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: Optimism seems the order of the day. The news of positive vaccine trials and their subsequent deployment over the coming year should provide an obvious confidence boost to the global economy. A combination of ample spare capacity, pent-up demand, benign monetary policy and increasing political stability establish the foundations for a mini boom. How much of this has already been discounted by investors remains to be seen. If anything is clear, then the path ahead will be non-linear. Expect setbacks along the way. At the same time, however, don’t lose sight of the bigger picture. It’s important to diversify away from conventional 60:40 allocation between equities and bonds and focus more on both truly active and more unconventional asset classes. In the very-near term, we lean in towards a somewhat higher cyclical bias, while remaining opportunistic.
- Equities: This is still the place to be in terms of asset allocation, based on relative valuations, an improving earnings outlook and a growing tolerance towards more risky assets. We expect truly active strategies to continue to prosper. A rotation away from growth in favour of value should be positive for stock pickers. Value as a style has underperformed growth for over a decade (the longest stretch since the 1960s), creating clear opportunities. Nonetheless, we also expect resilient growth and secular themes to remain in vogue, even if they won’t come so cheaply. Being more opportunistic also includes widening the lens. Areas such as US small caps and selected emerging market equities could be attractive.
- Fixed Income/ Credit: Investors in debt need to be conscious that while the yield curve is beginning to steepen (the spread between 2-year and 10-year debt in the US is at its most pronounced since 2017), there are still ~$17tr of negative yielding bonds globally, almost $10tr more than in March. Put another way, over 25% of investment grade debt globally has a yield of less than 0% (all data per Bloomberg). Such dynamics may end up pushing investors towards riskier segments of the market (i.e. high yield), potentially at their peril, in the context of high debt/EBITDA levels and worryingly low levels of interest cover.
- FX: Even if increasingly consensual, we see good reasons why the US Dollar should weaken further from current levels, particularly under an economic recovery scenario where the rest of the world expands at a faster rate than the US, albeit from a lower base. We would expect Emerging Market currencies to benefit at the expense of the US Dollar.
- Gold: As real yields have started to rise, gold has underperformed, falling by more than 10% from its August highs. Although this trend may continue in the near-term, pullbacks will create opportunities. The asset remains a strong hedge against both political uncertainty and markedly higher inflation. Supply is also currently constrained.
- Alternative Assets: We see a clear role for such assets in portfolios. Low yields generally strengthen the case for private assets. Infrastructure assets may also benefit from the increased role fiscal policy is expected to play. Elsewhere, we see selected opportunities for business models with strong balance sheets such as seniors’ housing or logistics REITS.
The key lesson investors have had to learn during 2020 is being nimble, or learning to deal with new and often quite unexpected news. November proved this in spades – consider developments both political and vaccine-related – with the biggest one-day mean reversion in value relative to growth since 2009 having occurred during the past month. If ever there were a time for truly active and differentiated strategies to have demonstrated their mettle, then it would be currently. Looking ahead, we believe that the fundamental tenets of this approach will continue to be relevant. Even if the outlook for the global economy and broader investing environment is now markedly more attractive than six months ago, much of this roseate is seemingly already discounted.
We were intrigued to read the findings from the latest Fund Manager Survey by Bank of America Merrill Lynch, which showed investors at their most optimistic since January 2018, with average cash levels at their lowest since April 2015. Growth expectations – albeit from a low base – are apparently at their highest in 20 years. Against this background, our best counsel is to stick with what’s worked – as a broad strategy, be both active and pragmatic. If we are en route to a recovery boom, this implies leaning in somewhat more towards cyclicals. At the same time, we doubt any recovery will be linear; there will be clear setbacks along the way.
It is certainly too early to claim a return to normalcy, but we are at least on the way there. With hindsight perhaps, bull markets (in equities) almost always start when the underlying economy looks the worst – i.e. late March. Under such a view, the market has already shifted (or is now shifting towards) early-cycle dynamics. All other things being equal – and this is a big caveat – this would imply steeper yield curves and higher inflation break-evens as 2021 plays out.
Certainly, from where we stand, the most troubling moment is over: the scientific uncertainty at the heart of COVID- 19 is resolved. We must consider this an impressive achievement: it took less than 300 days from sequencing the genetic profile of SARS-Cov2 to completing successful large-scale trials. For context, it took around 9 years for a similar landmark to have been reached for measles, and 20 years for polio. Approved vaccines should begin to clamp down on the virus. As multiple solutions become available, this should imply that the willing population could be inoculated at a rapid pace.
