FeedBurner makes it easy to receive content updates in My Yahoo!, Newsgator, Bloglines, and other news readers.
In a recent article, Albert Edwards, strategist at Société Générale, reiterated his view that the Standard & Poor's 500 would establish a floor at 450. 450, not 1450! I too have written in the past about the possibility of this index revisiting its March 2009 level (670) in the coming years. These levels seem completely absurd given that the S&P 500 is now at 1625. But can they really be ruled out completely?
The following graph shows the price/earnings ratio of the US market according to Professor Robert Shiller's version. In this version, the earnings used for the ratio's denominator are the average earnings over the last 10 years for companies in the index, rather than the earnings of the last 12 months or those estimated by analysts for the next 12 months. The advantage of the Shiller version is that it normalises the earnings used and thus avoids being based on any one particularly good or bad year. This is important today since companies' profit margins (and therefore their earnings) are at historically high levels. The graph shows that at its historic lows, this ratio stood at around 6. It is currently 23. A return to 6 would see the US market at the level predicted by Albert Edwards.
Shiller's price/earnings ratio for the US market:
Source: Morgan Stanley
It is true that it would require extraordinary conditions for the value of the US market to fall to such a low valuation level: war, economic depression or rampant inflation. However, with the monetary policies currently being conducted by the central banks, there is no certainty that some of these conditions won't return in the next few years. But even excluding such extreme scenarios and the particularly low valuations that would come with them, it is clear that:
- apart from 1929, 2000 and 2007, the US market has never traded at as high a valuation as it does today. In those three preceding episodes, the market subsequently plunged by at least 40%;
- the long-term average for this ratio is 16. To return to this average, the S&P 500 would have to fall to 1100, a 30% decline;
- the market has historically oscillated between phases when for several years the ratio was above this long-term average, and long phases when it was below it. Apart from a brief period in 2009, the market has been expensive since the middle of the 1990s. Stock market history seems to suggest that such a period of overvaluation will be followed by a period of undervaluation. Supposing that without falling to as low as 6, the Shiller ratio were to drop back to around 10 to 12 (where it has often been in the past), the S&P 500 would fall to between 700 and 850.
One might argue that in the above, I have assumed 'all other things being equal'. It is true that a decline in the price/earnings ratio could also happen due to an increase in the denominator (earnings) rather than due to a decrease in the numerator (share prices). However, it should be remembered that Shiller's version of this ratio uses the average earnings over the last 10 years. Since this is an average, it will not by definition see spectacular variations from one year to the next. Yet for the ratio to return to its long-term average of 16 without a fall in share prices, average earnings for the last ten years would have to a rise by around 45%. It is also important to note that we are talking here about the market as a whole. But just as it is reasonable to assume that for a company like Coca-Cola, earnings in 2013 will be substantially higher than those in 2003, and that in the calculation of average earnings over 10 years, a low figure (earnings in 2003) will be replaced by a considerably higher figure (earnings in 2013), this reasoning is less convincing for companies across the board. And even in the case of Coca-Cola, this exercise would only raise average earnings by 8%.
The aim of the above is not to say that the US market will fall by around 50%. It is in fact to point out that such a fall is not impossible and, above all, to show that people who are today arguing in favour of a prudent strategy have history on their side and that really, it is up to those who are expecting prices to keep on rising to show why, this time round, things should be any different and why the principle that the price determines the return is no longer applicable. Especially at a time when the economic indicators are deteriorating again and, unlike in the period from 2009 to 2011, earnings growth is no longer a reality.
For many observers, the response seems to lie in the low level of interest rates, given that in manipulating interest rates to keep them artificially low, the monetary authorities are encouraging investors to seek alternatives to fixed-income investments and in particular, to buy equities. Investment decisions are therefore not being taken based on fundamentals and this distorts them. And while, in the financial sphere, quantitative easing seems to be having the effect of driving asset prices higher, there is nothing to show that they are having any effect in the real sphere by stimulating economic activity in a sustainable way. Generally speaking, investors have dismissed the possibility of a significant fall in share prices as long as the central banks continue their current policy.
A defensive strategy is frustrating in this type of environment where share prices are continuing to rise despite the deterioration in fundamentals and valuation multiples at levels which in the past did not suggest good prospects for returns over the following years. Over the following years, not the following weeks: the fact that equities are expensive won't necessarily stop them from continuing to rise for a while yet. But it is really important to remind ourselves that at current levels, the main risk is not missing out on a further rise but forgetting the lessons of stock market history.
The efficiency and profitability improvements mentioned in the previous article "Investing in Japan - Automation for the people", have been mainly implemented in the export-oriented manufacturing industry. However, such improvements are few and far between in non-manufacturing industry segments. For us as investors, this means that there are many business segments in Japan in which it is difficult to identify profitable companies that could be considered as long-term investment candidates.
In this context, at one of the recent conferences, I had an interesting discussion with a sell-side analyst covering Japanese stocks. To illustrate the differences in efficiency between some manufacturing companies and businesses in non-manufacturing sectors, he used an illustrative, and somehow anecdotic example: "When visiting Fanuc's (the robotics company) domestic factories, I am always impressed by the high degree of sophistication and their fully automated production process. In contrast, if you were to go into one of the Tokyo branches of a Japanese bank to transfer money to Luxembourg (or any other European country), you will probably be stuck there for at least one hour, the time I think it will take to complete the transaction" So much for the differences in efficiency!
After the banking sector, the domestic retail segment serves as another example of this lack of efficiency. Since the collapse of the asset-inflated bubble at the beginning of the 1990s, retailers have had to endure a very difficult operating environment, with intermittent periods of deflation putting constant downward pressure on prices and dragging down sales for extended periods of time. Many traditional supermarkets, department stores or small mom and pop stores have been devastated by this environment, as they have not been able (or were not willing to) make the necessary changes to their business model to adapt to this environment. As a result profitability for these companies has constantly been very low.
It is in this environment that a new breed of retailers has emerged, companies with a focus on customer needs and strong commitment to growth and profitability. These new companies were ready to adapt their business model to the tough environment and grow their businesses by increasing turnover and by opening new stores. It's among these businesses that we find interesting investment candidates. Companies like ABC-Mart, Don Quijote and Nitori have a similar approach to business: they are obsessive about profitability, focused on efficient execution, very strict on cost control, conscious about fashion and design and readily adapt to customer needs and desires. Forbes Magazine summarized it very well in a story about Akio Nitori, the founder of Nitori Holdings : "these companies are the new face of Japanese retail".
In still highly fragmented markets, they are constantly gaining market share at the expense of weaker competitors, such as small local shops or large general merchandise stores less focused on a specific business activity.
ABC-Mart is one of the biggest shoe retailers in Japan and by far the most profitable. It generates high operating margins as a result of good management of its inventories, good positioning of its stores at strategic locations, and a range of high quality shoes at attractive prices. Half of its sales are generated by own-brand shoes with high margins, produced in countries with low labour costs. With these brands, the company is also present in South Korea and Taiwan via local retailers. ABC-Mart has managed to position these brands successfully and promote them through extensive advertising campaigns.
ABC-Mart store in Shibuya
Nitori is a low-cost provider of inexpensive furniture (comparable to IKEA) and the only major national furniture chain in Japan. Nitori stands out from the competition thanks to an innovative business model that integrates the whole furniture distribution chain from production to marketing of its own brands. The company's business model and the fact that all its factories are situated in countries with lower labour costs, gives it a valuable competitive advantage. Unlike IKEA, which currently only operates 7 stores in Japan, Nitori also offers delivery, assembly and setting services free of charge, which adds to its user-friendly appeal in a country experiencing an ageing of its population and used to receiving meticulous service.
Don Quijote is a mass-market discount retailer, selling almost everything, from groceries to cosmetics over electronic appliances to fashion items like watches or apparel. Just like its famous eponym, who was fighting against windmills that he imagined to be giants, Don Quijote set forth to challenge the well-established retailers with a revolutionary store concept. Special displays, late-night opening hours, discount prices and an enjoyable shopping experience, coupled with its know-how in low-cost operations enables the retailer to significantly differentiate itself from the competition. This unique store concept is summed up in its last annual report: " Stores operated by Don Quijote are intended to be spaces for amusement that transform the typically routine chore of shopping into an entertaining experience through unique presentations." When looking at market share evolution over the past, this concept is definitely a success. So, unlike the knight-errand in Miguel de Cervantes novel, this Don Quijote actually seems to be winning its battles.
Another thing these companies have in common, is that their founders still own large amounts of company stock and are still involved in company management.
This alignment of management interests with shareholder interests is rather rare in Japan, where large owner-run companies are scarce and where pursuit of shareholder value is not always a high priority.
The article at hand and my previous post give a snapshot about our investment approach to Japanese equities and draw a picture about the kind of Japanese companies that correspond to our investment methodology. All the companies mentioned are holdings of BL-Equities Japan1. For us, the key to successful investing is to identify quality companies with a tangible competitive advantage that is resilient to short-term economic news and developments. Factory automation, smartphone fabrication and retailing are just a few of the segments in Japan where we can identify attractive long-term investment candidates.
This article should be read in conjunction with the first part: "Investing in Japan - Automation for the people"
1 BL-Equities Japan is an equity fund that invests in Japanese companies. The investment philosophy of the fund is based on the principles of "business-like investing". This approach implies that the fund manager considers every investment like a stake in a business with a long-term investment horizon. This means that he is on the look-out for quality companies with a tangible competitive advantage that results in high levels of profitability and strong potential for free cash flow generation. Great importance is also attached to company valuation.
|Share Class||A||B||H1 (Euro hedged)|
Article written by Steve Glod,
Fund manager of BL-Equities Japan
In the last couple of months I attended two investment conferences in Tokyo to meet up with some of the Japanese corporations that we own in our investment funds. These conferences were a unique opportunity to sit down with senior management of these companies and discuss their business and the current state of their affairs.
These trips were also good opportunities to get a glimpse of everyday life in the largest metropolitan area in the world. I visited the retail stores of the companies owned by our funds, discovered some of the products that I had until then only seen on photos or read about in annual reports. In the following lines I put down some of my takeaways from these trips and share my thoughts on some of the Japanese companies and segments we are invested in.
When arriving in Tokyo, one can only be impressed by this vibrant and modern city. It starts with a hassle-free one-hour trip with the express train from Narita airport to Tokyo station, that gives a first impression of the very advanced and well-maintained infrastructure in Japan. This impression will be confirmed when using the efficient metro system (the busiest in the world), where trains rarely encounter delays and run on very tight schedules transporting almost 10 million users per day. In the city, modern architecture and design is omnipresent. In the Ginza area, you can find spectacular department stores, while the famous Omotesando street is lined with outlets from the world's leading fashion designers. The neighbourhoods of Shibuya and Harajuku draw crowds of younger shoppers seeking the latest fashion trends, while Akihabara, the major shopping area for electronic goods, illuminates the night with its neon lights and animated billboards.
Akihabara electronic town
Nearby these glamorous shopping districts, there are quiet neighbourhoods with cosy restaurants, original mom and pop stores, extensive recreational areas and parks, and impressive historic buildings like temples or the Imperial Palace. Meiji Jingu for instance, a Shinto shrine located in a forest of 70 hectares in the heart of Tokyo offers a breathtaking sight. To me, the shrine and its adjacent parc was like an oasis of calm seperating the very shopping and business districts of Shibuya and Shinjuku. Tokyo is also often referred to as one of the world's safest cities and is the second most livable city in Asia (behind Osaka, another Japanese city) according to a recent ranking by the Economist Intelligence Unit (EIU).
Although Tokyo might not be representative of Japan as a whole, it is difficult to imagine that this is the capital of a country that has been enduring two so-called " lost decades" with stagnant economic growth, recurring periods of deflation and rising public debt levels. An interesting article published a year ago in the New York Times points out this discrepancy and showed that, by many measures, the Japanese economy has being doing well in the last 20 years and that "its citizens, despite the many economic setbacks, might be better off than in many other developed countries in the world". The article is entitled "The myth of Japan's failure" and is definitely worth a read.
Offering hall of Meiji Jingu shrine
This more positive view on the current state of Japan can, however, not hide the fact that Japan is facing significant challenges for the future. The lack of economic growth, high public debt levels, the deflationary pressure the government is desperate to fight against and poor demographics with a rapidly ageing population, are some of the country's biggest challenges. However one should not forget that many developed economies, especially in Europe, may be faced with similar challenges in the years ahead.
So what do we make of all this in terms of our equity investments in Japan? The short answer would probably be not much:
I might agree, that for me as a fund manager, short-term political and economic developments have to be monitored, at least to some extent. But at the end of the day, my task is to find attractive long term investment candidates, without paying to much attention to short-term noise: profitable companies that have the potential to grow their business over time, without being too dependent on sociopolitical and economic developments.
So where to find these companies in a country that in economic terms has virtually been at a standstill for more than two decades and whose demographics don't bode well for future growth either? A country, whose booming 1980s economy has lead to enormous amounts of capital stock being accumulated by the private sector and where the opportunities to find adequate investment opportunities for this money are scarce. When looking at individual companies, one is often surprised by the amount of cash that sits on their inflated balance sheets and shocked about the lack of profitability that most of these companies get from their investments. In most market segments, differentiation among companies is low and there is way too much capital chasing too few investment opportunities, leading to structurally low returns on investment. This makes the task to find fundamentally attractive long-term investment candidates very challenging.
One domain where Japan has always excelled in, is in so-called 'industrial technologies'. In the broadest sense, this term applies to an industrial branch that develops engineering and manufacturing technologies that allow industrial production to become faster, simpler, more precise and more efficient. In this vast field of industrial automation, Japanese companies often occupy small niches for specialized technological applications and continue to deliver cutting-edge technologies that allows them to stay ahead of competitors from China or other emerging countries.
One example of such a company is Keyence, a leading supplier of sensors and measuring instruments for factory automation. Keyence is one of the most innovative and profitable industrial corporations in the world. The company’s unique selling point is the quality of its products, its responsiveness to client demand and its capacity for innovation. From one year to the next, between 20% and 30% of sales are generated by 'new' products (i.e. that have been launched over the last two years). Keyence pays some of the highest wages in Japan and as such succeeds in attracting the best engineers and keeping them over the long term.
Another example of a company fitting into this category would be Fanuc, a leading Japanese manufacturer of industrial machines for the automation of factory systems. Fanuc is the leading manufacturer of industrial robots and computerized numerical control (CNC) systems. Fanuc’s CNC-systems, which allow to control the functions and motions of an automated machine, have become something of a world standard, resulting in a market share of over 60%. This dominant market share reflects Fanuc's competitive advantage in terms of technological know-how, distribution network and production costs.
Industrial robots at a car manufacturing plant
Demand for industrial automation continues to accelerate. Companies like Fanuc or Keyence are, for instance well positioned to benefit from factory automation in China, where raising labor costs and increased efficiency awareness pushes production companies to automate their manufacturing processes. A good example is Apple, which in the last couple of years has significantly increased its investments in factory automation and has become one of Fanuc's biggest buyers of robots and so-called 'robomachines'. This equipment is to be installed in the plants of its leading contractor Foxconn and are, for example, used to carve out metal casings for Apple's portable electronics devices such as the iPhone or the iPad.
The companies in the field of factory automation are not the only Japanese companies benefiting from the growth in smartphones and tablets. Although big and well-known Japanese consumer electronics giants like Sony, Panasonic or Sharp missed out on this trend and nowadays struggle to stay profitable, smaller electronics companies still occupy attractive niches as leading suppliers for highly added value components for mobile devices. A recent study for instance finds that more than half of the components used in the iPhone 5 are made by Japanese manufacturers.
Murata Manufacturing, a world-leading manufacturer of ceramic-based electronic components, is one company that stands out in this field. These components, many of which are made of the ceramic materials that have been a Murata specialty since the company was established, are used in many sorts of electronic devices, such as computers, mobile phones, automotive navigation and air bag systems, and medical equipment. It holds significant market shares in multilayer ceramic chip capacitors (MLCC) and certain components used in wireless telecommunication and supplies modules from both of these categories to Apple for the production of the iPhone5. In Septembre 2012, the company announced that it had developed the world's smallest monolithic ceramic capacitor with a size of 0.25 x 0.125 mm!
Nitto Denko is another key supplier for the production of portable devices. Nitto Denko is one of the world-leading producers of adhesives and coating films and has more than 20 products with top market share worldwide, including optical films for LCDs. Most of the products are related to flat-screen televisions, mobile phones and computers. The company has a competitive edge in the manufacture of transparent conductive films used in the production of touch screens. Although companies like Apple or Samsung are not publicly divulging their suppliers, it can be assumed that Nitto Denko is suppling its products to almost every tablet PC and smartphone manufacturer in the world.
All the companies mentioned above can be characterized as export-oriented companies. The biggest chunk of their turnover is related to global demand and not to domestic consumption. In the past, these companies had to adapt to a very competitive landscape with rising competition from low-cost Asian countries. Not only did they have to defend their technological edge, but they also had to enhance their efficiency and productivity in order to compensate the drawbacks of high labour costs and a very strong currency.
Article written by Steve Glod,
Fund manager of BL-Equities Japan
"While nature essentially controls the quantity of gold in existence, it is men who assign it values in terms of dollars and pounds and rubles."
"When we look at the alternations between inflation and deflation in our history, men seem to have done a poor job of regulating the supply of money."
These two quotes from Peter Bernstein, economist and author of numerous books including "The Power of Gold: The History of an Obsession "*, are a good summary of the problem facing investors interested in gold:
- gold has no intrinsic value so it is impossible to say at any given moment whether it is overvalued or undervalued or if the fall (or rise) in its price is excessive.
- the demand for gold (and hence its price) has in the past generally increased during periods when the monetary policies of the central banks ceased to inspire confidence.
These two factors also explain why Warren Buffett’s opinion on gold, often cited by people who are not keen on it, is interesting but bypasses the essential point about it. Buffett basically says that "gold doesn’t create anything and in 100 years’ time, the world’s gold stock of 170,000 metric tons of gold will still be 170,000 metric tons" (whereas an investment in companies will have produced dividends, an investment in bonds, interest, an investment in property, rent, and so on). This is true, but buying gold can't be compared to a traditional investment. Instead, gold should be considered more like a currency but, unlike paper money, it cannot just be created by the monetary authorities (its advantage) and does not produce interest (its drawback). In periods when confidence in the monetary authorities is high, gold's advantage is small and its drawback significant, but in periods when confidence in the authorities is low, gold’s advantage is strong and its drawbacks negligible (especially as during these periods, interest rates are generally low or even negative in real terms). And compared to the dollar (and most other currencies) which has lost around 85% of its purchasing power in the last 40 years, gold has performed rather well.
It is in this context that the rise in the gold price over the last 12 years and its correction since September 2011 should be interpreted. In 2000, the price of gold was very low. Between 1980 and 2000, the gold price dropped by more than 60%. During this period, the credibility of the American monetary and political authorities was very high, particularly due to the anti-inflationary policy conducted by the Federal Reserve under the chairmanship of Paul Volcker and the strong-dollar policy pursued by the Clinton administration. The advantage of gold (a safe haven against flawed monetary policies) was very weak and its disadvantage (opportunity cost related to the fact that it does not yield interest) high. Furthermore, the massive hike in the gold price in the 1970s led, with a bit of a delay, to a huge increase in production from gold-mining companies over the next two decades. In the early 2000s, the gold price fell below $300/ounce, a price which often failed to justify the necessary investments to maintain production at a number of mines. The central banks started to sell their gold reserves and gold mining companies engaged in massive forward-selling to hedge their future production. Gold sentiment was at its lowest.
After 2000, gold's environment changed completely. Gold mining companies gradually stopped forward-selling. The demand for gold from emerging countries increased in parallel with their economic development. The terrorist attacks in September 2011 added a political component. Lastly, the flaws in the United States' monetary and economic policies (copied by most other industrialised countries) became increasingly apparent. Since 2000, the bullish trend for gold was thus well established despite temporary corrections of differing degrees: for example, the near-30% decline between March and November 2008, largely due to a wave of panic selling prompted by the financial crisis. Given that investor enthusiasm had actually become a little too extreme by 2010 and 2011, the current correction can only be welcomed.
But is it really only a correction? Ultimately those who think that the bull cycle for gold is over are those who think that the economic crisis is being resolved and that the world economy is on the road to sustainable recovery. If that really were the case, the monetary policies in the main industrialised countries would gradually normalise and gold would lose its attraction as a safe haven and an insurance against systemic risk.
Gold price in USD
I continue to think that the factors in favour of gold remain valid:
The gold price is essentially determined by the demand for gold for investment purposes, compared with its demand for industrial purposes, which is relatively stable. The above factors influence this demand. On the supply side, having increased considerably in the 1990s, gold production has stagnated since 2000. The priority of gold mining companies is increasingly geared towards maximising their free cash flow rather than their production. This does not augur well for a big increase in supply in the coming years.
Gold production (in tonnes)
Source: Gluskin Sheff
For now, the situation is calm. Equity markets are going up and their rise seems to be convincing increasing numbers of observers that the global economy is on the way to sustainable recovery. Even the eurozone crisis does not seem to have overly concerned investors since the declarations by the President of the European Central Bank, Mario Draghi, that “whatever it takes” would be done to save the euro. While this calmness persists, gold will hold little attraction. We could even see continuing capital outflows from tracker funds invested in gold. These funds would then be obliged to sell physical gold to cover these outflows, creating a sort of vicious circle.
