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: if 2018 has been tricky from an asset allocation perspective, with most mainstream asset classes currently delivering negative returns, then we expect 2019 to be even trickier. This is quite explicitly not to say that there will be either a recession or a bear market next year; more that investors need to adjust to and correspondingly position themselves for a regime change. Put simply, 2019 will be the year when quantitative easing turns decisively to quantitative tightening. The corollary is that the rising tide which lifted almost all asset classes should now move into reverse. Its effect is likely to be profound, particularly given high levels of corporate, consumer and government debt. Appropriate positioning will be crucial. We continue to favour equities over credit on a relative basis, but see a growing logic for further allocations to uncorrelated, real assets.

Asset Allocation:
• Equities: Investors should expect generally lower equity returns in 2019 than 2018, owing to a combination of peak margins and slowing earnings growth, particularly in the US, with Trump’s tax benefits now behind us. There is no better time than now to consider active stock selection strategies over passive ones (where we expect the massive concentration of capital in ETFs to unwind) and we strongly favour value over growth. From a geographical perspective, it is hard to ignore the marked outperformance of the US equity market over every other region in the last decade. In contrast to the S&P 500 Index, neither the MSCI World nor MSCI Emerging Markets Index has regained its pre-crisis high. After sustained recent underperformance, emerging markets now look particularly attractive for the longer-term investor.

• Fixed Income: 2019 looks set to be a difficult year for credit, with more debt issuance and a deterioration in its quality. What we mean by this is that state budget deficits are expanding (particularly in the US, to fund fiscal stimulus) just as credit spreads are starting to widen. Quantitative easing allowed many businesses that should have gone bankrupt to survive. With monetary conditions now inexorably tightening, concerns over creditworthiness should grow. We have limited allocations both to government and corporate debt.

• Alternative Assets: As the investing environment shifts from being one dominated by quantitative easing to one driven by quantitative tightening, we expect uncorrelated assets to outperform. There is a growing logic for investors to seek to harvest illiquidity premiums. Real assets backed by sustainable cashflows also provide an inflation hedge. We consider allocations to infrastructure assets, direct lending, niche private equity and real estate to be attractive.

• Cash: In the current uncertain environment, cash may act not just a as source of defence and form of diversifier, but also as an asset that is now beginning to offer some marginal yield.

Regime change

Let’s begin with a sobering fact: almost no major asset class year-to-date has delivered returns in excess of US consumer price inflation (CPI). For the record, CPI is currently 2.5% in America. Viewed from an alternative perspective, 89% of all assets analysed by Deutsche Bank had delivered a negative return in US Dollar terms in the 10 months of 2018 through to the end of October (November’s data is not yet available). This has been the worst performance since 1901. What makes these statistics all the more interesting is that 2017 marked the best-ever year in Deutsche’s study, with just 1% of assets tracked posting a negative return.

‘Regime change’ is the expression which perhaps best captures this abruptly shifting dynamic. Put simply, if quantitative easing fuelled an ‘everything bubble’ which found its apogee last year, it is only fair to consider what happens when the trend goes into reverse. Negative returns should not be surprising given that we come from a position where the majority of assets globally are expensive relative to history owing to the consequences of extreme (and previously untested) monetary policy.

We are reminded of the observations of Hyman Minsky, the American economist. He noted that risks always pile up in quiet times. October’s correction was not a fluke; red flags had been appearing everywhere. Indeed, events from 2018 potentially portend things to come. A ‘Minsky moment’ is popularly understood as being a sudden, major collapse of asset prices after a long period of growth, sparked by debt and/or currency pressures. We are not saying a Minsky moment is specifically imminent; more, that investors should position themselves for the reality of regime change.

2019 will, in our view, mark the year when quantitative easing turns decisively to quantitative tightening, with the balance sheets of all the major developed world Central Banks seeing declines. Given the distortions that recent monetary policy has wrought, the process of normalisation will be difficult, rendered all the more so by still somewhat complacent expectations about the future path of policy. Investors have become conditioned to expect Central Banks to repress financial volatility at the first sign of market vulnerabilities. The reality is that we are now moving towards a world of tighter (or increasingly tight) liquidity.

