Contemplation is a central feature of the summer season. Long, warm days and time away from the office are essential ingredients for introspection. For investors, summer represents the half-year mark wherein the inevitable taking stock of efforts during the period takes place.
Residents of the United States, please read this important information before proceeding
Judging from the returns across asset classes over the past six months, investors should be pleased (Figure 1).
In the service of summertime contemplation, a look at the great debate among investors is in order. This debate centers on the profoundly differing views of the world between fixed income and equity investors, and the attendant ‘who is right’ conclusion. Yields in the global fixed income complex have remained stubbornly low, and the periodic emissions from the Federal Reserve (Fed) suggest there is a lack of a coherent policy to judge economic growth and, therefore, a construct to determine the proper level of interest rates.
The European Central Bank (ECB) appears reluctantly to be giving in to the need for a more muscular approach to quantitative easing (QE) to prevent the currency bloc from sliding into the clutches of systemic deflation. (To be fair, the ECB has fewer degrees of freedom within which to operate than other central banks.) The Bank of Japan appears at the ready to provide another blast of QE to push the currency lower, and thereby sustain budding inflation. Beyond central bank manoeuvres, an implicit belief of those who think the bond market has it right is the idea, advanced by the bond management giant PIMCO that the “New Neutral” is essentially correct. This conviction holds that economies will generally grow more slowly, due to a deleveraging of historically high debt levels across the globe. Because fragile economies and consumers cannot handle normalised interest rates, central banks will be unable to raise them. Judging from the path of economic growth in the developed world since the end of the Great Recession, this idea has gained traction.
Equity investors are on the other side of the debate, and their views are diametrically opposed to those of the “New Neutralists”. They see rising global equity prices supported by higher sales and earnings, and perceive a different world emerging: one in which growth is gathering steam rather than dissipating. This group, call them the “Dynamists”, equates accelerating employment in the US, organic attempts at recovery in Europe, indications of success with the Abenomics program in Japan, and encouraging electoral developments in certain emerging markets as indications of a dynamic, rather than sclerotic, economic future. The Dynamists have their worries: will rising interest rates be a headwind for further gains? Will a changing regulatory landscape add costs (and impair profitability) to doing business? Are expanding valuations sustainable?
The most dangerous place for any investor to find him or herself is in a sea of consensus.
This debate is healthy for several reasons. First, it clarifies the market forces at work. Central bankers do pay attention, and the debate is likely to exert itself into their thinking as they consider policy actions. Second, the debate militates against the formation of a uniform consensus view emerging. The most dangerous place for any investor to find him or herself is in a sea of consensus. For professional investors, aligning with the consensus view often ensures career survival. However, for the owner of capital, embracing the popular view is akin to the sword of Damocles. Opinions make markets, and when opinions are sharply divided, there is generally an opportunity to profit. But to do so, one must take a position.
We have taken a position by firmly planting our flag with the Dynamists. Although we understand the view of the New Neutralists, the risks are asymmetric if they are wrong. Simply put, more can be lost than gained. Furthermore, the prolonged presence of easy and ubiquitous money has impaired the market’s ability to price risk. To wit, sovereign yields in a few periphery eurozone countries are trading either at par or below the yields on US government debt. In crisis zones such as Iraq, government debt has traded at an average yield of 6.7% since the end of April.1 (One has to ask: “Is this enough yield to compensate for the risk?”)
Similar distortions can be found in recent vintage debt underwriting. The Fed has increasingly vocalised its concerns about some of these trends. These distortions are both part and parcel of a prolonged cheap money regime and the dark underbelly of central bank policy.
Criticising is easier (and makes one sound smarter) than the task of offering a more constructive view of things. The critic sees things as they are and observes how they could become worse, while the optimist sees things as they are and wonders how they might be better. The optimist can be waived off as a wishful thinker, anchored not by reality but by prospects of something yet to come. At the risk of being dismissed as wishful thinkers, we enumerate below our reasons for siding with the Dynamists:
- US growth appears to be gathering momentum: consumer and business confidence, vehicle sales, and employment growth all are at pre-recession highs. Manufacturing output is above its 2007 peak, and household net worth is higher than pre-crisis levels. Consumer credit is rising, and revenue and earnings growth are apparent in both large and small companies. Plans to hire among small business owners are pushing higher, and wage growth is on the rise.
- In Europe, growth is trying to take hold despite a strong currency. This budding recovery will be assisted greatly by a helping hand from its central bank. Levered to international growth, eurozone companies should benefit from multiple catalysts. Small- and mid-sized companies are sporting particularly attractive valuations.
- European equity valuations are appealing relative to US equities, which appear fairly valued. Large eurozone companies continue to trade at levels even lower than the normal discount to their US brethren. Investors establishing or adding to US equity positions are likely to be compensated for the risk of ownership over the next 12 to 18 months. However, the price of admission may be a market correction at some point that could very well be material. The US market is overdue for a technical correction, as it has been two years without one. Predicting when and how it will happen is tantamount to predicting the unknown.
The sum of it all is a constructive view of the future, tempered by the reality that the risk of overpriced assets fuelled by cheap money can rock markets when the day of reckoning occurs. The best defence against volatile times is paying keen attention to economic and earnings growth and the prices paid for assets bought. Valuations matter whether you are a fixed income, equity or commodity investor.