Under this scenario, we should think of vaccines as offering effectively a powerful dose of stimulus, or the much-needed trigger for the economy. Even if vaccines do not arrive immediately, there may well be a psychological confidence boost ahead of the event. Do not forget, however, that nobody has ever tried to vaccinate an entire planet at once. As the effort mounts, syringes, medical glass and staff may all run short. Further, the vaccine is not a silver bullet – it will not eradicate COVID-19 or prevent transmission. This matters, given that the US Centre for Disease Control estimates that 40% of all people with COVID-19 do not show symptoms. Enhanced testing will, therefore, be important as a complementary effort.
Nonetheless, the OECD estimates that global economic growth in 2021 will be 7%, with a vaccine; two percentage-points higher than without. Pent-up demand can help drive an economic mini boom, particularly when all economies are clearly operating below full capacity. Estimates put the US at ~10% below full capacity and the Eurozone closer to 20% (per Alpine Macro). Currently high savings ratios will also help. At 14.3% currently, the level in the US roughly double its long-term average.
Furthermore, investors do tend to look forward. Even if there is a risk of the economy contracting over the winter, it’s more about looking beyond this. GDP and earnings estimates are going up, even if they are not forecast to return to pre-pandemic levels until the end of 2021 in the US and mid-2022 in Europe and Asia (per Goldman Sachs). Notably, the US Conference Board (which measures the confidence of CEOs) showed a reading of 64 in Q3 versus 45 in Q2, where anything over 50 is considered as optimistic, and this was pre-vaccine news.
All the above is also occurring against a supportive monetary and political backdrop. The messaging from the Federal Reserve and other Central Banks is that of remaining pragmatic. The lesson learned from the Great Financial Crisis is not to withdraw stimulus too early. Against this background, Central Banks are urging caution over exuberance. Jerome Powell has noted that it is “too soon” to put away emergency tools, while the European Central Bank (ECB) has said that it will “review all its instruments” with a view to providing more stimulus.
Politically, things also appear to be improving. The pending installation of Joe Biden as President of the United States should usher in a more predictable policy agenda, both domestically and internationally. Expect some fiscal expansion, but the presence of a likely Republican Senate to act as a buffer against tax hikes and more forceful regulation. Divided governments are generally less intrusive. Sure, the bigger picture dynamic of worsening US-Chinese relations is not going to go away, but it would at least be fair to see the incoming President as more of a conciliatory consensus builder. Rising US inequalities will become something that it is difficult to ignore, but this perhaps remains a discussion for another day.
A possible mini boom supported by ongoing monetary accommodation and a more stable political backdrop is also occurring in the absence of any inflationary pressure. US CPI (consumer price inflation) is just 1.2%, while in the Eurozone it stands at 0.9%, with the ECB warning that risks remain weighted to the downside. Importantly, inflation expectations are currently no higher than they were pre-pandemic (per Bloomberg). There is clear spare capacity in the economy at present, supported by low levels of employment (a headline US unemployment rate of 6.9% masks the fact that lots of people have currently dropped out of the workforce and may re-join later), which will cap wage pressures in the near-term. Under a divided government scenario in the US, a major – and potentially inflationary – stimulus programme also looks less likely. Finally, we have argued for some time that structural factors – high debt burdens, adverse developed world demographics and the growing pervasiveness of tech – should all continue to exert deflationary pressures over time.
The clear challenge for investors is to consider how to position for such an environment. Our messaging on this topic has been consistent for some time – that it is crucial to consider more unconventional and uncorrelated investment strategies. Even if a default 60:40 portfolio of US equities and bonds has proved its resilience (up ~14% through to the end of November, in line with the S&P 500 Total Return Index and ahead of ~4% return in the HFRX Global Hedge Fund Index, per Bloomberg), future returns will be lower than those which investors have become accustomed to historically. On several metrics both equities and bonds look expensive relative to their history and a high starting point, by definition, implies lower subsequent returns. The 60:40 approach generated 5.4% annualised returns in the past decade but is forecast to return just 4.2% in the coming ten years (per JP Morgan). If investors don’t want to accept lower returns, they need to diversify. It’s important not to lose sight of the bigger picture. Welcome to the era of being (even more) nimble.
Alex Gunz, Fund Manager, Heptagon Capital
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