Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win. - Sun Tzu, The Art of War

There was no greater war leader and strategist than Chinese military general Sun Tzu. The Warring States Period (circa 475-221 BC) was an era of division in ancient China. Various states were at war and fighting for control of China. During this period, those with knowledge on strategy and leadership were highly sought after. Of these military experts, history has remembered best a man named Sun Wu from the state of Ch’i, known as “Sun Tzu” or “Master Sun”. Sun Tzu’s ability to win victories for his warlords gained him credibility and power. To pass down the wisdom he gained from years of battles, Sun Tzu wrote a book, the Art of War. Less than two hundred pages in English translation, the Art of War is written with “aphoristic distinctness of Chinese literature” in the form of brief notes. To this date, Sun Tzu’ work continues to influence many competitive endeavours around the world including culture, politics, business and sports.

 The Art of war is not a book on step-by-step instructions and methodologies on conduct of war. Instead, Sun Tzu argues that there are no set rules and models that can guarantee a win, as he endeavours to explain that war in reality is different from war in the abstract. The most fundamental assumption in Sun Tzu’s work is that war is an art not a science – that each military problem has many potentially correct solutions and not just a single optimal solution, which are derived from the imagination, creativity, and institution of the military leader. "Now in war there may be one hundred changes in each step." (The Art of War, p. 83) "And as water has no constant form, there are in war no constant conditions." Sounds familiar? Do we face the same conditions in markets?

 The endless complexities inherent in the study of war make it impossible to formulate a deterministic theory of war even if certain laws or maxims are suggested (or in Yogi Berra’s words: In theory there is no difference between theory and practice. In practice there is). Sun Tzu clearly recognises the staggering complexities of war makes it impossible to predict its shape and course through the mechanical application of supposedly immutable formulae. He then uses this beautiful metaphor to explain the infinite complexity in a combat and the importance of reaching out beyond the meagre wisdom of one-sided (narrow) points of view.

 There are not more than five musical notes, yet the

combinations of these five give rise to more melodies than can ever be heard.

There are not more than five primary colours, yet in

combination they produce more hues than can ever been seen.

There are not more than five cardinal tastes, yet

combinations of them yield more flavours than can ever be tasted

- Sun Tzu, The Art of War (p.101)

 Several hundred years later and there is no better way to describe diversity and no better time to remind voters, politicians, investors, and the like, of the importance of diversity in dealing with the increasing complexity. At AMP Capital we take diversity seriously (as described by  Adam Tindall, CEO AMP Capital - “The role of inclusion and diversity in driving business performance is compelling – beyond that it is simply the right thing to do”). We are committed to building a culture that is inclusive of different people, approaches and ideas – the key enablers in delivering an outstanding investment experience for our clients.

Beyond the workforce, diversity forms the foundation of our investment process. Achieving effective diversity in an investment framework is not an easy task. There is an ever increasing flood of information. Promoting diversity by including every piece of information that comes our way is unlikely to lead to positive results (we will either end up making knee jerk reactions too many times or conversely become paralysed as the information cancel each other out).

Diversity is best described as the art of thinking independently together (Malcolm Forbes). To ensure we think independently together, we must share the same principles, values and philosophy (e.g. some key principles of our investment philosophy: avoid crowded assets, buy cheap but only when fundamentals have become less bad/good, avoid leverage, etc.) This is when togetherness is achieved. The fact that we view markets through five independent lenses (value, economic/earnings cycle, monetary policy/economic liquidity, sentiment, and technical drivers combined with the fact that the team is made up of a diverse range of individuals) helps us process the information independently together.

Rather than seeing the market through the narrow lens of long term valuation multiples or the economic backdrop, the multifaceted approach to investing has served us well through the ups and downs of the past several cycles. Case in point: A narrow focus on the economic/earnings indicators in early 2016 would have resulted in significant opportunity loss. A year later, a narrow focus on long term valuations, is also likely to result in lost opportunities. While the conversation a year ago was about the sky falling, the focus is now on full valuations, expensive markets and bubble in asset prices (a timely opportunity for another great quote: the man who only has a hammer in the toolkit, every problem looks like a nail – Abraham Maslow).

Don’t get me wrong, worrying is great when it comes to investing. As we often say, risks are the highest when there is a broad-based belief that there are no risks. And given the ongoing worry about asset price bubbles, expensive valuations, low volatility etc., market participants have not dropped their guards which is good news.

