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 cannot time markets, but would prefer to be early rather than late. The current cycle will not endure unchecked and 2018 could well be the year of boom then bust that 2017 wasn’t. An over-valuation of most conventional asset classes, accompanied by broad market stability that is breeding potential complacency concern us. Looking ahead, we worry additionally about potential monetary policy error, rising default levels and elevated political instability. With investors increasingly being forced to make the same asset allocation decisions (driven by a perceived fear of missing out), there are few places to hide. When the correction comes, many will therefore be vulnerable. Against this background, now is the time to be proactive. Our focus remains insistent on valuation and we favour allocations to emerging markets for the longer-term as well as to truly uncorrelated and diversified asset classes.

Asset Allocation:

• Equities: Global equities (led by the US) have enjoyed almost nine years of unbroken expansion. They are now expensive relative against historic metrics, but remain undervalued relative to mainstream fixed income. Despite valuation, equities can probably continue their upward momentum for as long as current economic and monetary conditions remain benign. Prospects for such a scenario, however, look stronger in the first half of next year than the second. Our approach remains one of focusing on relative value strategies and managers offering true differentiation. By region, emerging markets trade at an 18% sector-adjusted discount to developed markets (per Credit Suisse), and look even cheaper on a Shiller P/E basis.

• Fixed Income: The fixed income bubble is bigger than that witnessed inequities. We see the current credit cycle as stretched and, in most cases, yield does not compensate investors adequately for the risks involved. Credit spreads and default rates could widen over the next year. Meanwhile, do not forget that over $8trillion of debt globally still trades with negative yield (per Deutsche Bank), implying effectively guaranteed losses when rates rise and inflation returns.

• FX: We have no active views on currencies heading into 2018, but note that relative Dollar weakness over the past year may potentially unwind further in the near-term (most likely at the expense of the Euro). From a valuation perspective, emerging market currencies look particularly compelling, trading at a 27% discount to the Dollar (per Credit Suisse).

• Alternative Assets: We continue to favour investments in genuinely uncorrelated strategies. This is one of our highest conviction views. Within this universe, we consider allocations to catastrophic reinsurance (especially in the context of the recent hurricane season and higher premiums), infrastructure assets, direct lending and niche private equity to be attractive. Such assets provide diversification and allow investors scope to harvest illiquidity premiums.

More of the same?

There is no doubt that we are late in the current cycle. We also know that very few people have the ability to time markets precisely or call their tops. The 2008 Lehman-inspired collapse – viewed without the benefit of hindsight – was a case in point; an event that was described by the then Governor of the Bank of England, Sir Mervyn King, as a ‘failure of the collective imagination.’ The irony, however, is that early in the cycle investors are generally reluctant to add risk to their portfolios despite the high implied returns. Now, valuations (for equities and conventional fixed income) suggest only modest long-term returns are on offer and that there is a greater likelihood of short-term disappointment. Nonetheless, it is proving increasingly hard to get investors to signal much semblance of caution; quite the contrary. Against this background, it should come as no surprise to our regular readers when we assert that valuation remains crucial, particularly at this stage of the cycle.

The thesis we laid out at the end of 2016 was that 2017 could be a year which was characterised by boom and then bust. This clearly has not occurred, but such a scenario looks increasingly tenable for the next 12 months. In other words, after the very strong returns achieved during the past year, 2018 could be the year of boom then bust that 2017 wasn’t. The reduction of perceived tail risks coupled with higher growth expectations yet still moderate inflation trends has helped push most asset classes (but equities in particular) higher. The ‘lazy’ assumption is that the current cycle can continue potentially for as long as some form of the Central Bank put, or effective backstop, remains in place. Thought of another way, the burden of proof currently remains very much on the bears. This said, the best backdrop the bulls can probably hope for is simply a continuation of existing trends.

Investors are benefiting from an exceptionally rare set of current circumstances. Synchronised global economic expansions that are indicative of a self-reinforcing profit cycle do not come along very often. Moreover, even if real economic growth has normalised back to the pace seen before the great financial crisis, interest rates and monetary policy have not. There is limited evidence of wage inflation – and until labour gains full pricing power, generally loose monetary policy can remain intact. Many commentators have therefore asserted that the current ‘exuberance’ being witnessed in markets can be considered as rational (as opposed to Alan Greenspan’s notorious observation), for as long as the status quo is unchanged and the broad pace of earnings upgrades continues. Street consensus expectations are for another year of double-digit earnings growth for world equities.