The risk of a further fall in the gold price can therefore certainly not be ruled out. Those versed in technical analysis will point out that there is a critical support threshold at around $1,550 which, if crossed, risks triggering heavy sales. However, it makes no sense to base an investment strategy on temporary capital flows that may or may not materialise. The macroeconomic environment continues to favour gold and the prevailing pessimism surrounding it (and gold-mining companies) is relatively encouraging. During the last major gold rally in the 1970s, the gold price lost around 45% between February 1975 and August 1976. Many observers were of the opinion that the economic conditions which led to the increase in the gold price in 1973 and 1974 had disappeared and that the bull cycle was over. In the next three years, gold gained around 700%.
* Peter Bernstein. The Power of Gold: The History of an Obsession
(John Wiley & Sons. ISBN 0-471-25210-7)
"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. (...) As inflation proceeds and the real value of the currency fluctuates wildly, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless."
(John Maynard Keynes: The Economic Consequences of the Peace)
For nearly 40 years, governments in the majority of industrialised countries have conducted fiscal policies based on Keynesian principles: in times of economic contraction, they have increased public spending. However, during this period, they have neglected the other side of Keynes’ recommendations – that in a period of economic growth, the focus must be on fiscal rigour and the generation of budget surpluses. Since the end of the 1990s, this irresponsible fiscal policy has been crowned with an inept monetary policy. Driven by the Chairman of the Federal Reserve at the time, Alan Greenspan, this policy seemed to have as its absolute priority supporting financial and real estate assets rather than the long-term well-being of the economies concerned.
The result of these policies was an increasingly high level of debt. As a percentage of GDP (which ultimately illustrates the capacity of a country to honour its debt), this debt is now at a historical high, well above the previous peak in the 1920s. Contrary to general thinking, the level of debt has not gone down since 2008 as the modest reduction in private sector debt has been more than outweighed by the sharp rise in public sector borrowing.
Against this backdrop, it is astonishing to hear numerous commentators talking about a return to normal and a global economy on the road to a sustainable recovery with a return to a growth rate close to that before the 2008 crisis. It is possible that the deleveraging (debt reduction) process that appeared to have started in 2008/2009 has been temporarily halted and replaced by a new debt cycle with the consequence that the next slowdown will take place with an even higher level of debt and will therefore be even more dangerous. From some angles, however, the current situation is fundamentally different from that of the last three decades, especially from that at the beginning of the 1980s when the debt cycle really began:
- interest rates are near zero. The Pavlovian reaction of the monetary authorities to every economic problem – reduce the cost of money – therefore becomes increasingly difficult to put into practice;
- contrary to previous cycles, the level of debt is now so high that even a slight increase in interest rates (which would be logical if the global economy were really on the road to a sustainable recovery) would hurt;
- the years before the 2008 crisis had already shown a steady decline in the productivity of debt. In other words, more and more debt was needed to produce a certain level of economic growth;
- the events of recent years have shown that governments have exhausted their capacity to finance themselves on the markets and need increasing recourse to their central bank to procure the money they need;
- the ageing population in industrialised countries means that there will be fewer and fewer people working and more and more pensioners (unless there is a much greater reliance on immigration and/or the retirement age is raised). Given the fact that economic growth equals the number of people working times the productivity of these people, this points to a lower growth rate (making it even more difficult to service a historically high level of debt).
The economic situation in industrialised countries since 2009 is a good reflection of these issues: despite very expansive fiscal and monetary policies, the recovery is extremely weak. The capacity of many economic and political policymakers to ignore the structural factors weighing on growth and use every slightly better (or slightly less bad) than-expected economic statistic to announce the end of the crisis is extraordinary in this regard.
What are the consequences for an investor of the economic reality we have described?
The main consequence seems to me to be that the authorities are gradually beginning to stop seeing inflation as an evil to be avoided, but rather as a potential remedy to the debt problem. Tolerating a higher inflation rate while keeping interest rates artificially low would seem to be the least painful way politically of improving the debt/GDP ratio. The independence of the central banks, which seemed sacrosanct just a few years ago, now exists only on paper. And although, unlike short-term interest rates, long-term interest rates are in principle determined by the market and not set by the monetary authorities, ways have been found to manipulate them, whether through quantitative easing or regulation.
As a result, fixed-income investments are almost bound to lose money for an investor, at least in real terms which means factoring in inflation. Holding cash can be justified for tactical reasons, i.e. to profit from potential opportunities (even though most investors – including professionals – generally overestimate their capacity to take advantage of a market correction), but monetary investments no longer have a structural place in a portfolio whose objective is to conserve, and hopefully augment, purchasing power in the long run. The same is true for most bond investments which, quite simply, no longer adequately remunerate the risk incurred.
The environment created by the actions of the monetary authorities has had a very detrimental effect on the performance of BL-Global Flexible in the last six months. The pronouncements of the President of the European Central Bank, Mario Draghi, that the ECB would do whatever it takes to save the euro, the continuation of an extremely expansive monetary policy in the United States, and the announcement by the new Japanese Prime Minister, Shinzo Abe, that he would be putting pressure on the Bank of Japan to resort to quantitative easing and relax its inflation target, led to a situation where risk-taking is strongly encouraged and a prudent investment strategy penalised. In this environment, three factors particularly damaged the fund’s performance:
- the marked underperformance of high quality companies (1) in the stock market rally. In recent months, lesser quality assets appreciated significantly more than those of high quality. This was the case in geographical terms (sharp outperformance by peripheral markets) and in sector terms (sharp outperformance by financials).
Outperformance of Spanish market since middle of last year
Outperformance of Financials since middle of last year
Some high quality stocks did not even participate at all – or only very marginally – in the stock market rally.
Coca-Cola versus S&P500
Nestle versus SMI
In this environment, the long/short strategy of investing the bulk of the portfolio in high quality companies while hedging part of the resulting equity risk through the sale of futures, was detrimental to the fund despite a net exposure to equities of around 55%.
- the strength of the euro: alongside the rising equity markets, Draghi’s announcement triggered a rebound for the single currency. Since the end of July, the euro has appreciated by an average of 11% against the currencies of the eurozone’s principal trading partners. This confirms once again the close correlation between the euro and the equity markets;
Euro trade-weighted index
- the poor performance of gold-mining companies. The fund had taken advantage of the 25% fall in the gold mines index between September 2011 and March 2012 to start building position in gold-mining companies at the end of the first quarter. These positions were increased during the second quarter. After a temporary rebound in August and September, gold mines resumed their downward trend and are now at their lowest level since January 2010, in spite of the price of the gold price being 50% higher than it was three years ago.
Gold miners index
Despite this adverse performance, the fund does not intend to fundamentally change its investment strategy. In fact, insofar as the long-term price of the measures currently being taken by the public authorities represents a further deterioration of economic fundamentals, we are of the opinion that a prudent policy is more apposite than ever (cf. my article of 24 January).
More specifically, as regards the three factors mentioned above, the following observations are relevant:
- in the past, periods in which high quality equities underperformed the market were a regular occurrence. Provided that this underperformance was not due to an extreme overvaluation of these shares (as was the case, for example, for Coca-Cola in 1998), they subsequently rectified the situation with a much sharper outperformance. Their underperformance in recent months can therefore be seen as an opportunity for a strategy combining investments in high quality stocks with a hedge on the indices;
- the weighting of the euro has been increased to 30%. Admittedly the arguments put forward to explain the current strength of the euro seem slightly doubtful. Specifically, the argument that the European crisis is in on the way to being resolved and the eurozone has found a floor and embarked on a sustainable economic recovery, does not seem to match reality, the more so since the appreciation of the euro is weakening European exports. Nevertheless, we are bound to conclude that, in an environment in which the authorities of the other leading industrialised countries are more or less actively encouraging devaluation of their currency while, in contrast, the European authorities seem content with a strong euro, in the belief that the strength of their currency represents proof of the eurozone's success, the euro could remain overvalued by default for some time yet, or even appreciate further;
- as regards investment in gold mines, it is obvious that such an investment only makes sense if a collapse in the price of gold is ruled out. However, three factors continue to justify a continuing rise in the price of gold over the medium and long term: the imbalance between supply and demand, the deterioration of the public finances in Europe and the United States, and the monetary policies being conducted by the central banks.
As indicated above, the gold mines index is currently at the same level as it was in January 2010 when the price of an ounce of gold was below $1,100. Its negative performance in 2012 came despite an increase in the price of gold over the year, for the twelfth consecutive year. There are several reasons for this. First, gold saw two major corrections during the year, between March and June and between October and December. During these periods, investors focused on the increase in production costs at a number of mines, which affected their views of the sector and weighed on multiples. However, statements from several heads of companies in the sector show that the priority of the management teams is heading increasingly towards maximising free cash flow rather than towards increasing production. At the same time, gold-mining companies will be able to attract a new class of investors if their intention to distribute a greater part of their free cash flow to their shareholders as dividends is confirmed. In common with high quality stocks, the gold mines’ underperformance could be considered as a buying opportunity while stressing that this is obviously a much more volatile market segment.
The chart below shows the asset allocation of BL-Global Flexible at the end of January.
20% of the fund's assets are currently held in the health care sector.
The currency allocation before and after forward sales is shown below.
(1) By high quality stocks, I mean shares of companies with low gearing, having a tangible competitive advantage that enables them to achieve above-average profitability and generate a consistently high level of free cash flow.
The key question for an investor at the start of this year is when will interest rates start to reverse? The monetary authorities’ manipulation of interest rates and the resulting artificially low cost of money has brought about numerous distortions in the financial markets and substantially reduced the risk premium on many asset classes. This is penalising prudence and encouraging the purchase of risk assets at a time when the fragility of economic growth would tend to call for the opposite. And it skews the valuation process of financial assets. An investment is merely an exchange of a current amount of money against a future sum of income (earnings, dividends, cash flow etc.). This future income is usually discounted using a risk-free interest rate to which a risk premium is added. Obviously if the current level of interest rates is used in this exercise, the intrinsic value of many risk assets, especially equities, will be far above their current price. The present value of EUR 1 million received in 10 years will be EUR 385,000 if it is discounted at a rate of 10%. Using a rate of only 5%, this value will rise to EUR 614,000.
The dilemma facing an investor in equities (as opposed to a speculator who will be less interested in the intrinsic value of what he is buying) can be summed up as follows: company profits might decline but the interest rates used to discount those profits are also going down. The stock market rise since the fourth quarter of 2011 is a good illustration of this point. It is entirely explained by the increase in valuations. In other words, share prices have not gone up because companies are making more money but because investors are ready to pay more for the same profits.
Source: Morgan Stanley
The main argument in favour of equities today is their relative valuation. To say that one should buy equities because the dividend yield is higher than long-term interest rates boils down to saying that one should buy them because interest rates are low and not because the prospects for earnings or dividends are particularly good. Quite the contrary, insofar as the current low level of interest rates is a reflection of the serious structural problems facing the global economy, these prospects are certainly not very rosy. This is why stock market history shows that periods of very low real (i.e. adjusted for inflation) interest rates are generally not favourable to equity markets. During these periods, equities trade at below-average valuations, affected by the economic problems that the low interest rates merely reflect. This is also illustrated by the performance of the Japanese stock market which is currently some 70% below its end-of-the-80s level despite near-zero interest rates since the mid-90s.
The question of the multiples that investors are prepared to pay for equities is very important. The change in these multiples determines to a large extent the type of market in which we are operating. Multiple expansion is equivalent to a tailwind, multiple contraction is a headwind. The contraction of multiples since 2000 thus explains the stagnation of the stock markets since then, just as the expansion of the multiples in the second half of the 90s was at the root of the very high stock market returns during that period.
Source: Morgan Stanley
Does the sharp rise in multiples since September 2011 mark a reversal of the trend and the start of a new sustainable expansion in valuation ratios? Saying that people should buy equities because interest rates are low is basically an affirmation that equities will become more expensive because investors have no idea where else to put their money.
The more so since the outlook for company earnings – the second factor in determining stock market returns – is not looking very favourable. In recent years, earnings growth has substantially exceeded economic growth. Given that "earnings growth = increase in sales x increase in margins" and that profit margins are already at historically high levels while the increase in sales is limited by the weak economy, it seems somewhat optimistic to expect a further sharp rise in profits in the coming quarters. The upturn in economic activity after the 2008/2009 crisis was abnormally weak due to the structural problems often mentioned in these articles and the next recession could arrive before many of the economic indicators have recovered to their level of 2007. The Citigroup Economic Surprise index which classifies economic figures according to whether they are better than or not as good as expected shows that although the stock market rise between August and November 2012 could be explained by a temporary improvement in economic indicators, this is no longer the case since then.
The exceptional environment in which we find ourselves and the unorthodox monetary policies currently conducted mean that the range of possible outcomes in terms of stock market returns for the current year is particularly large. A sharp increase in share prices due to low interest rates? A sharp decrease in share prices due to a resurgence of deflationary trends, a worsening of the European crisis or a faster than currently expected trend reversal in interest rates? It is therefore all the more important to build portfolios that can hold their own in different scenarios rather than seeking as high a return as possible at any price. The investment strategy should thus be geared to the following principles:
Many observers are wondering whether the euro can survive in its present form. But this is not the question that needs to be asked. Obviously the euro can survive in its current form as the break-up of the euro or the exit of one or other countries is a political decision. The markets cannot break up the euro or force a country to leave, in direct contrast to what they were able to do 20 years ago in forcing the pound out of the European monetary system.
As long as the governments of all the eurozone countries decide to keep the euro in its current form, the single currency will survive.
The real question is whether the euro should continue to survive in its current form. Will survival maximise the well-being of the majority of eurozone citizens? Asked differently, is it possible to save the euro and reboot the eurozone’s growth dynamic, thus enabling it to offer new prospects to its citizens and especially the younger generations? The fact is that the political authorities have until now been unable to come up with a coherent plan in this regard.
What would such a plan consist of? Basically, it would involve retrospectively rectifying the construction problems of the single currency and creating the conditions necessary for the eurozone to meet the criteria of an optimal currency union. Remember that the key criteria not currently being met by the eurozone in this respect are labour mobility, wage and price flexibility, and fiscal transfers. The last point, in other words fiscal union, is often presented as the solution but it is worth remembering that if the other conditions are not met, fiscal union would be nothing more than just a permanent transfer of capital from north to south (and it is important to point out in this respect that the countries in the north, including Germany, are far from being in good financial health). The eurozone would then become like Italy, with great economic divergence between north and south and continuous transfers from north to south.
Labour mobility and wage and price flexibility are connected with deregulation of the labour and product markets. Today, these markets are still highly regulated in some countries, as shown in the following graph.
Regulation of the labour and product markets (1 = low; 4 = high)
Source: OCED, Morgan Stanley
Empirical studies show that such deregulation increases a country's growth potential. However, the problem is that the positive effects of such structural reforms are only visible in the medium and long term. In the short term, they tend to impede growth. So political courage and the ability to explain the long-term benefits to citizens are required in order to impose the reforms on a democratic system.
Potential impact of structural reforms on GDP per capita over 10 years
Source: OCED, Morgan Stanley
To offset the short-term negative impact on growth, the ECB would have to continue to conduct an expansionary monetary policy and procure the necessary liquidity. In short, such a plan would rely on structural reforms, abundant liquidity, and banking and fiscal union. It could be that this is actually the plan that the authorities are following but so far they have been incapable of communicating it to the public. This has resulted in the people in the north thinking that helping the people in the peripheral countries is 'throwing money out of the window' while the people in the south have the impression that they are suffering just so the lenders in the north can be reimbursed.
The optimists will see some positive developments. Over the past three years, the unit labour cost has fallen in the peripheral countries, notably Spain and Ireland. This has resulted in a recovery in exports and an improvement in their current account balance (an improvement which is also due to the fact that imports have plummeted because of budget austerity).
Exports of goods and services (index 100 = 1st quarter 2000)
Source: Eurostat, Morgan Stanley
In reality, however, there are many obstacles standing in the way of the success of such a plan. The positive developments noted above result from the reduction in wages rather than structural reforms. In this respect, little progress has been made. Moreover, the majority of a eurozone country’s external trade is with other eurozone countries. For the peripheral countries to sustainably reduce their external deficit or even convert it into a surplus, the northern European countries will have to accept a reduction in their surplus or even see it transformed into a deficit. We are worlds away from that situation. It should also be noted that the latest economic indicators show that growth in the northern countries is also increasingly impacted by the crisis and that demand in these countries for the products and services offered by the peripheral countries is likely to suffer as a result (one could also ask what would be the products and services meant to provide a sustainable stimulus for these countries' exports?.
The state of the global economy is not contributing to the success of such a plan. The economic context is relatively weak and likely to remain so, particularly because of the structural brakes weighing on growth in the industrialised countries (demography and debt). It is therefore difficult for the eurozone to increase its exports beyond its borders especially as the majority of countries are actively trying to weaken their currency, which means that the euro is still much too strong. Finally, excessive regulations imposed by Brussels are certainly not helping the competitiveness of the EU countries.
The budgetary austerity measures being imposed on the peripheral countries cannot function in their present form. As noted above, the eurozone countries have already abandoned control of their monetary policy and their currency. Forcing them to also abandon control of their fiscal policy would deprive them of all the instruments that a country would generally use to meet its economic– and even social – objectives. The return to budgetary orthodoxy is certainly laudable. However, economists are increasingly arguing in favour of greater differentiation in public spending by distinguishing in particular between those that only serve to maintain a disproportionate public sector and those that serve to finance productive investments and produce future revenues. There is currently no such differentiation, the only targets imposed on countries calling on financial aid being to reduce their deficits. The danger is that productive expenditure will be first in line for reduction as cuts in non-productive spending are politically much more difficult to achieve.
Lastly, none of this can function unless these measures are accompanied by substantial restructuring of the debt of the countries concerned. Today there is quite simply no credible scenario on the basis of which these countries have any chance of honouring their debt. The debt accumulated in recent years has mainly served to finance consumption. This debt does not create future income that could serve to reimburse it. Moreover, the interest rate that these countries are paying on their debt is higher than the nominal growth rate of their GDP. Once again, the debt-to-GDP ratio is only deteriorating and the countries concerned find themselves in a vicious circle.
When we talk about peripheral countries, we generally mean Greece, Spain, Portugal, Italy and Ireland. But Ireland is in a very different situation. The country is competitive, its labour market deregulated and the rule of law respected (empirical studies show that there is a close correlation between economic prosperity and respect for the rule of law – the rule of law exists in a rather more casual fashion in Greece which makes the task of getting the country back on the path to sustainable recovery all the more difficult). Ireland’s only problem is an excessive level of debt resulting from the country’s decision not to let its banks collapse. Meanwhile, Iceland, which did not save its banks and is not locked into the euro, is recovering rather well.
Lastly, it is important to note that if this plan does not succeed, the ECB’s current policy will not only prove inefficient but irresponsible. Through its unconventional measures, it is keeping the price of money artificially low. In a market economy in which prices are supposed to give important signals, this can only lead to significant distortions and a poor allocation of capital. The effect of all this will be extremely difficult to rectify in the future. The fact that the central banks of the other leading industrialised countries are conducting policies that are just as irresponsible is a meagre consolation.
In the final analysis, creating – 12 years too late – the criteria that the eurozone should have fulfilled from the outset, and with economic divergences having only been accentuated over those 12 years, is likely to be a lost cause. Doing so without the approval of the people poses an additional and serious risk for democracy in Europe. It is worrying to see that just as the democratic process was already suspended at the time the euro was introduced, it is increasingly being suspended in the management of this crisis. The solution to a crisis triggered by an undemocratic measure (the introduction of the euro) should not lie in a further suspension of the democratic process.
To understand the euro crisis, it is helpful to remember that at the outset, economists were far from unanimous in their support for a European single currency. At the time, the political authorities did not take account of their arguments, preferring to brandish them as anti-European.The arguments put forward at the time were for the most part based on the works of two Nobel economic prizewinners, Robert Mundell and Jan Tinbergen.
Robert Mundell pioneered the optimal currency area theory, an area which would fulfil the four criteria listed in the table below:
Based on the table, the conclusion is that the eurozone, unlike the United States, meets practically none of the necessary criteria for an optimal currency area. Labour mobility is low (partly due to language barriers), the labour and product markets are highly regulated, and there are no fiscal transfers between eurozone countries.
Before monetary union, the Tinbergen rule was met by the countries which are today members of the eurozone.
To meet the above three objectives, these countries had four instruments:
Source: Strategic Economic Decisions
Since the introduction of the euro, the Tinbergen rule has ceased to be met. The eurozone countries have lost the control over their monetary policy, their money supply and their currency. The only tool left is fiscal policy (and even here, budget austerity in the peripheral countries means that these countries do not have the control over their fiscal policy) to meet their objectives. This is impossible and the results are less far from optimal.
It is important to note that the Mundell and Tinbergen theories are complementary. If the countries making up the eurozone had for example similar economic cycles, the problem resulting from the Tinbergen rule would not be as serious, since what would be good for one country (in terms of fiscal and monetary policies, currency and money supply) would be good for the others. Similarly, if labour mobility in the eurozone was as flexible as in the US, the fact of a country no longer having recourse - due to their membership of the single currency - to the instruments mentioned above would be offset by the ability of the residents of a country experiencing high unemployment to migrate to a country with low levels of unemployment.
