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.

With a quarter of 2011 now passed, investors have been forced to learn once again the lesson of having to expect the unexpected. Nonetheless, despite geopolitical tensions in the Middle East and North Africa, oil above $100 again and disruptions in Japan, equity markets have shown remarkable resilience. In the US in particular, the S&P’s 5.4% gain from January 1 marks its strongest quarterly start to the year since 1998.

None of the world’s major problems has gone away: structural deleveraging across the world still needs to happen (in the US, debt is still growing three times faster than nominal GDP); there may likely be further sovereign debt issues and potential defaults in Europe (Ireland’s debt is equivalent to €200m per Irish citizen); commodity-price/ input inflation shows little sign of abating; and Asian economies retain the risk of near-term overheating.

However, this is not new news and the current outperformance of equities/ underperformance of bonds provides a source for comfort, at least for the near-term. As we and other commentators including Jeremy Grantham and Bill Miller have asserted previously, it seems a logical bet to back the US in 2011: we are in year-three of the Presidential cycle and also year-three of an economic recovery; on each of the five previous occasions in the last 110 years when these two elements occurred simultaneously, US equities rose by an average of 25%, and did not fall on a single occasion. It is also noteworthy that in Q1, the S&P comfortably outperformed its peer indices in Europe and Asia.

While we are content to stick with this strategy for now (preferring equities to bonds, developed markets to emerging markets, and the US to the Eurozone), there are some reasons for adopting a note of increasing caution. When we assess a combination of macroeconomic factors centred on the three key areas of valuation, risk and liquidity, leading indicators suggest to us that equities are beginning to look a somewhat less compelling proposition than at the start of the year. In particular, we note with interest that it looks as if global earnings momentum has peaked, with revisions moving from a positive 40-50% range at the start of the year to almost neutral today. As a result, business sentiment (measured by indicators such as Germany’s IFO survey) looks close to rolling over too. To misquote Mark Twain, while history does not repeat itself, it does at least rhyme: on each occasion in the last fifteen years, when sentiment has peaked, equities have underperformed for the following three months.

Against this background, we see a case for remaining highly nimble in our positioning, but also adopting an increasingly defensive strategy. When we consider what matters, the following seem to us logical strategies to adopt for now:

• We prefer equities relative to bonds (they continue to look cheap, especially relative to fixed income markets: cash is essentially yielding nothing and the spread on the S&P’s earnings yield relative to that of the US ten-year Treasury note, for example, is over 300 basis points);
• We prefer developed markets relative to emerging markets (valuation levels and inflation constitute distinct sources of concern in the latter);
• We favour equities with strong pricing power and / or those that have natural inflation hedges (examples include US/Canadian-listed railway stocks and consumer staples businesses such as Nestlé with strong brands and dominant global franchises);
• We continue to see a case for US equities over other main geographical markets (the Presidential cycle/ economic cycle detailed above, helped also by the extension of Bush’s tax cuts and Obama’s seemingly more accommodative stance to business);
• We believe stocks with high and sustainable dividend yields have the potential to outperform (European telecoms network operators, for example, are yielding 6.1% on average);
• With regard to emerging markets, we favour Russia and Central/ South America over Asia (some examples include Carlsberg – for Russian exposure; and Walmex – as a way of gaining exposure to the Mexican economy);
• We continue to favour equities with dominant franchises, superior IP and secular tailwinds (this plays, for example, to several names within the tech sector and also a number of plays that are related to them with regard to the ongoing proliferation of the online world – hence the case not only for IBM but also for Amazon); and,
• We remain cautious on the financial sector (limited visibility, exposure to ongoing sovereign debt issues) and also on the Western consumer (the recovery has been distinctly jobless/ joyless, with US unemployment now more than two times higher than it was in 2007).

In conclusion, the risk trade (pro-equities) remains on for now, but we feel it is prudent to adopt an increasing level of caution and also be prepared to revise this view with speed as events change.

Alex Gunz, Fund Manager, Heptagon Capital