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: now, it’s all about show-time. The current gap between investor expectations and deliverable reality looks alarmingly wide. This outcome is manifested in many asset valuations and exacerbated by the length of the present business cycle. The practical shift from deflation to reflation, from monetary to fiscal emphasis, will neither be simple nor linear; and, it may not even be guaranteed. As a result, the scope for policy error (by both elected leaders and Central Bankers) is high. Against this background, our emphasis remains on two things: valuation and diversification. Consider investments that look cheap and/or are highly uncorrelated.

Asset Allocation:

 Equities: The prospect of higher rates should mean lower correlations within, and higher dispersion across, equity markets. This creates a plethora of opportunities for alpha-generators. However, generally high valuations may constrain overall market returns. At this stage in the cycle, equities remain attractive, as much as anything, in the absence of more compelling liquid alternatives. Our regional preference is for emerging markets, Europe and Japan.

 Fixed Income: Given the magnitude of the move in developed world government bond yields in the last few months, some reversion is possible in the very near-term. Nonetheless, after a 30-year bull market in bonds, valuations remain generally unattractive, while any evidence of sustained inflationary pressures would also undermine the case. At notably more elevated levels of yield than currently, Treasuries and other comparable debt may become attractive again, but for now we continue to avoid fixed income allocations.

 Currencies: Similar to fixed income, recent moves in major currencies (particularly the Dollar) have been pronounced and so may reverse further in the coming months. We have no active views in this area at present.

 Alternative Assets: We continue to favour with high conviction investments in genuinely uncorrelated strategies, and private asset classes in particular. Within this universe, we consider allocations to catastrophic reinsurance, infrastructure assets, direct lending and niche private equity to be attractive.

What can go most wrong?

Rather than muse, like the new President of the United States, on the figurative significance of the Dow Jones Index having crossed 20,000 within days of his inauguration, the much more pertinent consideration for investors should relate to where the major sources of risk currently lie; or, which factors may be the most likely to undermine the currently seemingly roseate outlook. This matters all the more given the abruptness and the magnitude of the shift in mindset that has occurred in recent months.

Out are the notions of deflation and accommodative monetary policy, along with the merits of globalisation; in their stead and in current vogue are reflationary and fiscal agendas set against a background of deglobalisation. This policy volte face constitutes a clear paradigm shift. And, while its most explicit signs of manifestation are in the US, the move should be seen as a much more global one. US-inspired actions can quickly become globally reinforcing, particularly if it helps the surge of more populist politicians around the world. Look beyond the US, and note that Chinese manufacturing input costs (or PPI) have begun to rise again after 54 months of decline. Meanwhile, in Germany, inflation has doubled in the last month, albeit from a low base.

Such a policy reset inevitably has clear implications for asset allocators. Already, equities, Treasuries and currencies have responded. Our purpose in this commentary is not to debate whether these moves are justified. Nor is it to ponder on the precise length of time for which they can endure, especially in light of 2016’s lessons, which served to humble almost all forecasters. Indeed, for us, the most appropriate consideration is to wonder what can challenge the comfortable and cosy consensus that seems increasingly to have been established in the last months. This matters too for allocators.

It’s all about starting points

The S&P stood at 805 and traded on a P/E of around 12x, while the VIX index of volatility sat at 56 on 20 January 2009, the day Barack Obama formally assumed the US Presidency. Wind the clock forward eight years to the date of Donald Trump’s inauguration and the corresponding figures were 2271 and a multiple of 21x, with the VIX at just 12. It is easy to assert, therefore, that current multiples don’t leave much room for error. In defence of the bulls, however, it is worth pointing out, as do Credit Suisse in some recent research, that equity markets tend to peak when their indices get to a level that is 100% above its 10-year rolling average multiple. In the US, this is currently ‘only’ 50%, compared to the peaks of 65% reached in 2007 and 123% in 2000. The more important point to note, though, is that the best time to invest in any asset class (if possible) is when a shift from despair to optimism, or fear to greed is set to occur. This was very much the case eight years ago; much less so now.