“That which depends on me, I can do;

that which depends on the enemy cannot be certain” (The Art War, p.85)

One of the most important aspects of managing a portfolio is to focus on the things you can control while mitigating the impact of things you cannot. Mistaking the two can often lead to disastrous results. In market terms, the fact that long term valuations are high and prospective returns are low is given. This is the hand we have been given and we can’t change that. What we can do is to adapt our investment approach given the limitations on prospective returns. Here is a summary of what we have done:

• Our Investment approach includes a detailed macro and market analysis in addition to valuations indicators. Unless valuations are at significant extremes (relative to historical averages), that fact that valuation multiples are above historical averages does not provide any useful information for the time horizon that many investors are happy to accept.
• While over the very long term, an equilibrium (fair) valuation multiple can be estimated (from which deviations from fair value is measured), in the medium term (time horizons of less than 10 years), equilibrium valuations are greatly impacted by inflation and real interest rates). 
• Valuations should be seen in the context of earnings cycle. Markets that trade at a premium to fair value can continue to rerate when earnings are recovering from a low base. In the same vein, markets that trade at a discount to fair value can continue to de-rate, if earnings are deteriorating from a high base.
• We invest without benchmark constrains. Nine years into the post GFC market recovery, and the bull market has led to pockets of market excess. Following benchmarks is like jumping right into the crowd and expecting to be carried along (as the highest weighting stocks having received the biggest share of flows). As we often say, liquidity is a coward, it disappears on first signs of trouble. The more crowded an investment, the more the risk of disappearing liquidity on first signs of trouble. We avoid markets and sectors that have benefited the most from several years of falling bond yields.
• We stay liquid. We know good times don’t last forever. We must have the flexibility to shift allocation quickly as conditions change (and our indicator weight of evidence evolves).
• We rely less on long term averages (such as long term average absolute valuations) and more on a dynamic approach using a diverse set of drivers. As we often say, relying too much on long term averages in the current market environment is much like putting one foot in the oven and another foot in the freezer and expecting to be comfortable on average!

With that in mind, here is how we see the current investment backdrop:

• Valuations are above historical averages in some cases (more specifically for US shares and Technology and some defensive sectors in particular). But there are plenty of divergences (dispersion between sectors)
• Earnings are recovering from a lows base (particularly in Europe). So there is plenty of room for further re-rating.
• Economic liquidity remains plentiful. Our liquidity indicators are still in an easy mode.
• Global savings glut continues to move around on a rotational basis (until economic growth becomes strong enough to suck liquidity out of the financial system). We centime to be nimble and aim to be ahead of periodical rotations using our sentiment and technical indicators.
• Volatility is low because correlations are low and underneath the calm indices there are significant sector divergences (not just because volatility is dead in every market subset). Low volatility can be resolved in two ways: rising vol (the most obvious and what most people currently believe) or rising correlations. Under the former, winners will join the laggards and lead to a correction (and rising volatility), but under the latter scenario, the laggards will take the leadership and join the winners in pushing the market into gear. We have a high cash allocation to take advantage of any opportunities in case of a correction. We have also made incremental additions to the laggards if scenario 2 unfolds.
• As global growth gains more traction economic liquidity will deteriorate. From then it will be a battle between liquidity and earnings. Any deterioration in liquidity conditions, if met with higher earnings (as top line growth improves) can see markets higher. Once any reduction in liquidity is fails to be offset with better earnings, a choke point is likely reached. Most likely this is also confirmed with optimistic extremes in investors sentiment and significant economic excesses – a backdrop that will see us cut back on growth allocation significantly.  

Bottom line:

• Despite the reversal in the post-election surge in reflation dynamics, the context remains a global economy that’s strengthening. Markets may have unwound the so called Trump trade, but global reflation continues. The recovery remains broad enough to be a driver in the reflation contagion across the world as the year unfolds.
• The first half of 2017 been the case of Trump off in market dynamics (ie. a continuation of the aversion cycle characterised by falling bond yields, falling inflation expectations, sliding growth expectations and value underperforming growth). Instead of indicating a faltering growth backdrop, the first half retracement is most likely the result of a necessary adjustment in unreasonable expectations which prevailed at the start of the year (we closed most of our reflation trades early in the year as the expectations became unachievable). With growth and inflation expectations moving from extreme optimism to pessimistic levels once again (at the same that the underlying trend in growth and earnings backdrop remaining firm), the second of 2017 may well trump on!  With bonds yields running out of downward momentum (coupled with sentiment measures showing extreme bond optimism), global financial and energy sectors outperforming fashionable tech stocks and cyclical outperforming defensives in recent days, the Trump on process may have already started.

And here is another great Sun Tzu quote from The Art of War to finish off with:

Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.

Nader Naeimi | Head of Dynamic Markets/Portfolio Manager | Multi Asset Group | AMP Capital