US for the first time since 2008. Real GDP growth in 2016 was 1.7% in the Eurozone. This compares to 1.6% in the US. Beyond the improving industrial output and consumer confidence statistics from Europe, the fact that German factory gate prices are currently rising 3.1% year-on-year versus an annualised decline of 3.0% recorded this time last year is perhaps indicative of just how far the European recovery has come. The continent seems to have moved out of deflation. Although we believe that the correlation between economic growth and earnings estimates is a tenuous one, we note that the ratio of earnings upgrades relative to downgrades for European companies is its best since 2012 (per BofA Merrill Lynch data), with European earnings growth outpacing American levels for the first time in six quarters (according to JP Morgan).

We also wonder whether political populism may have peaked. The victory of the incumbent party in the recent election in the Netherlands now marks three consecutive general elections in Europe (Spain and Austria bring the others) in which a pro-European party has been victorious. Perhaps history will show that the Brexit vote of last June and Italy’s failure to approve constitutional reform as outliers, indicative of country-specific issues. Should Marine Le Pen fail to win the French Presidency on 7 May, then it is possible to envisage the emergence of a more united pro-European bloc, committed to renewed integration and pro-growth fiscal policies. This could stand as a marked contrast to the much more combustible administration of Donald Trump. With European market volatility (as measured by the V2X Index) at its lowest since the financial crisis, investors may wish to wait until early May before actively considering the region, but fundamentals seem to be improving, while valuation remains undemanding. On headline P/E multiples, the Stoxx 600 European Index trades on 15.3x for 2017, versus a multiple of 18.1x for the S&P, according to Bloomberg data.

There is value to be found

Although the disparity between the European and the US equity markets seems notable, it is worth bearing in mind the TOPIX Index in Japan trades on a current earnings multiple of 14.8x, while emerging markets look even more compelling, valued on just 12.7x (for the MXEF Index). We see evidence in these regions of improving fundamentals at both a macro and a micro level. More generally, when considering that we are moving away from an investing environment that has been dominated by Central Bank distortions, this should be very good news for stock pickers. Several long-term secular trends are developing which we think should help inform investment decisions (beyond our strategy of growing allocations towards private assets): in particular, focus on local over global businesses, look for the beneficiaries of deregulation, and also for plays on demographics and ageing. Amidst other uncertainties, these trends are not going away.

Alexander Gunz, Fund Manager, Heptagon Capital