As noted at the start of this post, these economic arguments have been ignored by the political authorities. The single currency was allowed to be created and the first years of the eurozone were marked by the following developments:
- an expansionary monetary policy conducted by the European Central Bank, in response to the economic problems in Germany dating from the start of the century, but also due to the monetary policy conducted by the Federal Reserve in the United States;
- convergence of long-term interest rates of the peripheral countries towards the German level (why buy a German government bond offering a coupon of 4% if you could get 10% on a Greek bond in the same currency?);
- the peripheral countries experiencing abnormally low short and long-term interest rates, leading to:
These last two points are very important. Since the introduction of the euro and up until the crisis, there have been huge divergences in labour costs (or to be more specific, in unit labour costs that adjust labour costs for productivity gains) in the north and the south. The upshot of this is that today the south is no longer competitive: in concrete terms, the countries of the south are dealing with high external deficits while the northern European countries are faced with high external surpluses. And external trade deficits imply foreign capital requirements.
Change in unit labour costs (wage costs adjusted for productivity gains)
Source: Datastream, Natixis
The table below speaks for itself. It shows the current account balance (as a % of GDP) of the eurozone countries in the 10 years preceding and the 10 years following the introduction of the single currency. In the 10 years prior to the introduction of the euro, Spain's average current account deficit was around 1.8% of GDP, and its peak was 3.6%. Since the introduction of the euro, Spain’s average current account deficit has been 5.8% with a peak of 10%. Such a situation would not have arisen without the single currency which, while presenting a relatively balanced picture of the eurozone situation overall, masked what was happening within the member states. Of course, it is also worth noting that countries like Germany and Finland experienced the opposite trend in their current account balances.
In an environment in which the southern countries are no longer competitive, the Tinbergen rule is all the more important. In the past, these countries could have devalued their currency to restore competitiveness. Locked in the eurozone, they can no longer use this instrument.
Current account balance (as % of GDP)
Source: Nomura, Eurostat
The problems arising from the introduction of the single currency were further reinforced by two factors linked to the European banking system. First, regulations such as the Basel II framework have encouraged a situation of unhealthy interdependence between banks and states. Without going into detail, the Basle II rules strongly encouraged the banks to buy government bonds (and were as such very popular with governments which then had a captive source of refinancing).
At the same time, the banks of the eurozone's northern countries naturally wanted to take advantage of the 'economic boom' in the south, especially as the euro had removed the exchange risk involved in their investments in this region. When the crisis erupted, they found themselves very exposed to these countries (adding to their existing risk on subprime in the US. The banks hardly covered themselves with glory in the crises and it is particularly frustrating that the authorities are not taking the measures required to ensure that an individual bank will never again be able to pose a systemic risk to the financial system.)
German banks' foreign claims on Spain (in billions of $)
The interdependence between bank and state and the huge exposure that the banks of the north have to the peripheral countries are only exacerbating the crisis in the eurozone and explain why it is so difficult to find a solution. Both factors are usually put forward by those who claim that a partial or total break-up of the euro would lead to economic catastrophe.
The eurozone crisis is therefore made up of a range of crises:
with each crisis contributing to exacerbating the situation.
... fall into four main categories:
First of all, and regardless of what we think about its approach, it is important to point out that the ECB is not equipped to resolve a solvency crisis or a problem of competitiveness. It can only intervene to manage the other two aspects of the crisis, i.e. to help the peripheral countries to obtain financing, and to prop up the banking system. The second point is that the measures undertaken by the ECB often prove counter-productive. Given that such measures tend to calm the markets, they result in a certain complacency on the part of the political authorities. They also prevent the adjustments necessary by encouraging the banks on the periphery to borrow capital from the ECB (at a rate of 1%) that they then invest in the bonds issued by their country. Finally, the money that the ECB lends to the Spanish banks flies out again immediately given the lack of confidence in those banks.
Household and corporate deposits at Spanish banks
Source: ECB, CLSA
Regarding the other measures, it is clear that the budget austerity imposed is aggravating the economic problems of the peripheral countries and making it even more difficult for them to service their debt (in the debt-to-GDP ratio, the denominator falls faster than the numerator resulting in a deterioration of the ratio).
Moreover, the capital from the bailout fund is used mainly to pay back existing debtors and does not make its way into the real economy. Also there is no private sector involvement. Obviously no private company is currently prepared to make huge investments in Spain, for example, if it doesn't know whether Spain will still be in the euro in two years’ time. Regarding the restructuring of Greek debt, this has not gone far enough, especially as certain lenders, such as the European Central Bank, have not had to take losses on their positions.
The measures taken to date will enable the peripheral countries to refinance themselves (temporarily) on reasonable terms, either because they have taken refuge in the bailout fund (accepting or pretending to accept the austerity measures) and for the time being don’t therefore have to resort to financing in the capital markets (Greece, Ireland, Portugal), or because the measures announced by the ECB have been sufficient to lower their financing cost in the market (Spain, Italy). These measures help to gain time but they do not provide a sustainable solution to the eurozone crisis as they do nothing to address the solvency or competitiveness issues.
Later this week... "Can the euro survive?"
"Economic activity depends on a degree of trust between strangers. Since money is the agent of exchange, it is the agent of trust. Debasing money therefore implies debasing the trust upon which social cohesion rests. Further debasement of money will cause further debasement of society." (Dylan Grice)
The last two months on the financial markets have been dominated by the European Central Bank’s decision to engage in an ‘unlimited’ programme of buying up short-term Spanish and Italian bonds and by the Federal Reserve’s new round of Quantitative Easing.From the end of July to mid-September, the US and European markets gained an average of about 10%, with a particularly sharp rise for the Spanish and Italian stock market indices and for bank stocks.
It is worth noting that while these measures have prompted a rise in stock prices, they have done nothing to resolve the fundamental problems in industrialised countries and set the economies of these countries on the path to sustainable recovery. On the contrary, by keeping the price of money artificially low, they are preventing the necessary adjustments, leading to a poor allocation of capital, provoking a rise in commodity prices and forcing savers seeking yield to take substantial risks. It is therefore not surprising that the previous rounds of monetary easing failed to generate a sustainable improvement in the economy and there is no reason to think that it will be any different this time. In the absence of such an economic improvement, there cannot be a sustainable increase in company earnings, especially at a time when profit margins are already very high. Without a sustainable increase in earnings, the upturn in share prices is not sustainable. Unless we think that abnormally low interest rates and a massive injection of cash justify a rise in valuation multiples to considerably higher levels. That is the implicit reasoning of people buying equities in anticipation of the measures announced by the Federal Reserve.
Obviously we do not share this reasoning. If there were a positive correlation between exceptionally low interest rates and high share prices, you could be forgiven for wondering why the Japanese market is now nearly 75% below its level at the end of the 1980s. In fact, stock market history shows that the valuation multiples of shares were at their lowest during periods when interest rates were negative in real terms as is currently the case. This seems logical given that negative real interest rates are rarely the reflection of a fundamentally sound economic situation.
In our investment strategy, we do not therefore envisage chasing a rise in share prices which is not justified from a fundamental point of view. The more so since economic indicators and announcements from a number of companies point towards a relatively marked slowdown in economic activity.
The fact is that the economic environment in which we currently find ourselves is exceptional. While economic history can generally give at least a few indications on the developments we could expect, many economic parameters are now at levels unprecedented for the last 200 years. Notable among these parameters are the level of public debt and of budget deficits in the leading industrial countries (and this even BEFORE demographic trends have begun to weigh heavily on public finances), the explosion of the central banks’ balance sheets in these countries (in absolute value and as a percentage of their GDP), and the level of short- and long-term interest rates. Added to this we should add a monetary union in Europe which isn’t working and which is starting to endanger the positive benefits of the European project, a banking scene in a sorry state but having a strong political lobby so it can oppose the reforms that are needed, and a welfare state that most countries can no longer afford to pay for but which is extremely difficult to change in a democratic system, not least because the politicians’ main objective is to get (re-)elected. In this environment, the authorities have chosen to suspend the rules of the market economy and pursue fiscal and monetary policies that will only increase the structural imbalances. By further aggravating the gap between rich and poor, they will also weaken social cohesion all the more. It is difficult to see a favourable outcome to such an environment.
It follows from the above that traditional investment rules – and more specifically the distinction between money market and bond investments as risk-free and equity investments as risky – no longer makes sense. In my blog on 16 May, I wrote that there is no longer any such thing as a risk-free asset class but that the risks differ depending on the type of investment and the investment horizon. For fixed-income investments, the risks are loss of purchasing power (more or less inevitable at present but which the majority of investors seem prepared to accept, at least while the official inflation rate stays relatively low) and the possibility of not getting 100% of your money back if you try to chase higher yields. In the case of equity investments, the risk is loss of capital. However, here it is important to distinguish between a temporary and a permanent loss.
A permanent loss on an equity investment, or at least a loss which cannot be recovered in a reasonable time frame, can result from two factors: buying shares of poor quality companies or buying shares of good (or bad) quality companies at too high a price. However, as the quality of the companies we buy and the valuation multiples we pay for are actually among the few parameters that, as investors, we can control, the risk of a permanent loss can to a large degree be eliminated. This is why in our daily work, it seems to us more logical to focus on an analysis of the quality and valuation of the companies we hold in our portfolio or in which we are thinking of investing, rather than trying to predict the actions of the political and monetary authorities. In so doing, we should be able to reduce as far as possible the risk of a prolonged loss in our equity investments.
On the other hand, the risk of a temporary loss is inherent to investing in stock markets. An investor who is not prepared to run that risk should never invest in shares.
To sum up, our investment strategy is based on the following ten observations:
As at 22 August 2012, 94% of the fund was invested in equities, 49% of which was covered through the sale of futures, with the remainder in cash. The fund held no bond positions.
The rally on the stock markets since June was used by the fund manager to lower the net equity allocation from 51% to 45%. The rally was mainly due to the lull in the eurozone crisis (linked to the holiday period) and investors' expectations of a new round of quantitative easing (QE) in the United States and particularly in Europe following the announcement by the president of the European Central Bank that the monetary authorities were ready to pull out all the stops to save the euro.
It is interesting to note that this kind of statement is still able to spark rallies on the equity markets. Most investors seem to be obsessed by the decisions of the monetary authorities, despite the fact that they have consistently shown that they are incapable of finding sustainable solutions to the current crisis and that most of their measures only exacerbate the situation.
Notwithstanding the excellent performance of stocks in the past three months, the reality is that the economic situation is deteriorating to worrying levels and that there is a strong risk of a systemic crisis. The main impediments to economic development are extremely high levels of debt and a severe lack of confidence in the future. In this light, it is distressing to note that the authorities seem resolved to prevent the adjustments necessary to help the economy get back on solid ground, which explains the lack of a sustainable recovery.
In geographical terms, 42% of the equity portfolio is invested in Europe (18.5% after hedging), 28% in North America (2% after hedging) and 24% in the Pacific Rim. The low net allocation to North America is due to the high valuation of the US market.
The chart below shows the geographical breakdown of the equity portfolio.
Equity allocation by region
The allocation of the equity portfolio remains defensive and is strongly weighted in sectors that are relatively resilient to the economic situation. Gold-mining companies were slightly raised to 7% following some price weakness in May. The current environment, which is marked by high debt levels, deteriorating public finances, rock-bottom interest rates and central banks ready to embark on monetary experiences of which they have no measure of the consequences, is arguing in favour of investments in gold and gold-mining companies, which are currently undervalued.
At the end of July, the average price/earnings ratio of the equity portfolio was 14, while the average dividend yield was 3.7% (source: Bloomberg).
The euro (the fund's reference currency) was lowered again. This was due to the fact that the key condition for a strong currency (i.e. a central bank with quality assets on its balance sheet) is quite simply no longer met in the case of the euro. All the so-called solutions to the euro crisis are pointing towards a depreciation of the single currency.
The chart below shows the currency allocation before and after forward exchanges.
The net asset value of BL-Global Flexible has gained 6.26% since the start of the year.
In April 2009, we made our first foray into the microfinance sector with an initial investment of $650,000. This was a loan to the Confianza microfinance institution (MFI) with an interest rate of 8.75% and maturity of 2 June 2011. Our initial investments in microfinance were made within the BL-Global Bond fund. Since then, our financing operations in this area have grown and today our total investments in this sector have risen to around €50 million.
Why did we decide to include this sector in our portfolios? And what is the general view of this type of investment against the backdrop of a worsening economic crisis, particularly in the eurozone?
The question of whether to make microfinance a new component of our risk diversification strategy arose just before the crisis of 2008. We wanted to develop our investment policy and were looking for a new 'asset class' to incorporate into our portfolios so that we could continue to optimise the risk-return of the bond funds. After investigating the emerging markets universe, in which we had invested first via third-party funds, then directly in government debt denominated in hard and local currencies, we studied the possibility of investing in emerging market corporate debt. Unfortunately, this market was still under-developed. In 2008, emerging market corporate bonds were displaying a high level of volatility, which clashed with our requirements. Between May and October 2008, the average yield spread of the CEMBI Diversified index over the US Treasury bond increased from 315 basis points (3.15%) to around 1107 (11.07%). The average yield to maturity went from 6.8% to over 14% over the same period, corresponding to an index price drop of 32%. Such volatility seemed (and still seems) far too high.
Figure 1: Emerging Market Corporate Debt Spread
In light of this, and given the characteristics of the microfinance sector and the instruments used to invest in this market, the opportunity to integrate this activity into our portfolios seemed more attractive. In addition to a noticeable lack of volatility in microfinance investment securities, there was also resilience in the nature of the funded activities which reinforced our motivation to invest in this market. A paper produced by Nikolas Krauss and Ingo Walter of New York University provides an analysis of the relative stability of income linked to this activity which is usually at the bottom of the economic pyramid.
Figure 2: Correction of the microfinance sector with the MSCI World Index (variance of the various financial components)
MFIs: Microfinance Institutions
EMIs : Emerging Markets Institutions
EMCBs: Emerging Markets Commercial Banks
Source: "Can Microfinance Reduce Portfolio Volatility?", N. Krauss & I. Walter - March 2008
Regarding microfinance investments, in 2009, interest paid out by MFIs on loans made by our funds was expected to exceed 9% in dollar terms and reach 13% in local currencies (such as the Peruvian sol or Indonesian rupiah). As for the financial instruments used to invest in these markets, they are nothing more than promissory notes whose clauses are negotiated directly with the microfinance institution. Once issued by the MFI, these notes are kept at the custodian bank until the principal and interest due are repaid at the loan's maturity.
Since 2009, the sector has experienced a number of problems, ranging from the Andhra Pradesh crisis to the controversial resignation of Muhammad Yunus of Grameen Bank. Other unfortunate events that impacted the sector were a civil war in Kyrgyzstan, a currency devaluation in Belarus, and the near bankruptcy of institutions such as SKS Microfinance, which recently entered the stock market. However, despite the continued series of bankruptcies in the European and US banking sector, such as the recent bail-out of Bankia in Spain, no event of an equivalent level of seriousness has occurred to startle investors, destablise regional economies or undermine the validity of the microfinance model. Excess is a thing of the past, and measures to improve customer protection are starting to be introduced.
Clearly there are still risks linked to the microfinance sector, but they are different to those encountered in 'traditional' finance. Most significant and least predictable is political risk, as the latest crises have shown. For example, in Nicaragua, the No Payment Movement (No Pago) was supported by the current president and former member of the Sandinista party, Daniel Ortega, who accelerated the failure of the largest national MFI, Banco del Exito, more commonly known under the name of Banex. And in India, the Spandana MFI was hit hard after the commissioner of the Krishna district decreed in 2006 that it was illegal for borrowers to pay back their loans to MFIs and to Spandana in particular. Spandana's outstanding loans in the district of Krishna represented 15% of its portfolio.
Given the preponderance of this type of risk that is not specifically linked to microfinance nor even the governance of these institutions, we have streamlined our investment methodology and reviewed our investment solutions in order to better reflect the realities of the sector. Our investments are guided primarily by environmental aspects (legislation, political stability, etc), the macro-economic framework and the financial profile of the institution under consideration. Accordingly, many of our microfinance investments have been made in countries in whose government debt we were already investing. Such is the case with Indonesia, a politically stable country with a population of 240 million people. The government of S. Bambang Yudhoyono continues to reform the country's economy and inflation has fallen from 18% to 4.45% since November 2005. Public debt to GDP declined from nearly 100% in 2000 to 25% in the space of just one decade. In this country where around 20% of the population still lives below the poverty level, we picked out MBK, an institution whose average loan was $75 when we first invested in September 2000. At the time it had 142,000 borrowers. Since then, the number of borrowers has increased to 280,000. The institution lends exclusively to women and the average loan is now $105, which is still relatively low. Some 75% of MBK's clients live below the poverty threshold. The latest loan given by our BL Microfinance fund was offered in Indonesian rupiah at a rate of 11.5%.
The BL Microfinance fund, our first microfinance fund, was launched at the end of 2010 to meet the characteristics described above. We also apply concepts linked to our methodology as bond managers. The BL Microfinance fund produced an annualised return of 5% since its launch, setting it apart from its peers. Two years on, we plan to repeat the experience by launching the Capital Gestion Microfinance fund, which will have an identical investment philosophy and is expected to produce similar returns. We firmly believe that this sector should be included in our portfolios, especially as it allows us to help serve the bottom of the economic pyramid.
Article written by Jean-Philippe Donge, portfolio manager of BL-Global Bond and Selectum Sicav - SIF - BL-Microfinance.
"I think it's worth considering that the architects of the monetary union knew all along that it would lead to a crisis and the crisis would lead to a federal solution. In fact, you could say that it was actually designed to create a crisis." (Niall Ferguson)
"How dare European policymakers tell the population to continue suffering for their mistake, just so that they do not lose face?" (Charles Gave)
"Throwing more debt after bad debts ends up meaning more debt." (Dave Rosenberg)
The European monetary union is not working. Worse than that, we are rapidly reaching a stage at which it is endangering the positive benefits of the European project. The euro should not be maintained, at least not in its present form. Unfortunately, the current generation of politicians remains locked into a reasoning that the single currency should be defended at any cost. It comes as no surprise then to see them paint disaster scenarios in the event of the euro’s partial or total collapse.
In fact, these disaster scenarios are unfolding right now, especially in Southern Europe. Bank deposits are in free fall in Spain and Greece, with many savers withdrawing their euros and depositing them in a ‘Northern’ bank. Private investments have stopped given that no entrepreneur is prepared to launch projects in the current climate of uncertainty. Consumption has fallen away following austerity measures and increasing employment. And the latest economic indicators show that these trends are no longer limited to the Southern countries but are also increasingly impacting European countries hitherto less affected by the crisis, and even the rest of the world. The inability of European leaders to manage the crisis thus risks provoking an economic catastrophe.
The authorities’ capacity to try and gain time through half-measures is fading and their credibility on the financial markets has been thoroughly rattled. At the end of the day, there are only two solutions: accept fiscal union or abandon monetary union.
Many observers are now suggesting the issue of eurobonds (bonds issued and jointly guaranteed by eurozone member states) and the establishment of a banking union with a mutualised deposit guarantee scheme as the first steps towards fiscal union. These suggestions made a comeback after France finally aligned itself with the Southern countries following the election of François Hollande, one of whose first measures was to reduce the retirement age in the midst of a public deficit crisis.
But would the issue of eurobonds, banking union and even fiscal union really be a solution to the crisis? In this respect, we should bear certain facts in mind:
- Greece, Portugal, Spain etc. are not going to be able to finance themselves on the market on reasonable terms in the foreseeable future. Private investors know that the debt level of these countries is not sustainable and that if their debt is restructured, their own rights will be arbitrarily subordinated to those of institutional investors such as the European Central Bank;
- the enormous financing requirements of these countries must therefore be financed either directly by the ECB or by a pan-European entity with virtually unlimited access to ECB loans (by granting bank status to the ESM, for example);
- realistic estimates of the resource requirements for such an entity suggest a figure of at least 4,000 billion euros. Germany would have to guarantee a large part of this amount, especially as countries needing capital cannot seriously be considered as guarantors of such an entity. For comparison, Germany’s current public debt is around 1,500 billion euros. It could therefore virtually double;
- Southern countries have 3 problems whick are linked together: too much debt, an insolvent banking system AND an excessive external deficit. This latter point is all too often forgotten. Southern Europe is no longer competitive, which results in high external deficits and a commensurate need for external capital. In the past, to become competitive again, these countries would have opted to devalue their currency. But this solution is not possible while they are locked into the euro. The only route is therefore ‘internal devaluation’, which means reducing wages and employment (especially among young people). Issuing eurobonds or fiscal union would do nothing to remedy this situation;
-- fiscal austerity on its own is not working. The negative impact of this austerity on growth is such that the countries concerned lose more on one side (fiscal receipts) than they gain on the other (lower public spending, assuming they really are prepared to put budget cuts in place). In other words, instead of improving, the public-debt-to-GDP ratio is deteriorating, with the denominator declining faster than the numerator. The capacity of these countries to service their debt is thus reduced;
- the quick-fix solution called for by the Southern countries, the financial markets and many economists could have disastrous consequences in the medium and long term, especially for future generations. The essence of this solution is to pool European government debts in order to monetise them by directly or indirectly allowing the ECB to print money indiscriminately. The eurozone crisis is in fact primarily a welfare-state crisis that quite simply the European countries can no longer afford to finance. Chancellor Merkel is therefore right to oppose this facility solution and to maintain pressure to force the peripheral countries to start making structural reforms. However, there is a real possibility that she might be forced to make more and more concessions especially if she has to face an upsurge of criticism in her own country now that the German economy is starting to feel the effects of the crisis.
If saving the euro were an end in itself, rapid fiscal union would be a solution. But the goal should be to reach a situation which “will maximise the well-being of the greatest number of citizens” (to quote Woody Brock, founder and president of the firm Strategic Economic Decisions) and in particular, offer prospects for future generations. This goal cannot be met if fiscal union takes place before the necessary structural reforms are implemented in the eurozone countries. If that happened, fiscal union would simply equate to a permanent transfer of capital from some countries to others.