The current global expansion is one of the longest in history, albeit fuelled through artificial stimulus. In the US, its duration has only been exceeded once previously (during the 1991-2001 period). Meanwhile, after 75 months of job growth under Obama, jobless claims in the US are at their lowest since 1973. Against this background, there is not a lot any President – Republican or Democrat – can do to bolster a full-employment economy near the end stages of a multi-year cycle, facing the dual headwinds of limited labour supply and productivity growth. Put another way, the odds of a recession and/or a bear market in the next four years are quite high, regardless of who is in charge at the White House.

Excesses are building

This matters, since imbalances rather than age generally prove to be the factors that contribute most to the destabilisation of market momentum. We see evidence of these in three particular areas: labour markets, inflation and debt. With regard to the former, take the last non-farm payroll wage report in the US: wage growth is running at 2.9%. Meanwhile, the Fed’s Beige Book of current economic trends highlights “tight” labour markets in all districts while noting that “pricing pressures had intensified somewhat” since its previous report. These concerns could metastasise further should policy intervention (fiscal easing) potentially push the labour market beyond full capacity. Similar trends are occurring in many other developed economies around the world. Eurozone inflation currently stands at 1.8%, up from 1.5% a month prior.

The corollary of labour market pressures is pricing pressures. Current annual US consumer price inflation is 2.1%, while the yield on the US ten-year Treasuries is 2.5%. The concern would be if these figures were to move higher. While such a scenario would be particularly worrisome for bondholders, history suggests that should yields move above 3.5%, then equity investors will suffer too. These developments need monitoring. Finally, don’t forget about debt. Even if the return of inflation would decrease the headline value of monies outstanding, absolute levels suggest limited scope for manoeuvre. This matters, particularly when it comes to considering the true scope for fiscal stimulus. Data from the Bank of International Settlements highlights that US debt/GDP currently stands at 104%, notably higher than the 72% level of 2008, a time when stimulus would have anyway had more impact. A similar picture can be seen elsewhere in the western world.

Political optimism looks misplaced

Rarely has so much effort, time and data been dedicated to assessing political outcomes than in recent months. As a result, the gap between political expectations and reality is very wide. Note, for example, that US small business optimism is at its highest since 2004; American consumer confidence, its best since 2007. Now, the ‘hope’ bubble needs to be confirmed, or it will inevitably burst. Expectations are currently running highest on the delivery of tax reform, infrastructure spending and deregulation. Whether any of these will provide the desired impact (particularly at this stage of the cycle), and whether Trump will be able to strike the appropriate balance between them, remain to be seen. Conjecture will soon have to give way to tangible delivery; even if investors are forward-looking, they are rarely patient. Meanwhile, it is worth considering the contrast between Trump’s very broad agenda and his much more finite amount of political capital. Indeed, a recent Gallup poll shows his approval rating lower than for any other incoming American President.

Scope for policy error and an undermining of investor (not to say voter) confidence is not just a US-specific issue. A look at the political calendar for 2017 highlights a multitude of potentially unknown election outcomes facing Europe in the coming months. There is also the uncertainty of Brexit with which to contend, while Greece (a subject much discussed in these commentaries five years ago) may return to the headlines again too. It is making sclerotic progress in reform, its economy is mired in recession (indeed, the only one in the Eurozone with industrial output below 50) and debts are ballooning. Finally, China will have to maintain a delicate balancing act of managing a slowing economy and controlling ever-present excesses (in its housing market, for example) ahead of its 19th National Congress in the Autumn.

And, some things are structural

The changes being sought by more populist administrations around the world are intended, above all, to alter sentiment. As a result, policies being either contemplated or implemented relate to cyclical matters; they do not address more structural concerns. All current or aspiring leaders face the challenges of slowing trade, the negative tide of demographics, heavy debt burdens and the onward march of technology. Most of these elements are inherently deflationary. Policies that seek to harm trade or make migration more difficult will be inevitably deleterious to growth. Meanwhile, few consider the importance of implementing measures to enhance productivity, potentially the best tool for driving sustainable growth. In light of such uncertainties, even if there are short-term investment opportunities along the way, our longer-term conviction in investing in alternative, uncorrelated assets continues only to grow.

Alexander Gunz, Fund Manager, Heptagon Capital