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 are in a bubble that refuses to burst. Both equity and fixed income investors continue to enjoy an environment of positive returns and unprecedented stability. Such a situation constitutes an opportune time for sober reflection. We are mindful of signs of some exuberance and also denial (regarding deteriorating credit conditions). At the same time, the risk of Central Bank policy error continues to grow. With valuation levels elevated in certain asset classes and heightened geopolitical tensions lurking, now is not the time to be paying up for already-expensive assets. Our focus is on relative value within equities, but more on raising cash (ahead of the inevitable correction) and increasing diversification, especially towards private assets.

Asset Allocation:
• Equities: The currently high multiples investors are paying for broad equity market exposure can only be justified if earnings estimates are rising. However, positive revisions are at an 11-month low globally (per Morgan Stanley) and we believe that given the length of this cycle, now is not the time to be overpaying for growth. Dispersion levels remain depressed (in the 90th decile since 2005, again per Morgan Stanley) and our orientation would be towards distinct alpha- generating strategies. From a regional perspective, we see best relative value in Europe and emerging markets.

• Fixed Income: Most economic data point to an absence of near-term inflationary pressures, although this may not deter Central Banks from moving towards policy tightening. The risk of policy error remains elevated. Against this background, while further bond market ‘tantrums’ are possible, yields may continue to trade within a narrow, downward range. From a valuation perspective, most fixed income therefore remains fundamentally unattractive. Yields would need to be notably higher than present for us to consider revisiting meaningfully the asset class.

• FX: The Dollar Index stands at a 13-month low while the Euro has seen its biggest 3-month move in the last five years. Such an outcome may create some near-term trading opportunities, as currencies tend to mean-revert over time. We remain sceptical about the case for imminent reflation and expect most policymakers still to have a bias towards weaker currencies. Be mindful too of the impact of recent currency moves on listed exporters.

• 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. Such assets provide diversification and allow investors scope to harvest illiquidity premiums.

Good times?

Most investors have been able to enjoy the summer weather absent of market wobbles. Indeed, such has been the state of calm that over the last month the VIX index of volatility recorded 11 consecutive days with readings below 10, an unprecedented run since the index was created in 1980. Meanwhile, both equity and bond investors have been able to make hay (while the sun has shone). The MSCI World has posted 9 straight months of gains, a feat only achieved once in the last 20 years (in 2003). During July, the last vestige of the dotcom bubble was wiped out, with the US IT sector closing above its March 2000 nominal high. For bond investors, despite a wobble in late June/early July, yields are now lower than they were at the start of the year. We are in a bubble, which refuses to burst, although clearly this is far from a ‘normal’ cycle given the unconventional policies pursued to bring the economy back to health and the (still excessive) levels of Central Bank influence and intervention. Nonetheless, good times are often the best times to think about what can most go wrong. When Central Bankers say that asset valuations are “somewhat rich” (Yellen) and that they are worried about future stability – while also moving towards tighter policy – surely investors should be worried?

For how long can the bond and equity bull markets endure?
The pervasive investor mentality remains one of TINA – there is no alternative. However, such a view is informed, and hence needs to be assessed in the context of the enduring debate about deflation relative to inflation. Current opinion seems highly split on whether Central Bank behaviour is either too hawkish or too dovish. Taking a stance on these issues matters since, in general, the case for investing in risky assets is premised on the idea that the Central Bank ‘put’ exists. Since the credit crisis, ‘doing what it takes’ has helped steady markets and fuel animal spirits, but has also massively increased levels of moral hazard. In other words, this is a dangerous and risky stance that has been fostered. Moreover, against this background, the biggest concern is that Central Banks may commit some form of policy error; a worry that should be particularly pertinent given that the combined balance sheets of the Fed/ECB/BOJ/BOE are equivalent to c40% of their countries’ GDP (per JP Morgan data).