Ultimately, whether or not to maintain the euro in its current form is a political decision, just as it was for the introduction of the single currency. At that time, the decision ran counter to good economic sense.
(Nigel Farage is a European MEP and Co-President of the Europe of Freedom and Democracy Group. His analyses and speeches in the European parliament are worth listening to. This is his reaction to the bailout plan for the Spanish banks:
In view of the continued escalation of the banking crisis in Spain (Bankia was rescued last weekend with EUR 19 billion of government funds, the head of the Spanish central bank has (been) retired, in April alone deposits of EUR 31 billion were withdrawn from Spanish banks, according to Bloomberg, EUR 184 billion of problem loans (especially to property developers) still remain on the books of Spanish banks, etc.), it is understandable that investors are avoiding Spanish (government) bonds. It is therefore logical that yields on Spanish government debt are rising, both in absolute terms and also relative to the supposed stable core countries of Europe:
10-year Spanish government bond yield over the past five years
Differential from 10-year German government bond
(Source : Bloomberg)
However, in the markets, there appears to have been hardly any direct speculation against Spain. The risk of the ECB deciding over night to purchase massive amounts of Spanish government bonds is just too high. After all, it has done this before.
Although this would certainly lead to an increase in prices in the short-term, market intervention by the ECB would fundamentally be bad news for the owners of Spanish government bonds. Since – as has already happened with Greece – the ECB would be treated as a preferential creditor, non-governmental investors would receive less in a potential debt restructuring. ECB intervention in the market is therefore possibly another reason for selling Spanish government bonds.
Prior to any debt restructuring however, Spain would clearly first have to accept the EU rescue package. But for now, the politicians are (still) categorically ruling this out. Having said that, the same also happened in Greece, Portugal and Ireland until shortly beforehand. These countries actually accepted the rescue package when their respective 10-year government bond yields exceeded 7%. On Friday, the yield on 10-year Spanish bonds already exceeded 6.5% p.a. Things can therefore happen quickly.
If a country accepts the rescue package, this does not necessarily mean that it will restructure its debts (after all, Portugal and Ireland accepted the rescue package some time ago and have not restructured their debts). The example of Greece shows that whether or not this actually happens becomes a purely political decision and is therefore speculative. In the event, international institutions receive preferential treatment and it will be very painful for private investors.
An investment in Spanish government bonds therefore amounts to speculation that Spain manages to pull through either on its own, or with the rescue package but without debt restructuring, until the bond is repaid. As the acceptance of a rescue package, debt restructuring, and particularly the timing of these events are purely political decisions, no economic models exist for measuring this risk. I therefore wish every investor in Spanish government bonds the best of luck with timing!
Oh well, some commentators believe that Spain’s acceptance of the rescue package would be the litmus test for European institutions. I don’t share this opinion: Even though at approx. EUR 750 billion the debt of the fourth largest economy of the eurozone is about three times as large as the total debt of the three countries that have already accepted the rescue package, the ESM, or rather the EFSF, was specifically designed to also include Spain. As long as the crisis does not spread to another large economy (e.g. Italy), the rescue mechanism should be sufficient.
The immense problems in Europe beg the question how Germany, which may have to risk a lot of money as the saviour of the eurozone, can sell almost EUR 5 billion of two-year Federal treasury notes without having to pay any interest. During the week there were even buyers who purchased this bond with a negative yield. Why would anyone purchase a bond guaranteeing less money at maturity than was paid for it?
The answer is that the purchase of a German government bond, even with a negative yield, is an insurance against the break-up of the euro. A German government bond, which is later converted into “new Deutschmarks”, would, as a result of the currency effect, virtually increase in value overnight by 40-50% compared to currencies in the peripheral countries. An investor who considers the break-up of the eurozone a possibility can therefore use the purchase of Federal government bonds to hedge against this risk. If I assess the probability of a break-up at 5% and the resulting loss in value of my investment portfolio (Southern European countries) compared to German government bonds at 50%, then I can insure myself with an investment of 2.5% in German government bonds. Even if the yield expectation for this 2.5% is negative, this is cheap insurance.
The situation in Switzerland is similar. There for example, during the past week, almost CHF 750 million of Federal 3-month treasury notes with a negative yield of -0.2% p.a. were sold. Is this the price of insurance against Switzerland severing its link to the euro?
Yes, because if Switzerland were to give up this link, then the CHF would certainly rise markedly in value over night.
No, since it would actually suffice to physically buy CHF or just to hold CHF in a bank account. The negative yield therefore reflects the difference in quality between a bank and the Swiss state.
What action should therefore be taken today by an investor wanting to invest in bonds? An investment in crisis country government bonds is fundamentally a speculative investment, regardless of whether or not there is a break-up of the eurozone.
It makes little sense for an investor outside of the eurozone to invest in EUR bonds. The currency will remain under pressure until it finally becomes clear what is going to happen to the euro. Other investments, for example keenly priced shares in good quality companies, should protect this group of investors against a falling EUR. Following the same logic, it is advisable for euro investors to diversify broadly across foreign currencies. Part of the investment should definitely be in USD as the traditional safe-haven currency, even though the economic situation in the USA is not any better than in Europe.
An investor living and residing in the eurozone whose income and expenditure is in EUR should however not hold all of his investments outside of his reference currency; the currency market is inherently too volatile for this. Bonds are however not a viable and/or secure investment for such EUR investments. A “north-euro” investor would be better to invest his money directly in one or more “north-euro” banks. He would need to ensure that these banks don’t hold significant investments in “the South”. If he cannot find such a bank or does not trust “the banks”, then the German government bond with a virtually 0% yield remains the least risky investment for him. In the main, this principle is also valid for “south-euro” investors. Such an investor must however be aware that a break-up of the euro would also result in the introduction of capital controls. To allow him to remain liquid in this instance, he must continue to hold some of his investments in his home country.
Some commentators think, by the way, that corporate bonds are more secure than government bonds. This is correct in so far that, on the one hand, the income of companies, especially if they are of good quality and established globally, generally exceeds outgoings (which at the present time cannot be said for any budget of a eurozone state); on the other hand, they can use the income to repay their debts. In addition, the yield they pay is slightly higher than that of low-risk government bonds. There again, it is totally unclear which new currencies the bonds of private issuers would be denominated in if there were to be a break-up of the euro. In my opinion, at 1.22% p.a. for example for Royal Dutch’s five year bond, this denomination risk and the normal business risk is not adequately rewarded, even more so when compared to the money market rates of approx. 1% p.a. offered by most solid banks.
Since bonds are therefore generally less attractive, the only remaining option, as far as traditional cash investments are concerned, is shares. And, as a matter of fact, especially after the corrections of the last few days, there is a glimmer of hope here for investors. Please refer to Guy’s article, published a few weeks ago, for further details. In this connection I would, especially for income-oriented investors, like to emphasise high dividends. Even during times of crisis, when share prices of many companies fell heavily (and have fallen currently), it is amazing how stable the dividend distributions have been before, during and after these times of crisis, and how stable they continue to be. If you can tolerate these price fluctuations, dividend-carrying investments are very attractive.
In conclusion, I hope you can remain level-headed when considering your investments and that you will not rush inito buying or selling without due consideration and reflection.
Article written by Dieter Hein, Director BLI - Banque de Luxembourg Investments and responsible for fixed-income investments.
The macroeconomic environment is still suffering from a significant debt overhang in the industrialised countries and weak growth that is based on shaky fundamentals. The monetary and fiscal policies of the past few years have only served to deepen structural imbalances and exacerbate the economic and financial risks in the medium and long term. In such an environment, the logical response would be to not take any risk and restrict investments to asset classes that are safe.
The problem facing an investor right now is that assets that traditionally held little risk (i.e. cash and government bonds) have actually become quite risky. This problem would not be as serious if these investments at least offset their higher level of risk with a decent expected return. But this is not the case due to the monetary policies being conducted by the central banks. Their objective - and especially that of the Federal Reserve - is to boost the prices of risk assets by keeping interest rates close to zero in order to produce a wealth effect. In doing this, the central banks are discouraging savings (in the United States, interest income received by savers has fallen by more than 30% since 2008, while in Japan, it has fallen by 80% since 1991. This income is no longer there to stimulate consumption.). The banks are also encouraging speculation and distorting capital allocation, allowing lesser-quality companies to survive on artificially low financing costs that do not punish bad investment decisions. This is particularly true in the banking sector. It is therefore ironic that many observers consider that the market economy is the cause of the current crisis. The fact of the matter is that the authorities are no longer allowing the rules of the market economy to do their work, which explains why the macro-economic environment has become so fragile.
To come back to investments again, one major impact of the current environment is that there is no longer any such thing as a risk-free asset class. Returns on money-market investments are lower than inflation in most of the industrialised countries and there is currently no reason to think that the situation will change in the foreseeable future. In real, inflation-adjusted terms the return on a money-market investment is therefore negative: i.e. such investments destroy purchasing power. The same applies to government bonds issued by countries that are still considered as safe (Northern Europe, US, Japan and UK): the 10-year yields offered by these countries are below their inflation rate. As well as this, the countries that still have control over their currencies have more or less openly opted to print money. A case in point is the Federal Reserve, which has bought 60% of the bonds issued last year by the US Treasury; and the central bank in Japan, which is expected to buy around 80% of government bonds issued during the current fiscal year. While the ability to print money at will helps these countries to obtain financing and rules out - on the face of it - payment defaults, economic history shows that printing money has always more or less resulted in high inflation in the long term.
Those countries with no control over their currencies that have lost the confidence of the markets (Southern Europe) face a very real risk of a major payment default. The restructuring of the Greek debt has accordingly created a precedent. For the first time, investors holding bonds issued by an EU Member State will not recover the nominal value of their bonds. And new classes of investors are popping up - privileged investors such as the European Central Bank and the International Monetary Fund, which have not had to take losses, and other investors who have experienced huge losses despite buying exactly the same issues as the first group. They will certainly no longer be interested in bonds from other countries with unsustainable levels of debt.
An investor today faces three kinds of risks:
The first risk faced by investors today is volatility: the prices of certain assets fluctuate more than others. This is why equities are traditionally considered as being more risky than bonds. As a general rule, share prices tend to fluctuate much more than bond prices. This makes sense as unlike shares, bonds are not affected by a company's operational results (in so far as these results do not affect the company's ability to pay back its debt) and have a fixed maturity date on which the investor should be paid back their initial investment. The risk aspect of investing in the shares of good-quality companies is thus not that these companies will go bankrupt, but that the value of an investment in their shares may at any time dip well below the initial outlay, as the stock price fall for real reasons (because earnings are down) and/or psychological reasons (because the markets are down). This contrasts with the value of a money-market investment, which, in principle, never falls below its initial value.
The next risk is the risk of a permanent loss of part of one's capital. In terms of bond investments, this risk is largely confined to the quality of the issuer, while for stock market investments, this is linked to the quality of the company as well as the price paid, unless there is an exceptionally long investment horizon involved. An investor who bought Cisco Systems in March 2000 at $80 (150 times earnings) now has a stock worth $17, despite the fact that Cisco Systems' earnings have tripled over the past 12 years. If the share price rises by 7% annually from the current level, it will still take more than 20 more years before it reaches the March 2000 level again. The loss is perhaps not permanent, but it will take a long time to reach the level of the initial outlay. The likelihood of a permanent loss of capital was not supposed to exist for government bonds, however. This is why banks and insurance companies were not obliged to put up equity capital against their government bond holdings.
Finally, there is the risk of a loss of purchasing power following nominal returns lower than inflation, and therefore a negative return in real terms. This risk is usually less visible than the two previous risks and seems to be less of a concern for investors. It is however very real. Since being taken off the gold standard in 1971, the dollar has for example lost around 80% of its purchasing power. The same dollar invested on the stock market (i.e. the Standard & Poor's 500 index) would be worth $15 today. An investment in shares would have resulted in a substantial increase in purchasing power over this period, despite the many bad years on the stock market (stagnation in share prices between 1971 and 1982, stock market crash of 1987, slumps of around 50% between 2000 and 2003, and between 2007 and 2009).
Today it is possible to choose the type(s) of risk that one is willing to take but it is impossible to not take any risk. Doing nothing is also a decision.
For fixed-income investments, the risks of a partial loss of capital or a loss of purchasing power are prevalent, but it is also important to note that the volatility of bond investments has also increased following the decline in interest rates. The 0.50% increase in German bond yields in the second half of November 2011 (from 1.7% to 2.2%) is a case in point: the price of the 10-year German government bond fell 5% in the space of two weeks. With interest rates close to zero, the loss of purchasing power is practically guaranteed over the medium and long term, unless we believe that we are entering an extended period of deflation. Deflation is indeed a real threat in countries that have no control over their currencies. However, deflation would push up the cost of their debt even more thereby increasing the threat of a restructuring of that debt.
It is against this backdrop that the usual reasoning that an investor should avoid equities in an uncertain environment needs to be called into question. I have already explained why I believe that the conditions required for equities in general to enter a new structural bull market are not in place. Such a bull market would notably require valuation multiples to increase over a number of years: I do not believe that the current environment is pointing in this direction. While this conclusion is valid for the market overall, within the market, there are nevertheless regions, sectors and companies that have the potential, based on realistic assumptions, to offer much better returns. This is particularly true of quality companies in non-cyclical sectors. Such companies combine a number of advantages: a competitive advantage, sound financial structure, exposure to emerging markets, attractive dividend, etc. They are not cheap, but they are not overvalued either. Their valuation could even increase gradually as investors realise that unlike government bonds, shares in quality companies represent real assets and start to consider them as a kind of safe haven.
As explained above, the so-called equity risk associated with such companies is mainly due to share price volatility. In the medium and long term, the share price usually reflects the company's fundamentals, but in the short term, it can fluctuate significantly. Daily fluctuations are a fact that an equity investor must accept and are also the reason why equities are not compatible with short-term investment horizons.
On 20 April, 92.5% of the fund was invested in equities, of which 42% was hedged through the sale of futures. Cash was 7.5 % and the fund did not have any positions in bonds.
There have been no significant changes to the geographical allocation of the equity portfolio since January. The weighting of Japan was increased from 5.5% to 8%, while investments in the United States, the United Kingdom and the emerging markets were slightly reduced following the rally on these markets. It is easy to paint a gloomy picture of Japan given the significant ageing of its population and the worrying state of the country's public finances. The fact remains, however, that the valuation of the Japanese market is attractive. Also many Japanese industrial companies are world leaders in their field and are benefiting from economic development in the Pacific Rim.
The chart below shows the geographical breakdown of the equity portfolio.
The sector allocation of the equity portfolio remains defensive with a strong weighting in non-cyclical consumer and healthcare stocks. The price/earnings ratio of the equity portfolio is 15 and the average dividend yield is 3.7% (source: Bloomberg data).
Gold mining stocks were increased from 3% to 6% in the first quarter. Gold-mining companies continued to underperform the price of gold in the first quarter, and given the current price of the yellow metal, these companies are currently undervalued. Trying to predict the prospects for the gold price is always somewhat speculative. However, the current excessively debt-laden environment with its deteriorating public finances, near-zero interest rates and central banks prepared to take a monetary route without measuring the consequences, is favourable to a further rise in the price of gold, notwithstanding some intermediate corrections.
The basic principle behind the currency allocation is that as long as the central banks continue to conduct their current monetary policies, neither the euro nor the dollar can claim the status of a strong currency. BL-Global Flexible uses forward exchange contracts to increase its exposure to the currencies of countries with better economic fundamentals, such as the Singapore dollar, the Canadian dollar and the Norwegian krone.
The chart below shows the currency allocation before and after forward exchanges.
The net asset value (NAV) of BL-Global Flexible has increased by 3.7% since the start of the year.
"The notion that central banks are in control of events is a myth. It's the other way around." (Dylan Grice, Société Générale)
"You simply cannot create investment opportunities when they're not there. When prices are high, it's inescapable that prospective returns are low. The motto of those who reach for return seems to be: 'If you can't get the return you need from safe investments, pursue it via risky investments.' It takes a lot of hard work or a lot of luck to turn something bought at a too-high price into a successful investment. Patient opportunism - waiting for bargains - is often your best strategy." (Howard Marks, Oaktree Capital Management)
Since the European Central Bank set up its long-term repo operation (LTRO), which involves injecting liquidity into the Eurozone banks in the form of three-year loans, the stock markets have gained around 20%.
We are not comfortable with a strategy that involves buying ‘because there is a lot of liquidity’ or 'because interest rates are so low’. History shows that each attempt to boost the value of financial assets with cheap money has failed in the long run. That such efforts fail is only logical as instead of resolving fundamental problems, cheap money only tends to make the problems even worse.
For us, the only reason to justify an investment in stocks or any other financial asset is a sufficiently low price (and even then, we restrict our investments to quality securities). Satisfactory returns on an investment can only be achieved if the price paid is sufficiently low. Many analysts are arguing that this is precisely the situation today. However, that is not true. Based on valuation multiples which in the past have been a good indicator of future returns, the current valuation of the US market is compatible with an annualised return of around 4% in the next few years. For some investors, such a return might appear attractive compared to those offered by money-market and bond investments, and they won't think twice about buying stocks. But in our opinion, such a return does not adequately compensate an investor for the risk taken when buying equities.
Around ten months ago, in my ‘Equity markets at a crossroads’ post, I said that history showed that there were essentially two types of stock markets:
In the first type of market, there is a clear established upward trend. In such a market, an investor who buys and stays invested for 10 to 20 years usually enjoys high returns despite interim corrections. In 2000, the stock markets were well above their 1982 level. In the structural sideways market, this is not the case. In 1982, indices were more or less at the same level as in 1966, and in 2012, they are lower than in 2000. The article went on to say that following the rise in share prices between March 2009 and May 2011, investors were forced to make a choice:
The situation today looks quite similar. After that article was posted, the stock markets went down for six months and, despite the sharp recovery in prices since December, most markets are not higher than they were in May of last year.
Once again, the question is to understand if, following 12 years of sideways market, the stock indices can get out of purgatory and begin a sustainable rise. Before answering this question, a few basic principles.
If a company produces earnings of 1 euro per share and if the market is willing to pay 12 times these earnings, the share price of this company will trade at 12 euros. For the price to rise, the company's earnings will have to rise or the market will have to be willing to pay more for these earnings (meaning that the company’s valuation multiple – 12 in this example – will have to rise).
This principle is also true for the market as a whole. The only factors that can push up the stock market are company earnings and valuation multiples. In structural bull markets, both factors rise. This explains why in these markets, returns are very high. Going back to my company described above, if 10 years later, its earnings per share is 2 euros and the market is willing to pay 20 times these earnings, its price will be 40 euros and an investor who paid 12 euros will have made an annualised return of 13%.
On the flip side, in structural sideways markets, earnings usually continue to rise, but valuation multiples tend to fall. The fall in multiples cancels out the rise in earnings and share prices stagnate (structural bear markets are characterised by a fall in valuation multiples and earnings).
To answer the question about whether this is a structural bull or sideways market, one must therefore have an opinion about the direction earnings and valuation multiples will take in the coming years. Incidentally, I emphasise ‘structural’ to show that we are talking about investing and not trading.
In terms of earnings, it is true that they have been surprisingly good in the past few years, especially given the weakness of the economic recovery. However, company results published in recent weeks seem to show that a turning point has been reached with pressures on both sales and profit margins (the latter being currently at historical highs). In the longer term, there is also the issue of corporate taxes which have declined in recent decades.
In terms of valuations, opinions are currently divided about whether shares are over- or undervalued. The main point however is that the factors that were behind the rise in valuation multiples are no longer in place, or have actually reversed. Some of the more notable factors are listed here:
In light of the above, the conclusion is that the conditions for a new structural bull market are not in place. And that it is better to take profits following the stock market recovery of the past few months, rather than feel obliged to buy from fear of ‘missing the boat’.
This is why an investment strategy that involves buying shares because the central banks are injecting huge liquidity is foreign to us. These cash injections have no impact on how much companies earn and therefore do not boost the ‘earnings’ component. They do temporarily have an impact on the ‘valuation’ factor by producing an equity rally not based on an increase in earnings. However, experience shows that this kind of rally will not be sustainable in the absence of an improvement in economic fundamentals. Participating in a liquidity-driven rally implies that one is in a position to predict the end of this rally before the others. Few investors are.
"Bonds promoted as offering risk-free returns are now priced to deliver return-free risk." (Shelby Cullom Davies)
Greece’s debt haircut means that, for the first time ever, investors in a government bond of a eurozone member state are no longer receiving back its nominal value. With bond prices for the 10 year Portuguese government bond at approx. 50%, market participants also seem to be assuming that Portugal will proceed in a similar way to Greece in years to come. Even though it seems unlikely today, nobody can say for sure that other countries won’t follow suit.
Greece’s haircut has opened Pandora’s box, and so far nobody has been able to assess the consequences.
To start with, virtually all government bonds of the eurozone countries have lost the characteristic of being a risk-free capital investment. This may sound harmless at first, but actually has significant repercussions.
For example, since no credit risk had previously been associated with eurozone government bonds, banks and insurance companies did not need to hold reserves or equity to cover investments in these bonds. An investment in government bonds was therefore very attractive compared to the usual alternatives. States on the other hand had no liquidity problems nor did they have to think seriously about whether or not the current interest rate was sustainable. Now that government bonds are regarded as carrying risk, they have to compete with other investments. Some states have already been forced to issue bonds at terms that clearly cannot be financed in the long term.