The corollary is that the rising tide which lifted almost all boats (asset classes) is now sinking them. Furthermore, the impact of this unwinding is exacerbated by the excess concentration of capital in certain areas. Just as many investors rushed for passive strategies with heavy ‘FAANG’ (mega-cap tech) exposure, so these assets have corrected the most heavily. For evidence of regime change, then look no further than the subtle shift in investor psychology. Whereas ‘buying the dip’ has proved a successful default remedy for most of the last decade, it no longer now seems to be working so well. Rather, the mindset has shifted to one of ‘selling the rallies.’

Against this background, we believe it is reasonable for investors to expect lower returns in 2019 than 2018; or, if 2018 was tricky from an asset allocation perspective, then 2019 may be even trickier. We are quite explicitly not saying that next year will herald either a bear market (in equities/ fixed income) or a recession, but just that the best of the good times are now behind us. Negativity has grown extremely palpable and there are no shortage of uncertainties, both macro (tariffs and trade, Brexit, China, Italy’s budget deficit etc.) and micro (labour shortages, wage pressure), but let’s not forgot that this has been a very unusual cycle. Trying, therefore, to predict how, when and where it will end is not going to be easy.

Nonetheless, even if history may not repeat itself, then it may – per Mark Twain – at least rhyme. And what we think investors need to watch most closely is debt. Debt has played a critical role in just about every financial debacle in history, from Tulip Fever through to the Eurozone crisis. Without quantitative easing, the world may be in a worse place than it is currently, but its unintended consequences are certainly non-trivial. Beyond the unsavoury rise of populist politics that was quite possibly exacerbated by the widening divergence between real-world and asset-class inflation, accommodative monetary policy has allowed many businesses that should have gone bankrupt to survive. As monetary conditions now tighten, we expect concerns relating to creditworthiness to grow.

It’s all about debt

Investors, in our view, need to worry less about dynamics in the equity market (even if selling the rallies makes logical sense) and more about the widening of credit spreads. The lowest interest rates in modern history have created an unnatural divergence between corporate debt levels and corporate default rates. 2018 is set to mark the worst year for credit in a decade, with Bloomberg’s High Yield and Investment Grade indices all currently posting negative returns in both Euros and Dollars. Furthermore, credit spreads (i.e. the difference between the yield on 10-year US Government debt relative to that offered by junk bonds) has begun to widen, reaching its broadest since late 2016. With the Fed set to remain on a tightening course, we see the likelihood of spreads stretching further as being high. It is worth being mindful that the amount of corporate debt in the US rated BBB has almost tripled over the last decade to roughly $2.5trillion (per Bloomberg).

When we talk about debt, we are only getting started when considering corporate debt. Consumer credit as a share of personal consumption stands at 28% in the US, close to an all-time high. The key figure to remember though is that US Government debt is set to reach $21.5trillion at the end of the current fiscal year, equivalent to 106.4% of GDP (all data per the Federal Reserve). Investors may recall the conclusion of the famous work on debt by Rogoff and Reinhart written in the aftermath of the credit crisis: economies with government debt greater than 90% of GDP cannot sustainably continue growing their GDP. The Trump-inspired fiscal stimulus (equivalent to 4% of GDP) will somehow need funding – presumably through the issuance of more debt. Meanwhile, just as tax receipts are falling, benefit spend (with baby boomers retiring) is growing. Debt begets more debt.

How to position

Many investors have short memories and so may have forgotten what a bear market feels like. Even if one is not immediately imminent, it still pays now to position for the future. Regime change is happening and will likely not be without consequences. We would logically expect that the asset classes which have done best under quantitative easing (growth equities, passive instruments etc.) should now do significantly less well, and vice versa. We have long-contended that the best time to buy assets is when they are cheap and out of favour, particularly for those able to adopt a long-term perspective.

While there is a strong relative argument, we believe, for still owing equities over credit, now more than ever is a time for explicit selection. Active should certainly have its day over passive (and value over growth). The more subtle overlay we would add to this approach is simply to diversify away from mainstream asset classes. As regime change intensifies, the logic for diversification into uncorrelated asset classes only grows.

Alexander Gunz, Fund Manager, Heptagon Capital