Decent growth and benign inflation should be the best possible outcome for Central Banks. Despite such a confluence of events, our issue is that the Fed is becoming less data-dependent and more data-defiant, an action that is also worryingly being replicated elsewhere too. Put another way, low unemployment and low inflation may not necessarily put a break on tightening. For the record, it is worth considering that since the Fed established its 2.0% inflation target five years’ ago, US inflation has averaged just 1.3%. A quick look around the globe shows last reported inflation figures of 1.4% for the US, 1.3% for the Eurozone, 0.4% in Japan and 1.5% in China – so not a lot of evidence of upward pricing pressure. Some academics even suggest (not implausibly, to our mind) that the pricing power of labour may have been permanently impaired by the last financial crisis, putting a natural ‘cap’ on inflation. Indeed, the massive outperformance of deflation proxies (for example, tech stocks) is perhaps indicative of the fact that the war is being lost on inflation. At the least, disruptive technologies serve to suppress inflation.

We therefore find it hard to believe that there is enough of an inflation threat for bond yields to move significantly higher – and certainly not in a sustained fashion, without interruption. The only case we can see for Central Banks wanting seriously to tighten seems to be premised on the notion that it is simply to have more response flexibility for when the downturn comes. Further ‘tantrums’ (i.e. short, sharp periods of rising bond yields) may occur – since policymakers undoubtedly have the ability still to move markets – but this is unlikely to be enough to derail equities.

The final stages…

The obvious question that follows is that if higher bond yields won’t derail the equity market, then what will? We believe that the final stages of most rallies are characterised by two factors – exuberance and denial. There are currently some signs of both. Regarding the former, exuberance was in no shortage on our recent trip to California’s Silicon Valley, while more IPOs have been priced in the last two months than at any stage in the last two years (per Bloomberg). In terms of denial, we have written in past commentaries about the deterioration of credit conditions in many areas, most particularly, within the US auto, retail, real estate and student loan sectors. Per Federal Reserve data, US consumer credit currently stands at record levels (equivalent to 20% of GDP).

Consumers (and investors) may also be in denial in another way too: to return to our earlier observation, the working assumption remains that Central Banks will backstop risky behaviour. This could perhaps be characterised as false hope. Although it is impossible to state accurately when reality will bite, it will – recessions and market corrections are both necessary and healthy, purging the markets of excess and prompting a reset, with new investment opportunities.

How to position

Given that equity multiples and corporate profit margins are high (particularly in the US) and that the investing environment is constrained by a backdrop of heightened geopolitical tensions, now is not the time to overpay for growth. In particular, we note the length of the current US economic cycle (2.5x greater than average) and the fact that it is exceptionally rare for the S&P to have delivered such a long unbroken stretch of positive returns (eight consecutive years if 2017 ends in the black, a feat achieved only three other times since 1900). Admittedly many investors already appear to recognise these risks, with global money managers being more underweight US equities than at any time since January 2008, per the latest BofAML survey, but consensus can sometimes be right.

Similarly, while favouring European and emerging market equities has now become a much more consensual stance (our portfolios have been oriented with this bias for quite some time), we believe it is also the correct one. Beyond valuation – and both these regions trade at marked discounts to the US, especially given growth prospects – we see better structural prospects too. For Europe, not only is the continent recording the strongest levels of industrial output in six years, but also, every country within the Eurozone is now seeing its economy expand – a feat that has not been recorded for a decade (per Morgan Stanley). Business and consumer confidence levels are high, there is spare capacity within the economy (continent- wide unemployment is 9.1%) and after a likely Merkel victory in Germany in the Autumn, there is real scope for structural reform, aided also by a proactive new French President. Many emerging markets (and China in particular) seem to be in similarly strong underlying health, while corporate profit growth is expanding at a rapid pace. The absence of global inflation should also be generally positive for the region.

Of course, owning equities can only take an investor so far. They are liquid and more attractive than fixed income, but some of the risks we highlight for US equities, particularly in terms of the length of the cycle and with regard to valuation levels relative to history also apply more generally. We believe now is a time for being proactive: when away from the beach, investors should be thinking about increasing diversification. Over the medium-term, we see scope for private assets to outperform both equities and fixed income. Additionally, they offer income (dividend) potential and an inflation-hedge. Enjoy the sun, while it lasts…

Alexander Gunz, Fund Manager, Heptagon Capital