In addition, unlike in the past, an investor now has to ask himself how high the risk premium should be for investments in government bonds of a particular country. However, that is very tricky. Compensation for default risk forms the major part of a bond’s risk premium. Put very simply, this risk equates to average probability of default, multiplied by average loss in the event of a default. Therefore an answer has to be found to the following questions:
Since there has only ever been one such event under the current financial system, the answers cannot be determined from experience and are thus subject to wide fluctuations, which depend solely on the mood of the financial markets.
Take for example the prices of the Italian government bond BTPS 3.75% 1/3/2021 over the last 12 months, which clearly demonstrate these mood swings. Investors are more likely to associate 10 or 20% price fluctuations that occur either way, and over very short periods of time, with volatile phases in the stock markets. Such movements certainly don’t correspond with the expectations of the traditionally more conservative investor in government bonds. Incidentally, according to the finance principle that risk = volatility, government bonds have also become risk-carrying investments.
Analysts are now trying to assess these two variables by using macroeconomic models, but significant uncertainties exist over important parameters. For example, at what level does a country become overindebted? What will debt performance look like in the future? How much will the budget deficit, the personal savings rate, the balance of trade, national wealth, etc. be? There are no sustainable models which allow the determination of a fair risk premium for a government bond, because even where the performance of these parameters can be estimated, very little is known about when exactly a chain of events might lead to a debt haircut or a payment default, and how high the expected loss would be if that happens. An investment in government bonds made without any idea of its fair price will always be a speculative investment.
Even if it were possible to determine a fair risk premium for an investment in an Italian, Spanish, or Finnish government bond, the biggest problem would still be the reference value for a risk-free capital investment. This of course first begs the question as to what actually constitutes a risk-free investment. Since the collapse of Lehman, the interbank market with its “swap rates” no longer meets the criteria. A large number of banks have problems with their investments and their refinancing, and in general they have insufficient equity. Subsequently, the government bonds of the so called peripheral countries lost their risk-free or low-risk status during the Greek crisis. In the middle of November last year, even France, after all one of the largest core countries of the eurozone, was temporarily unable to retain this status. In terms of market perceptions, so far only German government bonds have managed not to ever lose their risk-free status. Government indebtedness of 80% and comprehensive joint liability for the sovereign debt of the other eurozone countries beg the question as to how much longer German government bonds can continue to be regarded as a risk-free investment.
The position of being the only “risk-free” asset leads to an artificial distortion of prices, because even though Germany’s total indebtedness exceeds EUR 1,100 billion, this is still a relatively small amount in terms of the total market. The USA has a total indebtedness of over USD 10,400 billion and Japan has a total indebtedness of almost JPY 920,000 billion, which at current exchange rates equates to approximately EUR 8,000 billion (USA) and EUR 8,400 billion (Japan) (all numbers and exchange rates according to Bloomberg as of march 15th 2012). The relatively low supply of risk-free investments, coupled with high demand, makes German government bonds very expensive.
The highlight to date occurred when Germany was able to issue a one-year bond with a negative yield. In other words, investors paid more money than they will receive back in a year’s time.
With interest rates at near zero, various phenomena occur which can lead to strange situations. Example: if a country for example makes interest payments of 3% of its GNP, with an interest rate of 6% it can afford a debt level of 50% of GNP. With an interest rate of 3%, a debt level of 100% can be financed, at 1% 300%, and at 0.5% even 600% (see chart).
Caption: debt ratio / interest rates
In an extreme case, the country could end up like Japan, which has a budget deficit in excess of 10% of GDP and a total debt ratio of over 200%, which is considerably worse than Greece. In effect it has reached the end of the road financially, but it remains solvent because interest rates are below 1%.
It is not difficult to create a debt mountain when interest rates are falling, but it is hard to deleverage disproportionately when interest rates are rising.
In order to remove the tensions from the financial markets, strengthen the banks’ balance sheets, pre-empt possible liquidity squeezes and significantly increase the total volume of risk-free investments, the ECB recently intervened massively in the financial markets with its two tranches of the “longer term refinancing operation” (LTRO).
In two months, it has injected a total of EUR 1,018 billion into the financial system, which almost equates to Germany’s total indebtedness. The simultaneous introduction, through the fiscal pact, of a debt brake in the eurozone is intended to ensure that the previously described interest rate trap is avoided.
The big problem with this approach is that massive reductions in budgets and increases in taxation will have to be enforced, which will curb growth and lead to a recession, so that the debt ratio may even grow if the deleveraging progresses more slowly than the recession.
A rising debt ratio will though trigger a vicious circle: a rising debt ratio leads to an increased risk premium, which results in higher interest rates, which cause a higher budget deficit, which once again increases the debt ratio.
In order to prevent higher interest rates, the ECB would once again have to intervene with a renewed LTRO (or similar transaction), and the whole financial system would become dependant on monetary policy measures at the lowest interest rates. Interest rates would no longer reflect macroeconomic expectations such as inflation or growth, and a sustainable valuation of government bonds, whether risk carrying or not, would no longer be possible.
Greece’s debt haircut opened Pandora’s box and we now live in a world with many new risks that are difficult to measure.
If all interested parties – the European Union, governments, the ECB, commercial banks and investors – act carefully by reducing debt and stabilising the financial system, the foundation of our financial system can once again be returned to health. As in the myth about Pandora, where the box also contains hope, there is definitely hope that this will happen. I myself am not convinced.
(article by Dieter Hein, Director of BLI and Head of Fixed Income Investments.)
The behaviour of the stock markets at the start of 2012 looks strangely like a re-run of the situation this time last year. Since the end of November, the S&P 500 index has gained 16.4%; between end of November 2010 and mid-February 2011, the index rose 13%. As was the case this time last year, share prices have soared notably on the perception of an improvement in the US economy, a perception that is further corroborated by January’s labour market figures which showed 243,000 new jobs and a fall in the unemployment rate to 8.3%.
Many investors still do not seem to understand the difficulties that the industrialised countries will experience in finding a way out of the colossal debt trap. And yet, economic history shows that:
• when debt levels are too high, the growth rate falls,
• the overindebtedness problem cannot be solved by adding more debt to the pile.
I am particularly concerned by the fact that not only are the authorities persisting with the erroneous policies that are the root of the current problems, but that they are applying them with even greater vigour. This is resulting in the central banks’ experimenting with increasingly adventurous policies without having any idea of their long-term impact. The markets are welcoming these policies for now, but this is no reason to sanction them.
The share price rally since November 2011 does not seem to be due to conviction-based buying or changes in asset allocation by institutional investors increasing their equity allocations at the expense of bonds. Rather, the rally is being driven by investors covering their short positions and by portfolio managers buying for fear of underperforming their benchmark. The fact that equities that have risen the most in 2012 are also those that fell the most in 2011 reflects the speculative nature of the current rally.
Last May, in my “Equity markets at a crossroads” post, I wrote that the key decision for investors is to decide whether the conditions for a new structural bull market are in place or not . If they were, it would not be too late to buy and then remain invested without worrying too much about interim corrections. I do not believe however that the conditions are in place at this time. On the contrary, I believe that the two factors that drive share prices could actually go against stocks.
First, while company profits have regularly exceeded estimations in the past few years, the latest figures seem to suggest that we have reached a turning point. Added to this is the fact that profit margins for a lot of companies remain at historical highs. History suggests that these margins will decline.
Second, while it is true that valuations have become much more reasonable, I do not see any reason why they should rise again on a long-term basis - I actually think that the opposite might happen in an environment of high public debt levels, a crisis in the eurozone and rising geopolitical tensions. (Though I do not rule out that in the current context of increasingly risky government bonds, the multiples of certain quality companies may rise.)
It would be even more risky to give in to the temptation to run behind the current rally given the increasing signs of a slowdown in the world economy. Since the start of the year, the International Energy Agency has twice downgraded its forecast for oil demand in 2012. Notwithstanding the prevailing economic optimism in the United States, the American economy remains very fragile. The main driver of US growth since mid-2009 was exports, driven in turn by the weakness of the dollar and the relatively robust growth outside the US. Both these factors are now starting to change.
2012 promises a rough ride for investors. Much of the industrialised world is engaged in a deleveraging process which will take several years and have negative consequences on economic growth. As a result, the global economy is extremely fragile and it won’t take much to trigger a major crisis. After 2008, the authorities tried to stabilise the situation using unprecedented fiscal and monetary stimulus measures, but in so doing, they merely delayed the outcome while aggravating the problem of excessive debt. Furthermore, the resulting massive deterioration in the public finances means that the risk of a systemic crisis is now much greater than it was 3 years ago.
The situation in the eurozone is particularly worrying. Within the eurozone, there is too much debt, too little growth, and the current-account imbalances are too excessive. This crisis is a particularly dangerous mix between a banking crisis and a public debt crisis with an undercapitalised banking system holding a large part of its assets in government bonds of overly indebted countries. This latter point also means that the European banks’ recapitalisation requirements cannot be known until the eurozone government bond market stabilises. And until these requirements are known, there will be no return to confidence in the European banks. With massive refinancing requirements, the banks will try to trim their balance sheets by shedding assets and reducing lending. This will be an additional brake on economic growth, already hampered in many countries by fiscal austerity. In short, the global economic situation is in danger of almost grinding to a halt just when the authorities have essentially exhausted their monetary and fiscal resources.
In the face of this distinctly worrying prospect, investors are entitled to want better remuneration for buying financial assets. But the opposite is happening. In recent years, the monetary authorities have done their utmost to avoid the necessary structural adjustments while at the same time maintaining artificially low interest rates. They have thus promoted a tide of speculation to the detriment of saving and productive investment. With a near-zero return on money market investments, with quality (or at least perceived as such for now) government bonds in some cases offering negative yields on short-term placements and below 2% on long-term maturities, and investment grade corporates scarcely better, the possibilities open to investors seeking regular income and trying to avoid huge fluctuations in the value of their portfolio are not very appealing.
So what’s the position for the stock markets? Although most equity markets fell in 2011, it would be unwise to think that the risks outlined above have already been factored into share prices. Especially as the US market, which generally sets the tone for the other markets, did not see a correction in 2011; based on normalised profits, it is still richly valued. The cycle of rising margins is coming to an end, and with it, that of regular better-than-expected profits. With the appreciation of the dollar, the S&P 500 also looks to be losing a vital support mechanism given that foreign sales account for nearly half of total sales of companies in this index.
By comparison, the European markets appear rather more attractive. However, this idea needs to be put into perspective. The view of Europe as cheap is based on the composition of the European indices, which are heavily weighted in favour of cyclical and financial stocks. But in the current eurozone crisis context, it is impossible to value the banks. And at the same time, shareholders in some of the banks could be sharply diluted in the event of a major recapitalisation, or complete losers in the event of nationalisation. For their part, cyclical stocks are obviously heavily exposed to any deterioration in the global situation. The cyclical nature of their results also means that they will always trade at a discount against more defensive stocks, yet these more defensive stocks are no cheaper in Europe than in the United States.
The period of convergence between European market valuations also seems to be over. Since the introduction of the single currency, the price/earnings gap between the most expensive and the cheapest markets in the eurozone has halved. With the structural weaknesses of the single currency becoming evident in the current crisis, there will continue to be high interest rate differentials between eurozone countries and this will have consequences on the economic performance of the member countries and the valuation of their stock markets. This does not augur well for the markets of Southern Europe.
As far as stock market valuations are concerned, it is worth noting that although it is obviously useful to compare current valuations to historic averages, it is also important to have an idea of the framework in which we will be evolving. Financial history shows that while US equities have traded on average at 15x profits over the last 100 years, this figure is only an average between long periods when their valuation was considerably below this figure and long periods when the valuation was a lot higher.
At the end of the last bull market in 2000, valuations were historically high. Since then, they have been on a downward trend. This trend is likely to continue given that:
- unlike the last 30 years in which increasing debt stimulated economic activity, the deleveraging process will dampen it. With less potential for profit growth, investors will pay less for these profits;
- in the coming years, we are likely to see shorter economic cycles and more frequent recessions. Corporate profits will be more volatile. Financial history shows that there is a negative correlation between earnings volatility and the valuation multiples accorded to these earnings;
- the increase in multiples during the 1980s and 1990s was mainly due to the fall in interest rates as inflation receded. Interest rates are currently at very low levels. Rather than reflecting a particularly brilliant economic environment, this is due to a host of structural problems. If interest rates fall further, it will be because Europe and the United States have entered a Japanese-style scenario, but with considerably less social cohesion. The experience of the Japanese market in the last 20 years shows that there has been a positive correlation between interest rates and equity valuations, the latter declining along with the former;
- in recent years, companies have been the prime beneficiaries of the fruits of economic growth. As a result, corporate profits are capturing a historically high share of national income. This trend cannot continue;
- the end of the Cold War sustained valuation multiples in the 1990s. Today we are seeing a new wave of geopolitical risk.
By contrast, the Japanese market is genuinely undervalued. Companies in the Topix index are trading on average below their book value and it is possible to find a good many companies whose stock market capitalisation is less than the net cash they hold. As is generally the case with an undervalued stock market, no-one is currently showing any interest in the Japanese market. While it is true that in the context of a slowdown in the global economy, investing in a market generally considered as cyclical is not the first thing that springs to mind, in Japan’s case, the potential for decent long-term returns (due to its low valuation) would at least compensate the investor for the risks incurred.
Price-to-book ratio on the Japanese market
The last year has confirmed that the emerging markets are not only correlated to other markets, but that their volatility is even comparable to that of the more cyclical sectors in Europe and the United States. This is hardly surprising given that exporters and commodities feature prominently in most of the emerging indices. A slowdown in the global economic situation and appreciation of the dollar will not be beneficial to these sectors. On the positive side, the easing of inflationary pressures should enable the authorities to relax their monetary policy.
In the current context, it is important for investors:
- not to allow themselves to be influenced by short-term fluctuations on the financial markets. These fluctuations are the result of the interaction between the authorities’ interventions and the poor fundamentals;
- to worry about what they hold in their portfolio, not about what they don’t hold. Concessions should not be made on the quality of the assets held, even if these assets temporarily underperform;
- to wait, if possible, for better buying opportunities to arise;
- to avoid creating a rational argument for the positions they hold that they don’t want to sell.
Based on all this, our investment recommendations for 2012 are:
in the current environment, stable quality income is becoming rare and something that is rare should be in the portfolio. Demographic trends also support strategies for producing regular income. Companies paying decent regular dividends should benefit. Given the risks hanging over growth, companies whose activities are very sensitive to the global economy should be avoided;
the past has shown that when aversion to risk increases, the US dollar benefits. Despite the many problems in the United States. the dollar continues to be the reserve currency which investors flee to when they are fearful. Especially in an environment in which the future for the dollar’s principal alternative, the euro, is uncertain to say the least.
In a context in which confidence in paper money is wearing thin, gold remains the ultimate safe haven for many investors. Its bull run seems set to continue, notwithstanding temporary corrections such as that at the end of 2011. Also, note that the central banks of emerging countries are continuing to buy gold. If the price of gold holds up or continues to increase, shares in gold-mining companies are undervalued, especially if these companies continue to demonstrate better financial discipline than in the past.
The government bonds of countries that continue to retain market confidence will also profit from structural economic weakness, despite the current very low level of long-term interest rates. The 30-year US rate could return to its end-2008 level in 2012. If this happens, the potential yield on a 30-year bond would be well over 10%. However, it is important to emphasise that the volatility of such an investment could be too great for a traditional bond investor;
It is sometimes helpful to bear in mind that the major trend marking the 21st century economy is that the East will steadily overtake the West as the driver of the global economy. In general, emerging countries have better economic fundamentals and more favourable growth prospects. Their stock markets should therefore occupy an increasing portion of a diversified portfolio. Since the stock markets of these countries are generally ‘high beta’, meaning that in the short term they tend to amplify the movements of industrialised markets – up or down – attractive purchasing opportunities could arise during the year.
US, European and emerging markets over the last 10 years (in euros)
Note that fears of a pronounced economic slowdown could also temporarily weigh on the currencies of some countries even though their fundamentals are better. Apart from emerging currencies, the Australian and Canadian dollars and Norwegian krone are often considered cyclical. Corrections in these currencies would constitute buying opportunities for the longer term;
the financial situation of these companies is generally excellent and in an environment in which government public finances are deteriorating, their shares could replace many countries’ sovereign bonds as preferred assets in the portfolios of institutional investors. Note that these companies often pay attractive dividends and realise a growing proportion of their earnings in emerging countries;
high debt is an enormous problem in an environment marked by low growth and deflationary trends. Furthermore, in the current year, governments and banks have massive refinancing requirements. Non-financial companies are in danger of losing out in such an environment;
Finally, long/short strategies aiming to buy quality assets while hedging part of the market risk make a lot of sense in the current environment.
The net equity allocation of BL-Global Flexible as at 12 January is 47%. 95% of the fund's assets are invested in equities, with 50% of the equity exposure hedged through the sale of futures on equity indices.
In geographical terms, the fund is invested 41% in Europe (20,5% after hedging), 30,5% in North America (3%), 18% in the Pacific Basin and 5,5% in other countries.
Equity asset allocation
As a broad general rule, equity investments currently tend to be in defensive, non-cyclical sectors with a particular emphasis on dividends. At the end of December, the equity portfolio's average price/earnings ratio was 14,6, and the average dividend yield was around 3,5 % (gross).
Currency allocation :
The currency allocation differs from the asset allocation. We use forward sales to lower the exchange rate risk on certain currencies or to increase exposure to other currencies. The following graphs show the currency allocation before and after forward sales.
Currency allocation before forward sales
Currency allocation after forward sales
The net asset value of BL-Global Flexible has fallen by 1,17 % in 2011. Since the start of the year, it has risen by 2,3 %.
'Snowballs get bigger as they run downhill.'
What with the EU summit of 26 October, the announcement and then the abandonment of the Greek referendum, and last Friday’s G20 summit, the last two weeks have certainly been turbulent for the eurozone. At the end of the fortnight, it's increasingly evident that the authorities are unable to find a solution to the crisis.
The 26 October summit, frequently referred to as the 'last chance' (and the 14th in 21 months), resulted in 3 decisions:
- ‘optimisation’ of the European Financial Stability Facility (EFSF) through leverage;
- a voluntary 50% ‘haircut’ on Greek debt;
- a bank recapitalisation of 106 billion euros between now and the end of June 2012 to arrive at a capital ratio of 9% for the banks.
These decisions triggered a mighty rebound on the stock markets on 27 October. But the response of the bond markets was distinctly more lucid: after briefly easing, the 10-year Italian bond yield rapidly started to climb again and has since definitively passed the 6% mark. The spread between French and German bonds has continued to widen and now stands at a 20-year record.
The bond markets soon saw that what was sold as a plan for a solution in fact boiled down to a few grand declarations followed by a stark lack of detail. A number of questions surround each of the three decisions taken:
1. the voluntary haircut on Greek debt:
- which creditors will have to accept the 50% write-off? Greek debt currently amounts to around EUR 350 billion. 150 billion are held by the ‘Troika’ (the European Central Bank, the International Monetary Fund and the European Commission) and won’t be affected by the discount. Thus the European Commission no longer represents 50%, only 30%. Of the remaining 200 billion, around 85 billion are held by banks and Greek pension funds and it is highly likely that the latter will do their utmost to avoid the write-off. If so, the actual discount would be 16%;
- the nuts and bolts of the write-off that the banks are required to ‘voluntarily’ support have yet to be negotiated. And there is no certainty that all the banks concerned will actually participate in the plan;
- what’s to stop other countries demanding a trim of their debt too?
Finally, the decision to make this discount a ‘voluntary’ event to avoid it being a ‘credit event’, which would trigger the payment of CDS (Credit Default Swaps), is likely to prove counterproductive. Why would an investor go on buying default insurance if it is obvious that it has no sound legal basis? And if the insurance isn’t valid, why buy the debt of peripheral countries?
2. recapitalisation of the banks:
- why does the European Bank Authority set the capital requirements at only 106.4 billion (we must at least applaud them for the detailed figure) whereas the International Monetary Fund’s estimate is double that amount?
- on what assumptions has the EBA based this figure? And what about a potential partial default on the debt of other countries in the eurozone?
- what if the banks decided to increase their equity ratio by decreasing their assets rather than by recapitalising (selling government bonds for example)?
- what will be the impact on the banks’ willingness to lend (and therefore on economic growth... and therefore on the quality of private and public debt... and therefore on the banks’ equity... etc. etc.)?
- what benefit would there be to private investors in recapitalising banks which have been more or less prohibited from paying dividends? If there is a lack of interest from private investors, the necessary capital will have to come from governments, generating a new round of public debt increases with consequences on their rating and their capacity to service their debt.
It is important to note that a credible recapitalisation of the banks is an indispensible condition for a return to confidence in them. And a return to confidence is all the more necessary given that the European banks will have to refinance some 600 billion euros of debt maturing in the next 12 months.
3. optimisation of the EFSF resources:
- first, it is ironic to note that the solution to a crisis provoked among other things by excess leverage is supposed to come from introducing significant leverage into the EFSF. A problem caused by too much debt won’t be resolved by adding even more debt;
- one of the possibilities envisaged seems to be for the EFSF to guarantee the first 20% of the loss in the event of payment default by a member of the eurozone, with this guarantee only being valid for newly issued debt. In practice, it’s not very clear how this is supposed to operate. In the first place, it is odd to offer this type of guarantee to an investor for government bonds issued by developed countries, given that this kind of debt is supposed to be of the ‘highest quality’ and therefore risk-free. In explicitly recognising that this is no longer the case, the European authorities are turning bonds into risk assets, thereby increasing the cost of financing of the countries concerned on a long-term basis. Increasing the EFSF’s resources through leverage won’t reduce the risk of default; it will just cause a change at the level of the losers – private lenders or tax payers. Secondly, history shows that when a country defaults, the loss incurred by its creditors is rarely limited to 20%. And thirdly, if the guarantee only covers newly issued bonds, this solution will create a two-tier market with new bonds and old bonds at separate levels;
- the idea of linking the EFSF to a special fund in which private investors and non-member countries of the eurozone could participate is also peculiar. Why would these lenders want to put money into such a fund if (for example) Germany is not prepared to contribute more money to the EFSF? Not to mention the fact that the idea of asking for help for the eurozone from countries like China and India, which despite the size of their currency reserves are still relatively poor, is frankly embarrassing.
