View from the top

View from the very top: a fear of missing out (or FOMO) has driven many asset classes to recent new highs. Elevated exuberance is rarely good. High starting points inevitably imply lower future returns. A potentially false confidence resides in the fact that policymakers will do what it takes to sustain the boom in (almost) everything. However, the combination of a coronavirus pandemic that remains virulent, inflation that is looking increasingly sticky and the lingering chance of a policy error – tightening amidst greater economic uncertainty – is a potentially dangerous one, particularly if certain assets are priced to perfection. Against this background, we believe there exists a compelling case for adopting balance across portfolios, embracing a range of styles and diversifying away from the things that have done very well recently. We also see some logic in increasing cash holdings currently.

Asset Allocation:

  • Equities: Risk assets such as equities have continued to outperform throughout 2021, but there has been significant dispersion. No style has been spared, with value gaining in the early part of the year and growth more recently. Even if earnings upgrades remain supportive, the pace of growth is slowing and higher costs will likely have a negative impact at some stage. We see a persuasive logic in balancing growth with value and more cyclical businesses with quality ones. We also note that emerging market equities look clearly undervalued versus developed peers.
  • Fixed Income/ Credit: Bonds have endured their worst performance relative to equities on a 10-year rolling basis since 1984 (according to Bank of America Merrill Lynch). While the current yield on US 10-year debt of 1.5% has retreated from its 2021 peak of 1.7%, its future direction may be partially dictated by the risks attributed to the re-emergence of the coronavirus as a concern. In general terms, we see a combination of low yields (versus long-term history) and rising inflation risks as an unappealing one. Our allocations within this space remain limited for now.
  • Currencies: A higher US Dollar has been the currency story of 2021. The Euro stands at a 16-month low relative to the greenback, while emerging market currencies are even weaker. Above and beyond mean reversion, a potentially more balanced growth and inflation mix globally in 2022 may argue for some Dollar weakness going forward.
  • Alternative Assets: We favour increasing allocations to this space since these assets bring clear diversification benefits to portfolios. We are also attracted to the collateral-backed cashflows that these assets generate. We expect infrastructure assets to benefit from ongoing fiscal stimulus initiatives. Additionally, we advocate exposure to business models with strong balance sheets such as seniors’ housing or logistics REITS.
  • Gold: Despite a mixed performance year-to-date, we retain conviction in allocations towards gold. We believe uncertainty generally benefits this asset class. For indirect exposure, consider the relative valuation (especially versus US equities) of the listed miners. Also don’t forget, Central Banks still hold gold (and not yet Bitcoin).

One of the most remarkable statistics from a year that has been characterised by its sheer unpredictability is that the MSCI All Country World Index of equities has almost doubled since its March 2020 nadir. Even if the emergence of the Omicron variant of the coronavairus may inspire a natural reset in the very near-term, the rally of the past 20 months remains among the most powerful in history. Such has been its extent, that viewed from a slightly different perspective, the gap between the S&P’s US Growth Index and its corresponding Value Index has now passed its prior year 2000 peak (data per Bloomberg). Even the most staunch bears have been shaken by these abrupt moves. Think of them as being part of the FOMO – or fear of missing out, for those unaware – rally.  

Stimulus at a time of crisis last year was undoubtedly the correct response (the counterfactual is perhaps too concerning to consider), but its consequence – whether intended or not – is that low risk assets have been rendered unattractive, offering low returns, hence resulting in a crowding into other areas. One doesn’t have to look too hard to find supporting evidence. Within the world of equities, consider not just the high level of retail participation or the record sums of money flowing into call options, but the fact that for the first time ever, the top-five constituents of the S&P 500 US equity index now comprise over 20% of its value (per Bloomberg). Even if history does not repeat itself, it can still rhyme and your author – who began his career in 1997 – sees certain similarities with the last days of the dot-com bubble: investors seem to see no other options than to keep backing the winners, with so called ‘losers’ (or the other side of the trade) correspondingly punished. More and more concentrated bets are being made. Bank of America Merrill Lynch notes in its latest Fund Manager survey that the most croweded positions are (in order): technology, Bitcoin and ESG stocks.

Beyond the world of equities, we also do not struggle to identify other potential signs of bullishness or investor complacency. 2021 to-date has been a record year for deals, with M&A totalling $1.4tr. It has also been the best year ever for IPOs, with over $600bn of new capital raised and a month of the year still left. It’s sobering to remember though, that 54 of the 100 largest businesses that have come to market in 2021 are still loss-making. Move into the world of high yield and consider that this form of debt (where also record sums have been raised year-to-date) now comprises 50% of the Bloomberg US corporate index, up from 35% in 2006 and 25% in 1990. Even more remarkably, Bitcoin as an asset class is now worth more than the total size of the US high yield market (at almost $3tr), with its value having risen sixfold over the past year (all data per Bloomberg).

It is perhaps not unreasonable to suggest that many investors are therefore perhaps hiding out in the same places. Warren Buffett’s famous quip that when the tide goes out, some will undoubtedly be left swimming metaphorically naked hence comes to mind. We have no doubt that there are several pockets of the investing universe that could be classified as being in bubble territory, but it is perhaps harder to say specifically what may burst these. It is never easy to call tipping points. What we are more confident in asserting is that high starting points naturally imply lower future returns. Owning any asset with a more demanding valuation at the time when a bubble does burst will not be pleasant (particularly when it takes time to get back to previous levels). We concur with Jeremy Grantham’s observation that bubbles can inflict “cruel and deep wounds.”

