- Marcus Brookes, Head of Multi-Manager
- Robin McDonald, Fund Manager
- 30 Nov 2015
Sometimes these outlooks differ significantly from year to year. This is not one of those times. Many of our thoughts from a year ago still stand. Here, we revisit some of these views as well as introducing a few new ideas.
What we think we know
We devote a lot of our time to assessing risk/reward opportunities. In our view, the rewards on offer to the Federal Reserve (Fed) and the US economy in keeping interest rates at zero were exhausted some time ago. The risks, however, particularly in financial markets, have continued to build.
I’m writing this piece in the second half of November, and as things stand it is anticipated that the Fed will begin the process of normalising monetary policy at its mid-December meeting, albeit in exceptionally dovish fashion. So, here are a few things we consider to be relevant:
- The global economy has not delevered. At the end of 2007, the global stock of outstanding debt was $142 trillion. Since then the world has added an additional $57 trillion of debt to its balance sheet.
- This record debt burden has been encouraged by global central banks and supported by near zero rates.
- Most financial assets have re-rated significantly on the back of near zero rates as it has encouraged investors to take more risk.
What we believe to be true
Every economic cycle is different and in many ways this one has re-written the rule book. Undoubtedly, the 2008 financial crisis was deserving of a radical response and in 2009 the US led the world in dramatic fashion, employing aggressive measures to rebuild its balance sheet. A little over two years ago, in 2013, total net worth of the US household sector hit a new record high. A reasonable question therefore is whether US rates have remained unnecessarily low ever since, and what will the consequences ultimately be if that proves to be the case? Here are a few things we observe:
- A US central bank that is desperate to move away from zero rates without distressing financial markets.
- An international economy trying to digest a stronger US dollar (global GDP growth is down 5% year-on-year in dollar terms).
- A corporate sector that has engaged in aggressive financial engineering by issuing huge volumes of low-yielding debt in order to retire massive volumes of equity.
- Global bond yields close to record lows.
- Global equity markets close to record highs.
What we know we don’t know
Sadly, what we know we don’t know with certainty is how financial markets will absorb this inflection point in US monetary policy. Fortunately, what we can evaluate is how financial markets are currently priced in a historical context, and broadly what investor expectations are. This is a decent starting point for making reasonable judgments about the outlook.
Our general view is that almost all assets are priced for continued low growth, low inflation and low (if not negative) real interest rates. If that’s the outcome – no great shakes. If the outcome is higher growth and/or particularly higher inflation, then we could see some big swings in the absolute and relative prices of bonds, equities, currencies and commodities. We are very much alive to this prospect as we are beginning to observe accelerating wage growth in a number of economies whose labour markets have tightened meaningfully. Below are some thoughts on the major asset groups as we enter 2016:
Fixed income & cash
Traditional fixed income tends not to do well in a rising rate environment. Our bias is for history to repeat itself in this respect considering how low current yields are. If we are wrong, and longer-term yields fall when the Fed hikes, it would be suggestive of a policy mis-step, making us more cautious on the economy. Either way, our suspicion is that weaning investors from such loose policy conditions will not be straightforward, so we expect bond markets in 2016 to be fairly turbulent.
Corporate credit spreads have widened over the past year suggesting, increased investor concerns about the potential for credit stress among highly leveraged borrowers. This is something we’re watching closely as history suggests that credit spreads often narrow when the Fed begins to raise rates. Importantly, however:
- The Fed doesn’t usually wait seven years into an economic cycle before raising rates. Typically the Fed starts normalising one-to-two years into a recovery when earnings growth is strong.
- A key reason why risky assets have done well this cycle is that investors have been encouraged to move out along the risk curve. How many investors have unwillingly bought investment grade credit and high yield this cycle in pursuit of a higher return; and how many will retreat to less risky assets when the Fed begins normalising?
- We strongly believe that when this credit cycle ends, the lack of liquidity will be a major issue. The latest data from the New York Fed shows US corporate debt inventories amongst primary dealers having turned negative for the first time on record. Until these markets are properly tested we don’t know how they will cope under such poor liquidity conditions.
So, although we can be modestly more positive on credit than we were a year ago as the degree of compensation has theoretically gone up, we have opted to retain a healthy cash balance across the Multi-Manager portfolios. Cash has been the hot potato asset of the last seven years. We believe it will become more desirable over the course of 2016 as the headwinds for fixed income intensify.
As a final point, 12 months ago we were rather more optimistic than we are today about the US dollar. Once again, history suggests the dollar tends to peak early into a Fed hiking cycle. This is contrary to popular wisdom, which suggests that in spite of a 25% rally in 18 months, the dollar remains a one-way bet. We tend to be wary of one-way bets as invariably they disappoint.
Equities appear richly priced
Our overriding view of the equity market is that it’s richly priced and has dubious internal dynamics, such as very narrow breadth (i.e. a small number of stocks leading the overall market higher). This combination doesn’t guarantee it will go down a lot. But nor do we believe our base case should be that it shoots up a lot either. Of greater curiosity to us at present is the relative opportunity set that’s emerged within the market.
We expect the trend of US equity leadership to flip in 2016 and for international equities to begin to outperform in both local and common currency terms. This reflects US economic, margin and valuation cycles that are more mature than elsewhere. In addition, Fed tightening is historically not good for US equity valuations. The reason why Fed tightening cycles haven’t historically assured outright equity weakness is because they usually get underway early enough in the cycle such that earnings growth effectively trumps the de-rating that almost always occurs (the tech sector in the late 90s was an exception). With the level of US profit margins close to record highs and with earnings growth already having moderated, we ought to be able to garner a greater return elsewhere. Our preference remains Japan and Europe where the above cycles are earlier in their evolution.
We consider investor positioning within the equity market to be heavily skewed in favour of the low growth – low inflation narrative. Yet, with US core inflation just a smidgen below target at 1.9% and a tight labour market, it may not take much of a spark from wages for the pendulum to swing away from this crowded group of ‘secular stagnation’ stocks towards higher inflation beneficiaries. The oil price bottoming around current levels would clearly be beneficial to this idea as well.
We are trying to resist the urge of becoming too contrarian too early here. Being different is often crucial at turning points, but can also prove a drag in the latter stages of a cycle when momentum investing typically works best. As ever we remain disciplined and patient, but equally open-minded to change.
We ask for the same degree of pragmatism from our underlying managers, particularly those running absolute return funds (one of our alternative asset classes). 2015 has been a challenging and in many cases frustrating year for even the most experienced investors we monitor in this space. We have no reason to believe the current higher volatility regime will not persist into 2016.
It has been the correct decision for us to stand aside of the commodity markets in recent years. This initially drew some criticism on the basis that we run (amongst other things) mandates benchmarked against inflation, and commodities are generally considered an effective inflation hedge. Inflation hasn’t been a risk the market has seen fit to hedge in recent years. As indicated earlier, we’re mindful that this could change in 2016.
For now, we continue to blend a number of fund managers in the alternatives portfolio who have historically proven adept at growing capital in weak markets. Sometimes this has been through contrarian positioning, sometimes through bold directional exposure, either long or short. Importantly the aggregate views expressed here are always in harmony with our wider portfolio themes. To summarise, these are to approach the bond markets with caution, to carry equity risk primarily outside of the US, and within equity markets to increasingly lean in favour of strategies that will benefit from a shift away from the low growth – low inflation beneficiaries. These views are expressed through both long only and long-short strategies.