- Ultimately, the EFSF represents an empty box filled with promises of a money given by countries that may well have to borrow that same money. Regarding the potential size of this empty container, the Financial Times summarised the situation very neatly in its edition on 28 October, noting that the fund’s size is ‘an estimate based on the still-untested ability to multiply a still-unknown asset base by four to five times’.
Having started off by indicating that the idea of a partial default of Greece was absurd, then that Greece’s problems were not going to knock-on to other eurozone countries, then that the European banks were adequately capitalised, the European authorities finally proposed a plan which does nothing to reinforce investor confidence in the debt of peripheral countries or in European banks. Two crucial objectives have not been reached. Contagion to other countries in the periphery, and even from South to North, has not been stopped and confidence in the banks has not been restored. As for Greece, the plan will condemn it to years of austerity and high unemployment with the sole promise of eventually reducing its public debt to 120% of its GDP, which is double the 60% figure used for Maastricht.
It is obviously easy to criticise. But the fact is that the eurozone problems are so numerous and complex (high public debt, interdependence between state and banks, under-capitalisation of the banks, lack of competitiveness in the South, etc.) that it’s hard to find a solution. These problems are mainly due to the fact that, economically, monetary union between countries as different as Germany and Greece never made any sense and that the type of economic environment that enabled this union to function for a few years in spite of everything, is no longer there and isn’t about to return anytime soon. The absence of fiscal union has done nothing to improve the situation. Such a fiscal union does not seem to be about to happen. On the one hand, the public finances in Germany are not particularly brilliant, especially when future expenditure based on an ageing population is taken into account. On the other hand, the euro is almost a relic of the cold war. Today, the economic and geopolitical links between the eurozone countries are weakening. There was greater integration between the eurozone countries in the three decades before the advent of the single currency. It is hard to imagine Germany sharing its sovereignty on taxation (which fiscal union would require) with countries whose interests are not necessarily the same. And even if it did, the conditions that it would impose in return would be likely to make these countries run away.
If, for now, Germany seems to be prepared to work for the survival of the eurozone in its current form, it’s because the weakness of other countries allows it to impose its views. Greater participation by banks in Greece’s default, the refusal to transform the EFSF into a bank, increased budgetary surveillance of countries in difficulty and the refusal to accept a more significant role for the European Central Bank in financing governments are all points on which Germany’s wishes have prevailed over other countries, especially France. It should also be noted that since the beginning of 2010, the German 10-year bond yield has declined from 3.4% to 1.8%. The crisis has therefore enabled Germany (and Northern Europe in general) to significantly reduce its cost of financing while this cost has soared in Southern Europe. This will only exacerbate the competitive differential between North and South.
Numerous observers have criticised Germany’s position on a greater role for the ECB in financing the periphery countries. It is true that in enabling the central bank to print money to lend to the periphery countries or to the EFSF, it would be possible to temporarily resolve the current crisis and delay its endgame. Countries in difficulty would then hardly have good reason to sort out their public finances though. History also shows that the easy solution of printing money has very undesirable consequences in the medium and longer term with inefficient capital allocation and rampant inflation. The fact that Germany is opposed to such a solution should therefore be applauded. But in a context where the rules of the free market economy are being increasingly suspended by the authorities, there is no certainty that the German government won't give way in its turn. (It is also ironic that some people consider that the market economy is responsible for the current crisis when, in fact, it is the failure to abide by the rules of such an economy that is the cause: artificially low interest rates for several years, protection of the banks against the consequences of their actions, capital directed to activities that do not create real added value, refusal to allow the disappearance of non-profitable companies, monetary union defying economic laws etc.).
Although the German position therefore seems to reinforce Article 123 of the Treaty of Lisbon, barring the European Central Bank from buying up the debt of Member States, it also substantially reduces the possibility of the eurozone’s survival in its current form. The solution recommended by Germany of budgetary discipline and general austerity will not be able to function either. It would plunge the peripheral countries into a vicious circle, with dangerous social and political consequences.
In my article on 6 July, I wrote that the eurozone crisis also poses the question of Europe’s governance. Until now, the creed of the European authorities had been to say that, whatever the cost, the single currency must be defended in its current form. This position seems to have moved on during the past week with the announcements by Angela Merkel and Nicolas Sarkozy that Greece was free to leave the euro. In this respect, the idea of a referendum mooted by the Greek Prime Minister was far from absurd. Asking the Greek people if they would prefer to submit to years of austerity or suffer the consequences of leaving the euro should form part of the democratic process after all. However, since decisions concerning the European process have only rarely been taken democratically, the general uproar that greeted the announcement of the referendum was hardly surprising.
To sum up, Europe has numerous problems, starting with the debt overhang. To reduce excessive debt (in relation to GDP), the most agreeable solution is economic growth. However, this solution does not look realistic at the present time, given that the money spent in recent years wasn’t spent to increase the medium and long-term growth potential of the eurozone. On the contrary, the lack of growth (reinforced by budgetary austerity) risks further aggravating the problem. Three possibilities remain:
- transfer the debt from highly indebted countries to less indebted countries through some kind of fiscal union;
- inflation to reduce the real cost of the debt;
- write down the debt.
Because of its history, Germany has a very strong anti-inflationary bias, unlike the Southern countries. Since it is in a position of strength to impose its view of things, the first two solutions are therefore off the table. Regarding the third solution, the German position is that a default on government debt should first impact private creditors, then the countries affected, and only then the eurozone as a whole. For a country to obtain partial default on its debt, it will have to submit to control by its European partners or the International Monetary Fund, with these somehow taking over the day-to-day management of the country. This is likely to enrage the population of the country in question which would take a very grim view of being supervised. But on the other hand, not imposing strict controls would mean rewarding the country for its poor management and would not encourage it to engage in structural reform. It’s a vicious circle.
Seeking people to blame for the current situation is a pointless exercise! Germany may reproach the Southern countries for their lack of discipline, while in their turn they will retort that it’s this very lack of discipline that is at the origin of the German surpluses by creating demand for German products. Rather than wanting to obtain even more powers to try and settle the crisis and thus strengthen anti-European sentiment among their people, the European leaders need to recognise their responsibility in the current problems and reflect on how to reduce monetary union to something that is viable for the long term. This will mean recognising that in its current form it isn’t!
We have invested 2% of the assets of BL-Global Flexible in gold mining companies, with an objective of gradually raising this to 5%.
I’ve written on many occasions that buying gold is speculation not investment. This statement is due to the fact that gold has no intrinsic value and cannot be valued whereas the intrinsic value of a share can be assessed based on the underlying company’s assets, shareholders’ equity, current and future profits, current and future dividends etc.
So why invest in gold mines? After all, if it’s impossible to value the product they sell, it follows that it must also be impossible to value the companies.
First, speculation can be a good idea, provided you are aware that you are speculating. Two conditions are necessary for the price of gold to rise:
The first condition seems undoubtedly to be met while at the present time there is no sign that the second is not.
So, if we start from the hypothesis that the price of gold is likely to at least remain at its current level (~1,800 $/ounce), an investment in gold mines could be considered a form of rational speculation. While gold mining share prices generally exaggerate movements in the price of gold (up or down), this time they have lagged behind. This can be seen in the following graph, where the gold miners index is divided by the price of gold. A drop in the ratio means that the miners have underperformed the metal, and a rise that they have outperformed.
There are a number of potential reasons for the miners’ underperformance against the actual metal:
The valuation of gold mining companies has consequently decreased considerably in recent years. According to various experts, the share prices of these companies currently discount a price of gold of around 1,300 $/ounce. Based on the current price, this would give our rational speculator a security margin of some 25%.
In addition, the stock market performance of gold companies since mid-August has been encouraging. Since then, they have decorrelated from the stock market, finally following the price of gold more closely.
In terms of individual stocks, there is generally a distinction between established producers (Tier 1), intermediate producers (Tier 2) and junior producers (Tier 3). In terms of investment, the latter are obviously by far the most risky. The Market Vectors Junior Gold Miners tracker fund represents a way of holding a diversified investment in this segment.
For their part, established or intermediate producers can be differentiated on the basis of their production costs, current and future reserves, and valuation. We have purchased Goldcorp, Gold Fields, African Barrick Gold and Newmont Mining. The latter has a unique dividend policy, directly related to the price of gold. Note that there is also a tracker fund for the 30 biggest gold mining companies: Market Vectors Gold Miners.
The last few weeks have been miserable for equity investors – the Euro Stoxx 50 index, for example, has slumped by 30% since 1st July. Whereas at the start of 2011, equity indices seemed set to return to their pre-2008/2009 crisis level, now some are even in danger of dropping below the levels seen at the very depths of the crisis.
Added to the recent slide in share prices is the fact that the longer term performance of the markets is hardly more joyful. At the turn of the century, the German DAX was hovering around the 7,000 mark. Some 12 years later, the index stands at 5,100. In France, the CAC 40 is a full 50% below its end-of-1999 level. In the United States, the S&P500, which has held up considerably better than the European indices this summer, is still trailing by 20%. Even people who were prepared to accept that an investment in equities needed a horizon of several years are starting to find that time is indeed long and reflecting on John Maynard Keynes’ quote that in the long run we are all dead. So should we still be investing in equities?
Before answering that question, it is worth reminding ourselves what a share represents. There are two ways for a company to finance itself – by borrowing or by issuing shares. The issue of shares represents equity, while borrowing (debt securities) represents external capital. Shares are fundamentally different from debt securities in that they represent a stake in the company. Shareholders are co-owners of the company and the return on their investment depends on the company’s future results. Holders of a debt security (generally a bond) issued by that same company are merely simple creditors and only concerned by the future progress of the company insofar as it affects the company’s capacity to pay the annual interest and repay the principal at maturity.
Accordingly, anyone contemplating buying shares in a company should be asking the same questions as someone considering acquiring the entire company. Such questions will inevitably revolve around two issues: quality and valuation.
For listed companies, there is also a psychological component to be factored in. Share prices go up and down, often bearing no relation to what is actually happening at the company. (I am always astonished to note that some 10 million Coca-Cola shares are traded every day when, in the majority of cases, there is no major news involving the company. Why did investors who didn’t want to buy/sell Coca-Cola on Tuesday suddenly want to do so on Wednesday? I still haven’t found an answer to that one...) Investors purchasing a stake in a private company don’t have this problem. They need only concern themselves with the operational side of the company and are not faced with a market telling them – in the form of a rise or fall in the share price – whether they were right or wrong.
Daily fluctuations in share prices may frighten investors but they can also offer opportunities. Benjamin Graham illustrated this using a character he called ‘Mr Market’, who Warren Buffett often mentions to his shareholders. The story goes like this: imagine that you and Mr Market are partners in a private company. Mr Market comes to see you every day and gives you a price at which he is prepared to buy your share in the company, or sell you his. The company’s results are relatively stable but the price that Mr Market offers you swings to extremes. The reason for this is that Mr Market is emotionally unstable. Some days he is wildly optimistic and can only see the positives. On those days, he tends to offer you a very high price. On other days, he is depressed and pessimistic and can only see a future clouded with problems. So the price he offers you then is very low. Mr Market also has another interesting personality trait: he perseveres and doesn’t mind if you reject his offer – he’s always back the next day. Whether a transaction takes place is your call. It is therefore extremely important not to let yourself be influenced by Mr Market's mood and not to fall under his spell. You are only interested in his wallet, not his views.
The story of Mr Market may seem rather quaint in the modern world where investment is often presented as something complicated and mysterious, with stupid theories about efficient markets, and where computer programs often take precedence over good judgement in decision-making. But the truth is that nothing has changed: buying quality assets at a reasonable price remains the best recipe for a successful investment over the long term.
However, there is another very important lesson in the Mr Market allegory. You can only take advantage of his mood swings if you are better at valuing your company than he is. I am often surprised by the number of people who buy shares in a company without the least idea of what the company is worth. But you can’t take advantage of a particularly low or high share price unless you have a benchmark to establish that the price IS very low or very high. At BLI - Banque de Luxembourg Investments, we call this benchmark the company’s intrinsic value. Without such a benchmark, you are totally exposed to market uncertainties, with the risk of you yourself becoming Mr Market.
It might seem obvious that people would want to buy quality companies at reasonable prices. But it’s not quite so simple in practice. The dot.com bubble at the end of the 1990s is one of the best illustrations of this. Newly created companies not making any profits (even in some cases not generating any revenues) suddenly had enormous stock market capitalisations while other companies were completely side-lined despite posting solid results. For a manager, this poses a very real problem: yielding to a trend under market (and often client) pressure or persevering with a strategy that makes good sense, with the risk of losing a lot of clients who reproach you for ‘being out of touch with the market’? At BLI, we have also adopted another Warren Buffett saying: ‘You don’t need to be more intelligent than other people, you just need to be more disciplined.’ In the end, you get the clients you deserve.
So to get back to the original question, ‘should we still be buying equities?’, the first consideration is that the question is too vague. After all, nobody would think of asking whether we should still own companies. Yet, as indicated above, buying a share in a company means becoming a co-owner of that company. (But note that this is only true in countries where the rights of shareholders and, particularly, minority shareholders, are protected.) Despite the risk of recession or the European crisis, you see very few entrepreneurs ditching their companies, and certainly considerably fewer than investors offloading their shares (remembering of course that for every seller there is a buyer). Moreover, unless you are obsessed with stock market indices, buying ‘equities’ or ‘the market’ doesn’t mean anything. It would be better to rephrase the question as follows: ‘At current share prices, is it possible to find quality companies with a sufficiently low valuation as to offer a reasonable prospect of an attractive return over the medium to long term?’ The ‘medium to long term’ part of the question is significant. ‘Buying quality companies at reasonable share prices’ is not a formula to gain lots of money quickly. Numerous studies have shown that over the short term (less than a year), there is no correlation between valuation and return. A quality company purchased at a low price could become even less expensive in the short term, which generally means a fall in its share price.
The answer to the rephrased question is yes.
"Tough decision-making is never easy, and wishful thinking and trying to postpone the day of reckoning is always tempting."
(Jeremy Grantham: Children at play, August 2011)
- the era of recourse to credit and debt to finance increasingly artificial growth seems to have ended. A large part of the global economy is currently facing a situation of excessive debt. The necessary deleveraging will hamper economic growth, making it even more difficult to service the debt. A vicious circle is thus in danger of setting in;
- from an economic viewpoint, the stimulus measures taken by the authorities in recent years were poorly designed. They are doing nothing to enhance the growth potential of their economies and have only added high public to high private debt;
- the problem with high public debt is that the interest paid on the debt absorbs an ever-larger part of the resources that could otherwise be used to create jobs and increase the standard of living;
- the current situation is more critical than that of three years ago given that interest rates are lower and that the degree of government debt is higher than in 2008. The authorities have very few resources to deal with the crisis;
- the current crisis is aggravated by a severe lack of leadership on both sides of the Atlantic;
- in Europe, the economic and financial problems have been amplified by the fact that the eurozone is not fulfilling the necessary criteria for a single currency: there is very limited coordination between the economic policies of the member states, labor mobility is weak, and fiscal transfers not existent;
- since the introduction of the euro, the economic fundamentals of the eurozone have never been so divergent;
- quite simply, there is no realistic scenario in which certain European countries could avoid restructuring their debt. The measures taken to remedy the problems in the peripheral countries are doing nothing to kick-start growth in these countries. To the contrary in fact, since the fiscal austerity that has been imposed will reduce economic activity even more, leading to further deterioration in the public finances – as we saw last Friday with the Greek government’s announcement that the objectives of reducing the public deficit to 7.4% in 2011 could not be sustained due to a bigger-than-expected contraction in Gross Domestic Product;
- in the event of restructuring the government debt of some countries, the majority of listed European banks would be in danger of facing a problem of solvency. This puts the stock price falls of the financials into some sort of perspective;
- in a recent paper entitled ‘Budget Cuts and Social Unrest in Europe, 1919 - 2009', the CEPR noted that there is a positive correlation between budgetary austerity and social instability. Demographic trends will result in social programmes becoming an unsustainable burden on young people;
- it will be difficult to solve the problem of competitiveness of certain countries in the eurozone without adjusting their currency. And without such an adjustment, these countries will only be able to become competitive again by reducing salaries and opening up their labour market at a time when unemployment rates (especially among young people) are already very high;
- the idea that the euro has more disadvantages than advantages is currently gaining ground in some countries. At the same time, the current political class continues to stick to the notion that more European integration is always better. This is creating a rift between the leaders and the people.
Based on normalised profits, equity valuations are not particularly attractive.
In the longer term, an environment characterised (among other things) by:
does not point towards higher multiples. Quite the opposite.
- weak growth in industrialised countries and a risk of more frequent recessions,
- increasing intervention in the economy by governments to ‘solve problems’,
- growing tensions between countries with a risk of protectionism,
- growing social tensions,
- a potential risk of high inflation in some countries,
- a risk of payment default in other countries
- a risk of a eurozone breakup,
In a high-debt/low-growth environment, the risk of deflation is greater than the risk of inflation. This is beneficial to high-quality government bonds. The problem lies in the fact that high-quality bonds are becoming scarcer in industrialised countries and that those currently seen as such (e.g. Germany and the United States) are offering very low yields.
The often-better fundamentals of emerging markets are an argument in favour of their sovereign debt but the interest rate differential between emerging and industrialised countries has already narrowed considerably.
10-year German bond yield and bond allocation of BL-Global Flexible
In an environment of weak growth and a risk of deflation, no government wants a strong currency. Some countries can more easily encourage a depreciation of their currency than others.
Neither of the two main currencies, the euro or the dollar, currently inspires great confidence. Periods when risk aversion has increased have been favourable to the dollar in the past, but the jury is still out on whether, after two rounds of QE and the prospect of a third, the US currency can still be considered as a safe haven.
At the present time, it is impossible to predict the consequences of the European crisis on the euro: a breakup?, a stronger euro (exit of Greece, Portugal, ...)?, a weaker euro (ECB loss of credibility, Germany to exit, …)?
The authorities of countries considered for the time being as a safe haven (Switzerland, Japan) are actively acting against any appreciation of their currency.
The fundamental trends argue in favor of an appreciation of Asian currencies in the long term.
Currencies connected to commodities are attractive, especially if they are from countries with solid fundamentals.
The interest rate differential between the principal currencies in industrialised countries is disappearing as interest rates home in on zero pretty much everywhere..
Currency allocation before hedging
Currency allocation after hedging
The above strategy has helped BL-Global Flexible to hold up well during the markets' decline in July and August, despite its net equity allocation of 45%.
“If we mean to prosper long term, I am sure that we need to act to make debt less attractive to everybody: it really is a snare and a delusion.”
(Jeremy Grantham: Children at play, August 2011)
“A novice monk approaches his teacher and asks, “Is this a bull market or a bear market? ” The teacher replies, “If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?”
(John Hussman: Zen Lessons in Market Analysis, October 2009)
Equity markets have seen something of a nosedive since the end of July. In the space of just two weeks, the markets shed 15%, and in some cases even more.
This fall can be explained by factors that are cyclical as well as structural.
But perhaps the tumble on the equity markets represents a good buying opportunity?
Source: S&P, Shiller, BLS, Global Financial Data, Morgan Stanley Research
Note : Shiller PE defined as inflation adjusted price to 10Y average EPS
In recent weeks, investors have generally become aware of the fact that the economies of the majority of industrialised countries are fundamentally weak and that the rally of the last two years was largely artificial and is therefore still fragile. But it is no real surprise that these economies are weak: even 80 years ago, the economist Irving Fisher noted that the major economic problems stemmed primarily from excessive debt. Just as debt can (temporarily) stimulate growth, cutting debt hampers it since the money needed to reimburse debt is no longer available for consumption or investment. Furthermore, the actions of the fiscal and monetary authorities over the last three years have done nothing to improve the situation – on the contrary, they have aggravated it. What was initially a problem of excess debt in the private sector has become a problem of excessive debt in the public sector. The result is that the authorities no longer have the means at their disposal to stimulate economic activity. In fact, quite the opposite in most countries where budgetary austerity is the name of the game – austerity that will constitute an additional brake on growth. This makes a return to recession quite possible.
On the structural side, the problems associated with the deterioration of the public finances are still far from solved. Particularly in Europe, the situation is becoming increasingly worrying. The cut in the United States rating could end up causing more problems in the eurozone than in the United States. How can France’s AAA rating be justified when the United States has had that top status taken away? Yet if France were to lose this rating, the very mechanism on which the support for the peripheral countries is based (giving such countries access to capital at a reasonable financing cost via a vehicle like the EFSF which has an AAA rating) would be fundamentally called into question. Furthermore, the increase in the price of CDS (credit default swaps that act as an insurance policy against payment default) on Germany show that investors are even starting to wonder about countries hitherto considered as ‘beyond doubt’, as the measures taken to combat a problem of excess debt in the peripheral countries is in danger of generating a problem of excess debt in the ‘hard core’ of the eurozone.