The necessary pandemic response has clearly created a feedback loop from which it may be hard to escape. Equities in particular have never been more dependent on the Fed (or Central Banks in general; and we may want to include increasingly profligate governments too) and the Fed has never been more dependent on economic data, which has never been more volatile. However, the brutal reality is that for the first time since at least the Great Financial Crisis, Central Banks in the developed world will not be creating more accommodative financial conditions despite GDP which is slowing (albeit from a high base). Tapering is happening and rate hikes may be imminent. The Omicron variant could clearly change this dynamic, but investors may be facing a potential triple whammy of lower liquidity (either via tapering or rate hikes), higher yields and slowing earnings growth (from a high base). In order for risk assets in general to continue their outperformance, it might be necessary to see a tangible improvement in GDP growth relative to inflation. Currently, it’s hard to see this happening – unless you believe more stimulus is on its way.

Of course, if anything has more power over the world economy than the combined might of interventionist Central Banks and Governments, then it would be the coronavirus. A fresh wave of pandemic would certainly represent a stiff test for risk bulls. Even without the emergence of the Omicron variant, several European countries have seen infections back to peak levels, as has China, with the latter currently recording more daily cases than in 2019.  No one wants to resort to lockdowns (and whether they are the right thing to do remains open to debate), but they seem to be happening again and will clearly impact the world economy.

In broad terms, the reflation narrative of late 2020 and the early part of 2021 has now, arguably, been replaced by one of destabilisation. Think of this as the story for 2022 and beyond; a world of more uncertain growth and higher inflation. Indeed, inflation has been the hallmark of the pandemic recovery thus far. At the very least, there appears to be overpowering evidence that the low-inflation paradigm of the post financial crisis decade has now ended.

Inflation evidence is abundant. Begin with data from the OECD, a club of rich countries globally. Inflation in the 12 months to the end of September excluding food and fuel stood at 3.2%, its highest level in almost two decades. In the US, the world’s largest economy, headline inflation stood at 6.2% last month, its most elevated since 1990. Even on the Cleveland Fed’s ‘trimmed mean’ basis, inflation is at its worst since 2008 (5.3x standard deviations above its ten-year norm), while the Atlanta Fed’s ‘sticky’ inflation measure shows its highest reading since 1991. When one looks at one-year forward expectations, the University of Michigan’s latest reading calls for 4.8% US inflation. Over in Europe, the picture is little better, with headline inflation in the Eurozone of 4.1% and core inflation at 2.1%, the highest it has been in almost 20 years. China’s figure is little better. By way of anecdote, we also note that Google Trends shows that searches for inflation are at their highest in Google’s history of collecting this data (which goes back to 2004), while Bloomberg notes a record number of inflation mentions by corporates on calls over the last earnings season. President Biden says reversing the inflation trend is a “top priority.”

Achieving this, of course, may be much harder. Supply chain issues are clearly not going away any time soon, especially if the pandemic has its way. Even at present, the JP Morgan Index of Global Purchasing Managers shows that input prices are at their highest in 13 years. Almost every company with whom we have spoken recently corroborates such a view, suggesting that supply chain shortages will most likely persist into 2022. Next, consider that wages are also under upward pressure. With 11.2m job openings in the US versus the number of unemployed at 7.4m, workers clearly have the upper hand. Indeed, those in the lowest quartile are seeing their fastest pay increases in 20 years (per the Bureau of Labour Statistics). Against this background, it may be hard to see inflation disappointing any time soon.

The implication of the above is that regardless of what happens to GDP, we will have to live with inflation for now. This creates a further concern or risk for the bulls; simply that of a policy error. Jerome Powell says that he “won’t hesitate” to act on rates “if warranted”, but he does (and the same could be said for other Central Bankers) run the risk of potentially tightening into a period of more heightened economic uncertainty, thereby creating a policy error. We were intrigued to see that 5Y5Y inflation break-evens barely moved on the news that Powell had been reappointed to the position of Chair of the Federal Reserve. Sure, continuity does diminish the risk of policy error and the ‘hope’ remains that inflation can be controlled. However, this may simply be false confidence, or even complacency, dare we suggest it. Central Banks may be behind the curve currently, but the consensus opinion suggests that they will be able to catch up.

Whatever happens next will be a delicate balancing act. Of course, Central Banks might be more reluctant to hike should the coronavirus prove to be resurgent, even if this may create problems further down the line. The metaphorical tightrope is also being walked at a moment just when many asset classes (or assets within certain classes) are priced to perfection. Put another way, late cycle valuations in many asset classes have seemingly become disconnected with what is arguably a mid-cycle economy and a set of policymakers that may be behind the curve. Such a combination is potentially fraught with risk. Our counsel remains one of balance and diversification.

Alex Gunz, Fund Manager, Heptagon Capital


The document is provided for information purposes only and does not constitute investment advice or any recommendation to buy, or sell or otherwise transact in any investments. The document is not intended to be construed as investment research. The contents of this document are based upon sources of information which Heptagon Capital LLP believes to be reliable. However, except to the extent required by applicable law or regulations, no guarantee, warranty or representation (express or implied) is given as to the accuracy or completeness of this document or its contents and, Heptagon Capital LLP, its affiliate companies and its members, officers, employees, agents and advisors do not accept any liability or responsibility in respect of the information or any views expressed herein. 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. Where this document provides forward-looking statements which are based on relevant reports, current opinions, expectations and projections, actual results could differ materially from those anticipated in such statements. All opinions and estimates included in the document are subject to change without notice and Heptagon Capital LLP is under no obligation to update or revise information contained in the document. Furthermore, Heptagon Capital LLP disclaims any liability for any loss, damage, costs or expenses (including direct, indirect, special and consequential) howsoever arising which any person may suffer or incur as a result of viewing or utilising any information included in this document. 

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