There are two interrelated problems with this Panglossian thesis. First, it breeds a ‘herd mentality’ whereby most investors have been chasing (diminishing) returns from the same asset classes – and continue to do so. This effect is compounded by the burgeoning popularity of passive investment strategies. Next, the wisdom of the American economist Hyman Minsky comes to mind: “stability creates its own instability by breeding over–confidence and bubbles.” One of the most remarkable aspects of this bull market is just how low current levels of volatility are. So much calm implies an increased risk of greater volatility going forward.

We see no shortage of uncertainties ahead. Listed in no particular order and beyond our more fundamental concerns regarding valuation, potential monetary policy error, rising default levels, and/or political instability are all crucial factors to monitor. Since the end of the financial crisis, Central Banks have historically over-estimated growth and inflation prospects; now there is a real possibility that these are being under-estimated. The US has already embarked on a path of rate increases and effective quantitative tightening is unlikely – at the least – to be positive for global liquidity. This could be a major problem when consumer credit in America stands at its highest-ever level (equivalent to 20% of GDP) while the savings ratio is at its lowest in a decade (3.1% of disposable income) – data per the Department of Commerce. Meanwhile, Credit Suisse notes that corporate leverage as a share of GDP is back to previous cycle-highs, with American businesses having taken on $7.8trillion of debt and other liabilities since 2010. Interest cover is also at its lowest since the end of the last cycle.

To the extent that history may rhyme, 2018 does mark a decade since the world’s last major financial crisis. It is, however, worth considering that next year also constitutes the 50th anniversary since the 1968 global protests against political elites. This is relevant given that 2017 is likely to have been the best year for wealth creation since 2012. The richest 1% of the world now owns over 50% of its wealth (again per Credit Suisse). Political backlash and renewed populism should not, therefore, be unexpected for the year ahead. Brazil, Italy, Mexico and Turkey all face elections, while Europe’s reform agenda may stall in the absence of a stable German coalition and with the spectre of Brexit looming large.

Against this background, the case for a pullback in markets (if not a more formalised correction) looks increasingly plausible. Investors should not be surprised were such an event to occur, especially given the context that the last major drawdown (a 5% intra-month move) for equities happened almost two years ago, while 10-year US Treasury yields have traded in a narrow band over the last year with the overall curve having flattened. This is the problem: Central Banks hold the key to determine when to push back by tightening policy; but when they do, asset prices potentially face a severe challenge. Until they do so, asset prices can plausibly persist above fair value. While equity markets are undoubtedly expensive relative to history, so are most other conventional asset classes. This means they are all vulnerable to falling at the same time, leaving few places to hide.

Where to position

Valuation and compounding remain the biggest drivers of returns, in our view. Moreover, the best time to buy assets is when they are undervalued: owning equities, for example, after a crisis and investing in credit when default rates are high. The corollary of these observations is to prioritise currently value as an investment style. Of course, ‘rational’ asset allocation decisions are often clouded by short-termism and heuristic biases: investors are constantly aware of career risk and have to tread a fine line between a perceived fear of missing out and the related fear of losing everything. As prosaic as the suggestion sounds, our counsel has been for some time that it is better to be too early than the inverse. We wonder what returns can be made from squeezing the final drops out of the current bull market.

Our strategy has therefore been one of diversification – a thesis we continue to advocate heading into 2018. In other words, we see considerable merit in less conventional and hence more uncorrelated assets such as catastrophic reinsurance, direct lending and niche private equity. Within the more mainstream world, it seems increasingly hard to justify, for example US equities, when the main benchmark indices are at record highs and the S&P 500 has returned more than 350% (equivalent to 19% annualised returns – achieved, at the same time, with very low levels of volatility) since having bottomed in March 2009. With such a high starting point, similar levels of future returns will be almost impossible to achieve. European and Japanese equity markets have yet to return to previous highs, but are not without structural challenges. When we look to the future, a combination of valuation and demographics suggests to us that emerging markets – from an equity, debt and currency perspective – potentially offer the most compelling returns. Now is the time to be proactive; before it is too late. With best wishes to all our readers for the year ahead.

Alexander Gunz, Fund Manager, Heptagon Capital