The economic environment does not look set to improve anytime soon. But is the bad news already discounted in share prices? After all, there are many commentators claiming that equities are particularly cheap at the moment.
Where then are we in terms of valuation? To answer that, we tend to apply Shiller’s price/earnings ratio. As has been explained many times, this ratio has the advantage of using average earnings over the last 10 years as its denominator and therefore avoids being based on one exceptionally good year (producing a very attractive P/E) or one bad year (giving a very high P/E). The Shiller ratio is all the more justified in the current situation where corporate margins – at exceptionally high levels – are starting to come under pressure. On the basis of this ratio, the following conclusions can be drawn:
So generally, we could say that the US market is currently relatively expensive while the valuation of the European market seems a good deal more attractive. But this assessment should be put into perspective given the significant weight of financials in the European indices. Admittedly, financial stocks do appear to be very cheap at the moment but their shareholders run the risk of being heavily diluted by future recapitalisations.
The theme of valuations calls for two additional remarks. First, it is clear that all valuation models based on interest rates show that equities are exceptionally undervalued. However, the Japanese example shows that using this model in an environment of high debt, weak growth and a risk of deflation makes no sense. Second, while it is interesting to compare the valuation of equities to the long-term average, the fact is that equities very rarely actually trade at this average. The average is useful to see whether, compared to the past, equities are rather expensive or rather cheap but it is just as important to find out if we are in an environment suggesting an increase or a decrease in equity valuations. The current environment would suggest a rise in the equity risk premium and thus a contraction of the multiples.
The equity markets’ recent correction does therefore not constitute a buying opportunity. While it is true that the dip in prices reflects a reassessment of the economic prospects by investors, it is nevertheless the case that the conditions for a sustainable recovery in stock prices are not in place: the economic and financial environment does not appear to be on the point of improving and equities are not cheap enough.
In such an environment, our investment strategy is based on the following three principles:
in terms of currency, we prefer currencies of countries with solid fundamentals (budgetary surplus, current account surplus, and low public debt);
"Insanity is doing the same thing over and over again and expecting different results." (Albert Einstein)
Last week the Greek Parliament went ahead and adopted a new austerity bill which will see the European Union and the International Monetary Fund (IMF) pay another 12 billion euro tranche to Greece and the implementation of a new bail-out plan for the country. Alongside this, French banks' plans to voluntarily roll over Greek bonds to avoid Greece defaulting in the strict sense of the term seems to be gaining support. The scene is therefore set for the Greek tragedy to continue.
Last week’s vote and the 12 billion euro injection will win some time for the country. However, it does nothing to alter the reality that Greece will never be able to pay back its debt and that it will never be able to finance itself in the market at reasonable rates as long as that debt hangs around its neck. The austerity measures laid down in the plan adopted last week are far from credible. And even if they were, they would still further undermine economic growth, increase unemployment, reduce fiscal revenue (in the first two months of the year, Greece’s fiscal revenue was down 8%, in contrast with the IMF's plan predicting an 8% increase) and make the weight of the debt even more untenable. Similarly, the French banks’ plan is first and foremost a rescue plan – for French banks, and even for European and American banks, but does nothing to lighten the load of the debt currently weighing down on Greece. In light of this, comparisons with the Brady plan, set up in 1989 to deal with the debt problems in Latin America, make no sense. The Brady plan was designed to significantly reduce the Latin American debt problem by allowing banks to convert their loans to the region into 30-year loans guaranteed by the US Treasury but issued at a discount of 35% to the original value.
Some will praise the pragmatism with which the European authorities are managing this crisis. Little by little, such pragmatism has led them to break the rules laid down in the European treaties. The measures implemented were justified by the need to prevent the contagion to other peripheral countries and protect the European banking system. Others deplore the fact that this pragmatism goes against common economic sense by ignoring a fundamental rule, which is that a problem of overindebtedness cannot be resolved by adding even more debt. Added to this is the fact that tension is starting to appear amongst Greece's lenders with Germany in particular calling for a greater contribution from private investors. The European Central Bank is categorically opposed to this given that its balance sheet is already polluted with Greek loans.
From an economic point of view, the logical conclusion is that Greece will have to default on most of its debt and adopt structural reforms to radically change its economic model and devalue its currency if it wants to see the light at the end of the tunnel and avoid years (and decades) of economic gloom. The last point obviously directly affects the survival of the single currency in its current form. Greece's problems are not just debt-related; the country is principally suffering from a lack of competitiveness. Keeping the country enclosed in a monetary union with much more competitive countries condemns it to a rather bleak future.
Despite numerous economic objections, the euro was implemented for political reasons to stabilise the European economy and speed up integration. The economic objections focused on the fact that by divesting the countries of their control over their currencies and monetary policies, they would lose their ability to react to changes in their economic situation. This was not necessarily an issue as long as the countries concerned were strongly integrated economically, but might become a very serious problem once the monetary union began to include countries that were less strongly integrated economically. The politicians' response was that the single currency would bring about economic integration - and in turn political integration.
In an ideal world, this might have worked. Taking away the control over the currency could have provided an incentive for the southern countries to implement the necessary structural reforms to improve their productivity and growth potential. Allowing them to enjoy the same interest rates as Germany (and therefore much lower rates than those to which they were accustomed), and consequently lower costs of financing, could have resulted in an improvement in their public finances. The reality is that the opposite has happened. The fall in interest rates has led to excessive consumption and speculative bubbles and given rise to a deterioration in budgetary discipline. At the same time, rising labour costs have reduced competitiveness, which is reflected in the relentless increase in the external deficit, making these countries more and more reliant on foreign capital. If these countries had not been members of the eurozone, the appearance of such deficits would have set off the alarm much earlier and we would not have reached the stage we find ourselves in today.
The ostensible aim of the euro - to promote greater integration between the eurozone economies - has not been met. While such integration was achieved in the decades preceding the introduction of the single currency, this has not been the case in recent years. The current situation will further increase the economic differences between the eurozone countries - if only because the northern countries are benefiting from very low costs of financing in contrast to the peripheral countries.
The current crisis is therefore raising questions about how Europe is to be governed in the 21st century. Even today, the European authorities believe that the single currency must be defended at all costs and that proposals to abandon or overhaul the euro are quite simply unthinkable. Their attitude is summed up in the statement made by German Chancellor, Angela Merkel at the Davos forum: "Should the euro fail, Europe will fail." This reflects a certain arrogance - or at least ignorance of economic history that shows that there are many more examples of monetary systems or unions that have not survived than those that have. Another point is the 'at all costs' aspect, which is becoming a concern, as the financial and human cost of past errors is starting to mount. In a recent paper "The fate of the euro" by Woody Brock, founder and president of the firm, Strategic Economic Decisions, he writes that the ultimate aim of governments should be to adopt policies that maximise the well-being of the greatest number. Ignoring this objective is likely to make the euro the emblem of a Europe that has been forced upon the people but not desired by the people.
Many observers believe that the solution to the current crisis is greater political integration and, notably, fiscal union. Admittedly, the absence of fiscal transfer mechanisms between the countries is one of the major weaknesses of the single currency. And to the extent that the euro is above all a political construction, such a union could theoretically be decided and imposed on its citizens.
To some extent, the euro is a leftover from the Cold War, when there was a clear separation between the western and eastern countries of Europe. The economic and political interests of the western countries, as well as their concerns about national security, were relatively similar. Today, the economic and geopolitical links between the eurozone countries are less solid. In economic terms, Germany has stronger trading links with Poland and the Czech Republic than with Spain, Greece, Ireland and Portugal put together. In geopolitical terms, Germany is strengthening its ties with Russia while countries like Poland or Romania feel threatened by that country's resurgence. Fiscal union means a loss of political independence. It is hard to believe that Germany will share its sovereignity in terms of taxation with countries whose economic and geopolitical interests are no longer strongly aligned with its own. From a broader perspective, Europe cannot finance Greece, Ireland and Portugal to the same extent that Western Germany was able to bail out Eastern Germany without provoking revolt amongst its citizens.
One can understand the European authorities' reticence to overhaul the euro in the midst of a crisis and their efforts to take measures to stabilise the situation and gain time. However, it would be reassuring to know that they have a plan B, especially since a lot of time has been lost with incoherent measures (are they concerned about saving Greece or the banks? Do they want to help or punish Greece?) Consensus is building towards the thinking that the euro project is no longer workable in its current form and that it is better to cut losses now rather than to throw good money after bad.
- The latest indicators confirm the fragility of the economic recovery in the United States. In previous economic cycles, there was a direct link between the severity of the recession and the strength of the recovery: the more severe the recession, the stronger the recovery that followed. This relationship has been broken in the current cycle. The weakness of the current recovery is particularly apparent in everything that affects consumers. There are fewer jobs than in 2000, despite the population growing by around 30 million. Only 20% of jobs lost during the recession have been made up again in the recovery. Average salaries are falling in real terms (i.e. adjusted for inflation). Following a period of stabilisation, house prices are falling again. The weakness of the recovery is all the more surprising given the scale of the unprecedented stimulus measures put in place by the fiscal and monetary authorities. In a strongly indebted economy, these measures are having less and less impact and are actually endangering the solvency of the United States;
- The European economic environment is dominated by debates about the wisdom of restructuring Greek debt and tensions are starting to emerge, particularly between the European Central Bank and the German government. Current problems are bringing to light the fundamental flaw in the construction of the single currency. The exposure of European banks to the sovereign debt of the peripheral countries and of US money-market funds to paper issued by European banks has the makings of another systemic crisis. In this respect, it is shocking to see how little has changed since the 2008 crisis and that enormous risks still weigh on the financial system;
- The economic fundamentals of the developing countries are in much better shape than those of the main industrialised countries. These countries are currently having to deal with inflationary pressures due to rising commodities prices, particularly food. The authorities there have introduced monetary tightening, which has weighed on the region's stock markets. In the past few weeks, a number of fears about a hard landing and a credit crisis in China have also come to light, but these fears seem unfounded, at least for the time being. The emerging markets will gradually take over from the United States as the driver of the world economy;
- Based on normalised earnings, the US and European markets are overvalued. but within markets, there are some attractive pockets of opportunity.
- Government bonds have become a structurally unattractive asset class. This conclusion has been reached based on the currently very low level of long-term interest rates, which is reducing the return potential and increasing the volatility of bond investments. As well as this, the unprecedented deterioration of public finances in many countries means that government bonds are starting to lose their ‘risk-free’ character. Measuring the risk of a portfolio in terms of its equity allocation is, in light of this, less and less relevant.
- World economic developments continue to support a strategy based on shifting the portfolio towards the emerging countries or towards companies located in the industrialised countries that generate an increasing share of their results in the emerging countries.
We took advantage of the recent correction in the stock markets and some stocks to increase the net equity allocation to 57%. Starting with the gross allocation of 87%, we achieve this figure by hedging 30% of the allocation through the sale of futures on the stock markets.
Asset Allocation - BL-Global Flexible - June 2011
There are two advantages of a strategy that involves reducing the equity risk using futures over a strategy of ‘just’ holding 57 % in equities:
- It ensures that we do not have to hold 43% (i.e. the part not invested in equities) in money-market or bond investments, which hold little attraction for the time being;
- It also allows us to invest the majority of the portfolio in the stocks of quality companies whose fundamentals are in much better shape than those of many governments, and which generally pay out attractive dividends. In our opinion, the particularly uncertain macroeconomic environment is continuing to favour a long quality/short market strategy. We believe that the quality of the companies in our portfolio is much better than the quality of the overall market.
In geographical terms, a positive growth differential and much better fundamentals are reasons for investing in the emerging markets. 19% of the portfolio is invested in the stock markets of these countries, particularly South-East Asia and Brazil.
24% of the portfolio is invested in US and Canadian equities, of which 14% is covered through the sale of futures on the S&P 500. In general, North American companies are selected from four main sectors - energy, healthcare, technology and non-cyclical consumption. A large portion of these companies’ turnover is generated outside the United States (mainly the emerging markets) meaning they are therefore well positioned to take advantage of any weakness in the dollar. 18% of the portfolio is invested in equities from the eurozone, of which 12% is covered through the sale of futures on the Euro Stoxx 50. As a broad general rule, eurozone investments tend to be made in defensive sectors with particular emphasis on the dividend component. The rest of the equity portion is invested in the UK (10%, of which 4% is covered through the sale of futures on the FTSE 100), Switzerland (6%), Japan (6%), Norway (3%) and Denmark (1%).
At the end of May, the equity portfolio's average price/earnings ratio was 13.3, and the average dividend yield was around 3.6% (gross).
10% of the portfolio is invested in bonds. Of this, 6.5% is invested in long-dated German government bonds and 3.5% in Brazilian real and Indonesian rupiah-denominated bonds.
The currency allocation differs from the asset allocation in the fund. We use forward sales to lower the exchange rate risk on certain currencies or to increase exposure to other currencies. We aim to be exposed to the currencies of countries with strong fundamentals worthy of a AAA-rating and avoid countries whose fundamentals are deteriorating and/or where there is a higher risk of resorting to the printing press. This results in our partially covering the exchange rate risk on the US dollar, sterling and the yen. However, only a part of this hedge is done against the euro, given that the single currency is currently not inspiring a great deal of confidence either. A large portion of the USD, GBP and JPY exposure is hedged against the Singapore dollar, the Norwegian krone, the Canadian dollar and the Swedish krone.
Currency allocation before hedging - BL-Global Flexible - June 2011
Currency allocation after hedging - BL-Global Flexible - June 2011
The net asset value of BL-Global Flexible has fallen by 3% since the start of the year. This is mainly due to the rise of the euro (the fund's reference currency) against most other currencies. The euro gained on average around 4.5% in 2011. As discussed above, only 36% of BL-Global Flexible’s assets are denominated in euro (after taking into account the currency hedging).
Year-to-date performance - BL-Global Flexible - June 2011
The history of the stock market shows that there are two main types of markets:
- Structural bull markets
- Structural ‘sideways’ markets, or markets showing no particular trends or in which prices stay ‘flat’. In his excellent book 'Active Value Investing', Vitaliy Katzenelson (1) also uses the term range-bound to describe this type of market.
I use the term ‘structural’ to refer to extended periods of around 10 to 20 years, such as the structural sideways market of 1966-1982, the structural bull market of 1982-2000, the structural sideways market of 2000-?, and so on.
The chart below illustrates these phenomena in the case of the Dow Jones Industrial Average.
Click here to enlarge chart
Source: Stifel Nicolaus
Within structural bull markets corrections of varying scale can occur (such as the stock market crash of 1987). For long-term investors, such corrections are not that significant, as the upward trend is well-established.
Within structural sideways markets, there are cyclical bull and bear markets (by cyclical, I mean movements of shorter duration ranging from a couple of months to a couple of years). The chart below shows these trends for the period 1998-2011. An investor investing passively in the index over this period would not have earned any money so to speak.
13 years with a lot of volatility
Click here to enlarge chart
The conclusion to be drawn from these two types of markets is not that equities should be shunned in structurally sideways markets, but that a much more active investment strategy is required. An active strategy is required in terms of the periods during which we want to be ‘in the market'; in terms of regions / sectors to which priority should be given, and in terms of the selection of companies in which we want to invest.
Since March 2009, the significant rise in share prices has brought the markets to a crossroads. As investors, we have to decide which side we are on:
- Either we are on the side of those who think that March 2009 was the start of a new structural bull market;
- Or we are on the side of those who think that the period since March 2009 was just a cyclical bull phase within a structural sideways market.
In the first case, the best strategy is to stay invested and not focus too much on interim corrections, as it will be almost impossible to time these corrections.
In the second case, an investor should envisage a gradual exit from the market. At the very least, such an investor should carefully reexamine the rationale behind his or her equity investments.
An investor did not need to have a precise idea of the type of market he was in. Stock prices had just fallen by 50% and were at the bottom end of the range that had been prevalent since 2000. In other words, knowing whether the markets were on the verge of a cyclical or structural recovery was not important. Even those who were convinced that stocks were in a structural sideways market were able to take advantage of the cyclical recovery in stock prices. This is not the case today where the markets are in the upper range of the past 12 years.
Equity prices are in the upper part of their trading range
I have on a number of occasions discussed our conviction that we are still in a structural sideways market and that it will take years before western equity markets manage to sustainably exceed 2000 levels again. Structural bull markets start when stock valuations are low and end when valuations are high. Prices then stagnate while profits continue to rise. Stocks that were expensive in 1966, for example, become cheap in 1982 paving the way for the next bull market. The valuations observed at the end of the last bull market in 2000 were extremely high, which explains why even after 11 years of price stagnation and rising profits, equities are still not cheap.
I am aware that there is a difference of opinion on this point. Many observers consider that equities are cheap, which is an easy conclusion to reach if:
- equities are valued based on models using the currently very low levels of interest rates,
- we presume that companiesprofit margins, which are currently at historically high levels, will remain at these levels or rise even further. This is tantamount to betting against history, which shows that profit margins usually tend to return to their historical average. This seems logical in a market economy in which too-high margins attract competition, while rising competition has the impact of reducing margins.
One way of getting round the problem of the currently high levels of profit margins is to value companies based on their sales or their book value. Another is to take the average of earnings over a number of years. The chart below uses the price/earnings ratio developed by Robert Shiller, a Professor of Economics at Yale University, which divides the share price by the average earnings of the past 10 years to avoid using an exceptionally bad or good year. According to this ratio, the US market is currently overvalued by around 30%. It is true that European equities seem less expensive. This is nevertheless partly due to the composition of European indices and particularly the preponderance of financial stocks in these indices which seem cheap but are not necessarily so as illustrated in the recent capital raising exercise by Commerzbank.
Shiller PER for the U.S. equity market
Source: Morgan Stanley
Using artificially low interest rates to value equities seems risky to say the least. At Banque de Luxembourg Investments (BLI), we apply a 9% discount rate in our valuation models as a broad general rule. Lowering this rate to 6% would significantly increase the intrinsic value of the companies we analyse and reveal numerous buying opportunities. By doing this, however, we would reduce the margin of safety that we require in our investments.
Finally, interest-rate valuation models give an idea of the relative appeal of equities over bonds but reveal nothing about the absolute attraction of equities. It could be that in the next 10 years, equity returns beat those offered by bonds, but that does not mean that equity returns will be good. The history of the stock market shows that an investment in the US market at current valuation levels has on average generated an annual return of 3% in the following ten years.
(1) Vitaliy Katzenelson: Active Value Investing; Wiley Finance
In the past few years Brazil has experienced undeniable economic success. In 2010, growth exceeded 7% and current analyst projections for this year place the figure at above 4%. The country is the eighth largest economy in the world and accounts for 36% of Latin America’s gross domestic product.
The reforms behind the country's economic success were implemented at the end of the 1990s under the Cardoso administration and consolidated at the start of the 2000s by the Lula administration. The reforms focus on two main institutional measures:
- The first was the budget responsibility law. This law, which came into force in 2000, enshrined in the constitution financial, budgetary and administrative restrictions imposed since 1995 by the federal government on the states. It basically prevents the federal government from lending to states and increases the legal and financial responsibility of governors.
- The second measure was the adoption of an inflation-targeting framework for conducting monetary policy. This involved setting an inflation target (currently 4.5% +/- 2%) that the central bank would be responsible for achieving using interest rates as its main policy tool. After a period of hyperinflation in the 1980s and the start of the 1990s, Brazil has experienced moderate inflation in recent years.
Both measures have enabled the country to improve its financial health. Over the past few years, Brazil has consistently posted a primary surplus (i.e. a budget surplus prior to interest payments on public debt), which has helped to stabilise the public debt / GDP ratio. The challenge for the coming years will be to improve the quality of this budgetary consolidation by lowering the tax burden and implementing reforms to reduce mandatory public spending, which today accounts for more than 70% of public spending. As far as the fight against inflation is concerned, it is important to note that Brazil’s central bank is still not independent and that its monetary policy is vulnerable to political decisions.
In addition to the reforms mentioned above, there is another extremely favourable factor for Brazil - the rise in commodities prices. Brazil is one of the major exporters of agricultural commodities, base metals and metal products. The surge in commodities prices has enabled Brazil to significantly improve its terms of trade (export prices / import prices) and boosted its trade balance as well as its exchange reserves. Whereas in the past, most of Brazil’s debt was denominated in USD, the country is today a net creditor in USD which makes it much less vulnerable to changes in foreign investor attitudes.
While Brazil’s economic success is based on relatively solid fundamentals, the country is nevertheless facing a certain number of challenges, the most important of which is infrastructure development. Despite its heavy tax burden, public spending in terms of investment is very low, as the major share of tax revenue is spent on current expenditure and social transfers, which safeguard the social peace and are usually required under the Constitution. Private investment is often discouraged due to the lack of credit, high intermediation costs and regulatory uncertainties. Moreover, using the private sector to develop infrastructure is often difficult to reconcile with an ideology that favours the continued control of the state. The World Cup in 2014 and the Olympic Games in 2016 should result in an increase in the investment component in Brazil's GDP. Currently this component is low compared to the other emerging countries, particularly China. On the other hand, the share of private consumption is much higher in Brazil and in this respect the country is more like an industrialised country.
The lack of infrastructure and shortage of qualified labour are limiting the potential for non-inflationary growth, particularly as the high proportion of the private and public consumption component in GDP puts Brazil in a chronic situation of excess demand. With capacity utilisation rates close to their peaks and unemployment around 6% (which, taking into consideration the high proportion of undeclared activities, corresponds practically to a situation of full employment), the country runs the risk of overheating. In light of this situation, inflation could exceed 6.5%, which is the upper band of the range set by the central bank in 2011. The shortage of qualified labour is all the more problematic at the present time given that the country would need productivity gains to face up to the appreciation in the real. The real has been boosted by large capital inflows in the form of direct and financial investments, the latter in part attracted by high interest rates, both in nominal and real terms (adjusted for inflation). In a bid to combat the strength of its currency, the government has started raising taxes on equity and domestic bond purchases (2% and 6% respectively).
BRL/EUR exchange rate
After a strong run between 2004 and 2007, the Brazilian stock market slumped by around 50% between May and November 2008, before staging a sharp recovery in March last year, which brought it back close to pre-crisis levels. Since then the index has lost around 10%. Three notable factors weighed on the market in 2010: the presidential elections, Petrobras’ capital raising effort (the biggest rights issue ever) and monetary tightening by the Brazil Central Bank. While the impact of the first two factors has since disappeared, monetary tightening is still an issue as seen in the recent decision of the BCB to raise its key interest rate again. Since April 2010, the rate has risen from 8.75% to 12%. With real rates close to 6%, there is little incentive for local institutional investors to invest in equities.
BOVESPA index over 5 years
However, at 11 times estimated 2011 earnings and 1.7 times book value, the valuation of the Brazilian stock market is today relatively attractive in absolute and relative terms (i.e. compared to other emerging markets). As with most of the emerging markets, domestic opportunities are not really reflected in Brazilian indices as these are dominated by stocks such as Petrobras and Vale. In our BL-Emerging Markets fund, we are invested in four Brazilian companies: Lojas Renner (retail), M Dias Branco (food), Natura Cosmeticos (beauty products) and Weg (industry).
BL-Global Flexible's net asset value fell 3.7% in the first quarter of 2011 due to various factors that weighed on the fund’s performance over the quarter:
- The fund’s reference currency, the euro, has risen against most other currencies. Only 40% of BL-Global Flexible’s assets are denominated in euros;
- BL-Global Flexible does not invest in financial stocks from the industrialised countries: these sectors made strong gains in the first quarter. At the other extreme, the more defensive sectors, in which the fund prefers to invest underperformed, and in some cases even declined;
- In this context, the fund’s strategy to hedge part of its equity exposure through the sale of index futures had an additional adverse impact on performance.
There were no significant changes to the fund’s asset allocation over the quarter. Bonds were slightly increased following the rise in long-term interest rates between September and February. By the same token, the correction on some stocks was used to increase their weight in the portfolio, which boosted the net equity allocation from 43% to 48% (82% of which 34% are hedged through the sale of futures). By the end of the quarter, the average PE of the equity portfolio was 13, while the average dividend yield was 3.6%.
BL-Global Flexible is an actively managed non-benchmark fund that is guided by fundamental analysis. Our main convictions are currently as follows:
- The recovery in the economy – and in turn on the stock markets over the past two years is to a large degree artificial and thus fragile. A significant slide in share prices can not be ruled out;
- The monetary policies conducted by the central banks - and the Federal Reserve especially - have incited investors to take more risk. This has resulted in a significant outperformance of cyclical and financial sectors and small and medium caps. These segments currently appear particularly vulnerable. At the other extreme, there are good opportunities within defensive sectors and large cap companies.
- The risk/return of government bonds has deteriorated given the low level of interest rates and rising public debt. Tactical opportunities do pop up from time to time, however. As in the case of equities, active management is called for as far as bonds are concerned;
- The emerging markets have much better fundamentals than the industrialised countries. In this respect, the weighting of the Southeast Asian countries in the portfolio will remain high.
“The Buddha taught that you can only understand something by looking deeply at its interconnectedness to other things, and to our own selves – nothing has a separate existence. ‘This is, because that is; this is not, because that is not.’ The problems and imbalances that have inflamed the world did not emerge from a vacuum. Rather, this is, because that is.” (John Hussman)
1. My first point is that we are in a highly dangerous macroeconomic environment and that the long-term return prospects for most markets are low. The extraordinary monetary and budgetary measures have only provided a relatively mediocre economic recovery that is still very fragile. Broadly speaking, these measures are only the continuation of those that led to the crisis in the first place and are doing nothing to resolve the fundamental problems. More often than not, they have had counterproductive effects, with the Federal Reserve’s policy contributing to the hike in commodities prices and the fall in the dollar, which have resulted in a decline in US consumer purchasing power. The measures have also led to an unprecedented deterioration - in peace times at least - in the public finances of the industrialised countries. The upshot is that if another crisis was to emerge, the authorities would have practically no room for manoeuvre.
2. The economic stimulus measures have led to a strong advance in stock prices over the past two years and pushed the markets to levels that strongly impede their long-term return potential ('the price paid determines the return' is still the most important rule in investment). Arguing that you should buy stocks because interest rates are low and bonds are unattractive is stupid and does not hold water from an historical point of view.
3. In light of the above, our investment strategy will maintain a strong defensive bias (unless the markets slump, which would bring stocks down to much more attractive levels). Of course, we are aware that a new round of monetary easing in the United States could prolong the stock market rally of the past two years. It is our opinion, however, that participating in this rally involves a great deal of risk. Contrary to financial theory which equates risk with volatility, we believe that the main risk for an investor is the loss of his capital. In other words, a strategy that produces moderate gains in 80% of cases but huge losses in 20% of cases is not acceptable for us.
4. It is important to note that having a defensive strategy does not mean that we are avoiding stocks. The traditional distinction between equities as risk assets and bonds as no-risk assets no longer makes sense in the current climate where businesses are often in better financial shape than governments. There seems to be little long-term upside potential from current levels for the stock markets, but within markets, there are attractive pockets of opportunity. Our investment themes are still ‘quality companies in defensive sectors’, ‘dividends’ and ‘emerging markets’. In terms of fixed income, some of the emerging markets are also offering a much better risk/return trade-off than bonds in most of the industrialised world.
5. As far as the events in Japan and the Middle East are concerned, one thing seems clear – they are putting further upside pressure on oil prices, thus increasing the prospect of an energy crisis. In the industrialised world, soaring oil prices are a deflationary not an inflationary event. They reduce consumers’ buying power and exert downward pressure on profit margins. In the United States, real wages (adjusted for inflation) fell in five out of the six past months.
6. Rebuilding Japan’s destroyed infrastructure will require raw materials and in turn support prices of these raw materials. Once again, it is important to point out that unlike in the past when rising commodities prices were usually a consequence of the strength of economic activity in the industrialised countries (and had therefore an inflationary bias), today this increase is resulting from the strength of economic activity in the emerging markets and geopolitical factors, and has therefore a deflationary impact on the industrialised countries. The fears of contamination of the food supply chain does nothing to reduce the inflation in global agricultural prices.
7. The tragedy in Japan has happened at a time when the Japanese government is facing huge debt and where the savings (of its population) required to support this debt are diminishing as its population ages. There are fears that the Japanese authorities will in turn resort to large-scale quantitative monetary easing (a euphemism for printing money). With the confidence in the dollar largely undermined, the euro could remain the default currency despite the problems within the eurozone. In the longer term, this situation could result in a new monetary order in which the emerging creditor countries would accept to revalue their currencies as the price to pay for being able to conduct independent monetary policies. Current inflation trends in these countries, the result of rising commodities (especially food) prices, could accelerate this process.
8. The fact that many strategists are recommending using the correction in the wake of the events in Japan to buy stocks is quite revealing of a state of mind that believes that any slump in share prices is a buying opportunity. First of all, the correction is negligible in light of the rally of the past two years. Second, risks are plentiful given the events in Japan, Bahrain, Yemen and Libya, the debt crisis in Europe, monetary tightening in China, and the prospect of the end of QE2 (the second round of the Federal Reserve’s extraordinary monetary easing) in the United States (1). Many markets have doubled in value since March 2009 and it would be naïve to think that these risks are currently factored into prices.
9. The Japanese stock market itself is currently relatively cheap. Companies are trading on average at one time their book value, compared to other countries where this ratio is well above two. As well as this, Japanese companies’ return on equity, traditionally low, is starting to improve.
10. In conclusion, the events in Japan and the (slight) correction in equity prices do not constitute a buying opportunity. In March 2009, stocks were trading at relatively attractive levels, and the economy and corporate earnings had begun to improve. Today, we are in the opposite situation. The rally of the past two years constitutes an opportunity to undertake a fundamental repositioning of investment portfolios, however, away from those countries whose fundamentals are deteriorating and towards those whose fundamentals are sound or improving.
(1) The end of the first round of extraordinary monetary easing in April 2010 led notably to a 12% correction in the S&P 500 and aroused fears of a return into recession. It was this situation that prompted the Federal Reserve chairman, Ben Bernanke, to hint at a new round of monetary easing as soon as the end of August. Today, some members of the Federal Reserve Open Market Committee are already talking about the need for QE3.
Defensive sectors have significantly underperformed during the stock market recovery of the past two years.
A number of factors are prompting me to think that this situation is coming to an end and that there are now grounds to give priority to these sectors, particularly telecommunications, healthcare, and food/tobacco:
- Our conviction that the economic recovery remains fragile. Independently of structural impediments to growth, linked to overindebtedness, economic activity could start to be negatively impacted by the increase in the price of oil and rising interest rates. In such an environment, the relatively stable earnings of defensive quality companies will once again be appreciated;
- Defensive sectors regularly go through phases of under- or outperformance, but the underperformance of the past two years is extreme from an historical point of view;
- The logical outcome of this underperformance is that the valuation of these sectors is currently attractive in absolute terms and very attractive in relative terms (i.e. compared to the overall market and cyclical sectors);
- Unlike cyclical sectors, the profit margins of defensive sectors are still well below their previous peaks;
- Certain defensive sectors are strongly exposed to the emerging markets where there is higher growth potential.
A final note is that the underperformance of defensive sectors goes hand in hand with the huge underperformance of large caps in the past few years. The following graph shows that over the last 10 years, large caps (and the general market) have been drifting sideways while small and mid caps have generated an annualised return of around 8.5%. This was due to the fact that at the start of 2000, large caps were very expensive compared to small and mid caps. The opposite is true nowadays.
Investing for the long term in dividend-paying companies makes a lot of sense. Many empirical studies show that in the long term, buying high dividend stocks is one of the best ways to combine attractive returns with less volatility. Despite this evidence, dividend stocks are often overlooked as investors prefer to buy high-growth stocks whose price appreciation potential is perceived to be more important.
One of the most exhaustive studies on the contribution of dividends was written by Robert D. Arnott, the founder of Research Affiliates. In an article published in 2003 in the Financial Analysts Journal, he analyses the sources of return from US stocks over a period of 200 years, from 1802 to 2002. He shows that over this period, US stocks generated an annualised return of 7.9%, of which 5% came from dividends, 1.4% from inflation, 0.6% from rising valuation levels and 0.8% from the real growth in dividends.(1)
The good results in terms of risk / return produced by a dividend strategy are hardly surprising. On the qualitative side, a high dividend helps to determine the quality of a company’s results and its financial health. On the quantitative side, the dividend provides some 'yield support' for the stock and, when reinvested in bear markets, helps to reduce the time needed to make up capital losses. As well as this, high dividend stocks tend to be attractively valued in relation to their earnings or book value.
The advantages of dividend stocks can only be appreciated over reasonably long investment horizons exceeding a number of years. Moreover, empirical studies also show that the best returns are generated by strategies combining high dividends and a low POR (pay-out ratio - the share of profits distributed in the form of dividends). This seems logical as a too-high POR undermines the sustainability of the dividend.
During the bull markets of the 1980s and 1990s, dividends lost much of their importance – especially in the United States, where they were heavily taxed. The outcome of this is that investors tend to associate the return on a stock with the growth in the stock price forgetting about the dividend component. As well as this, against a backdrop of increasingly short investment horizons and investors looking for the next Google or Apple, dividend strategies do not seem very exciting (neither Google nor Apple currently pay out dividends).
Demographic trends and the ageing of the population could nevertheless result in a change in investor attitudes. Investors will increasingly seek regular income and consequently a larger share of the return on stocks in the form of dividends rather than capital gains (especially since, based on current valuations, it seems illusory to think that the US and European stock markets can produce much more than 4% in real terms annually in the coming years). One could even make the point that given the decline in the 'risk-free’ reputation of government bonds, stocks from quality companies with low levels of debt and paying reasonable dividends could take over from bonds as the default investments in defensive portfolios despite their higher volatility.
Finally, in an environment in which many investors fear the return of inflation, it is important to point out that, unlike a coupon on a bond which is usually fixed, a company can increase its dividend. Dividend stocks therefore offer some protection against inflation.
Our conviction about the long-term validity of a dividend strategy was the impetus behind the launch of our dividend fund, BL-Equities Dividend, just over three years ago. The chart below shows the fund’s performance since launch (November 2007) and its comparative performance against the MSCI All Countries Index (in euro) and the same index with dividends reinvested. The chart confirms the comments above:
(1) Source: Robert D. Arnott: Dividends and the Three Dwarfs, Editor’s Corner, Financial Analysts Journal, 2003.
The emerging markets
The emerging markets are currently going through a challenging period. Since the start of the year, the MSCI Emerging Markets Index has lost 6% in local currency terms, contrasting with the industrialised countries, which have risen by just under 5%. The emerging markets’ underperformance is due to inflationary pressures that are starting to appear amid rising commodity prices - particularly food prices which represent on average around 30% of the CPI basket in this region. These pressures are forcing the region’s authorities to tighten monetary policy and raise key interest rates. Events in Tunisia and Egypt have also served to remind that the political risk remains high in certain countries. In an environment of short investment horizons, we are seeing a rotation towards the industrialised countries where monetary tightening is more of a far-off threat and where the latest macroeconomic data is on the whole better than expected. After the large capital inflows to the emerging markets in 2010, the past few weeks have seen significant outflows from these markets.
Before concluding that the recent absolute and relative performance of the emerging markets represents a strong investment opportunity, it is worth looking at this performance in a longer term context. Since 1990, a typical correction for the emerging markets was a 20% fall in share prices that usually lasted around six months. In this respect, the current correction of 6% over seven weeks could continue for a while. Such a scenario makes sense as long as the industrialised countries continue to benefit from a very favourable environment (better macroeconomic data and artificially low interest rates) and as long as investors are not convinced that the inflationary problem in the emerging markets is under control.
The current situation on the emerging markets and the good performance of the industrialised countries do not alter the economic and stock market reality, however. The growth differential between the emerging markets and the industrialised countries continues to favour an investment in the former. As a general rule, the emerging markets have much better fundamentals with, notably, a much lower level of debt. Their valuation is attractive in absolute terms with a price/earnings ratio of 11.8 for 2011 and in relative terms with a 15% discount to the industrialised countries despite a much higher profitability of emerging market companies. The fundamental attraction of the emerging markets is therefore not being called into question by the current correction.
The emerging markets are not a homogeneous class and it is important to differentiate between the various countries within this group. The chart below shows that three of the markets referred to as the BRIC (Brazil, Russia, India and China) countries have been underperforming the MSCI Emerging Markets index over one year, with a disappointing year on the stock markets in 2010 for Brazil and China in particular. We continue to give priority to the mature countries of Southeast Asia (which, for some, do not feature in the emerging market indices anymore).
Everyone should be made aware of the insanity of it all, and that preserving their capital and growing it slowly and prudently is a totally appropriate strategy for this radical money easing environment. This type of policy breeds speculative and dubious rallies, but what they inevitably trigger are boom-bust cycles such as the ones we saw in 1999-2002, 2006-2009, and the current one we are in today. This is no time for short memories.
(David A. Rosenberg, Chief Economist & Strategist, Gluskin Sheff)
BL-Global Flexible has not performed well since the start of the year. I briefly outlined the reasons for this in my 24 January post, but I feel that it is worthwhile further exploring the reasons behind this disappointing performance.
BL-Global Flexible is characterised by a high conviction management style. By definition, this involves an active approach to management, not dictated by benchmark indices and based on our fundamental convictions and analysis of the economic and financial situation. In an ideal world, our convictions would always lead us to the 'right' decisions, but we know by experience that this is not the case. In the short term, notably, market fluctuations may go against our views. (It’s important to point out that we are not the only ones in this situation. A study by Tweedy, Browne, the investment management company, shows that fund managers who have widely outperformed their benchmark index in the long term have experienced many years of underperformance. These periods were usually characterised by strong bull runs where caution was penalised.)
That said, amongst the various factors that are currently penalising BL-Global Flexible (and Banque de Luxembourg’s funds on the whole), the following stand out:
- BL-Global Flexible does not invest in banking stocks or insurance companies from the industrialised countries. Yet since the start of the year, these sectors have progressed the most in Europe. At the other extreme, the more defensive sectors, in which the fund tends to invest, are lagging;
- In this context, the fund’s strategy to hedge part of its equity exposure through the sale of futures has an additional adverse impact on performance;
- The emerging stock markets have been underperforming in the past few weeks due to the resurgence of inflationary pressures. However, this does not make them less attractive from a medium- to long-term point of view;
- The fund’s reference currency, the euro, has risen against most other currencies. Only 40% of BL-Global Flexible’s assets are denominated in euros;
- The bond weighting was sharply lowered in the third quarter 2010 and the rise in long-term interest rates since September has not put the fund at too much of a disadvantage. With around 10% of its investments in bonds, the weighting nevertheless had a negative impact.
A poor performance of a fund in January is not particularly wonderful in a field in which a fund’s performance tends to be presented since the start of the year. We believe that the factors that have weighed on the performance of our funds are temporary, however. Most of these are linked to the perceptions of investors that the world economy is on the road to a strong sustainable recovery and that the European crisis is being resolved - two opinions we do not share. In light of these developments, we plan to continue with our current investment strategy and not make any significant changes to the composition of the BL-Global Flexible portfolio.
“I know what’s around the corner - I just don’t know where the corner is.” (Kevin Keegan)
2010 was a good year for the stock markets, which, for the most part, notched up gains of over 10%. Behind this figure, however, was a great deal of volatility. The US and the European markets were down by 6% at the end of August when Ben Bernanke, US Federal Reserve chairman hinted that the US central bank would engage in a new round of quantitative monetary easing. This announcement prompted a spectacular rally on the markets, which, at the time of writing, is still underway. The current situation seems to confirm the old stock market adage whereby you should never go against the Federal Reserve and that in the short term, liquidity has the upper hand over fundamentals.
The behaviour of the markets in 2010 is a good illustration of the dilemma currently facing investors. Generally speaking, structural problems persist. More specifically, the increase in public debt, soaring budget deficits and an undercapitalised banking sector will lead to significant problems in the industrialised countries. In the next three years, certain countries such as Japan, Italy and the United States (not to mention Greece, which currently has the advantage of not having to resort to the market for its funding) as well as the European banks will face huge financing requirements.
While the risks seem obvious, the fact is that the authorities, particularly in the US, are willing to do anything to perpetuate the cycle of overconsumption and overindebtedness and to boost the financial markets. Such a situation tends to favour risk-taking, especially in an environment in which the investment horizon is getting shorter and shorter and in a profession where many investments managers have taken Keynes’ advice as their careers guidance: "Never, ever be wrong on your own. You can be wrong in company; that’s okay." They feel obliged to follow short-term movements on the markets for fear of losing clients. Against a backdrop of renewed optimism at the start of 2011 about the economic situation and the ability of European countries to resolve the crisis, this trend is currently resulting in an aggressive sector rotation within the stock markets, with more defensive sectors being sold in favour of financial stocks.
The current rally in risk assets could thus continue for some time. Many observers have pointed out that we have entered the third year of a US presidential cycle, which is traditionally good for equities: since the 1940s, the US stock market has never been down in the third year of a presidential cycle. Moreover, the economic risks that can be detected for the stock markets in 2011 (disappointing company earnings, fears about the sustainability of the economic recovery) seem to be concentrated in the second half of the year.
Our investment strategy will continue to be driven by a fundamental analysis of the economic and financial situation. Based on this analysis, here are our recommendations for 2011.
1. Long-term government bonds
This recommendation goes against the advice of most experts, who believe that the deterioration in public finances and the devaluation of currencies by more or less explicit recourse to the printing press will result in a rise in inflation and push up bond yields, especially in a context of economic recovery.
I agree that the increase in public debt is very worrying. However, when I speak of buying long-term government bonds, I do not mean that they should be held until maturity, but that they should be kept for around 12 months. An active investment strategy is increasingly as important for bonds as it is for equities.
Why am I recommending bonds now? First of all, the sharp increase in long-term interest rates since September 2010: over the past five months, the 10-year German bond yield has risen by more than 100 basis points, from 2.1% to 3.2%. This means that over the same period, the 10-year German government bond price has lost around 10%. (In the United States, we have seen a similar increase in bond yields, which have risen from 2.4% to 3.5%, leading us to the conclusion that German bond yields are rising for reasons other than just the fear of seeing “Germany having to pay for Greece”.)
Second, the two factors which, in the past, have played a crucial role in determining bond yields are still good for the bond markets. The first is the monetary policy implemented by the central banks and the second is inflation. The Federal Reserve and the European Central Bank will take no risks with the economic recovery and will wait a long time before raising their key interest rates. At the same time, they are doing everything they can to keep down long-term interest rates (over which they have no direct control). In light of this, the significant gap between short and long rates should bolster the bond markets and attract a certain number of ‘natural’ buyers of bonds, such as banks or institutional investors interested in achieving a balance between their assets and long-term liabilities. In terms of the inflation factor, the main component, unit labour costs (wage costs adjusted for productivity gains), is almost non-existent. Finally, I continue to believe that the economic recovery in the industrialised countries is generally artificial, because it is being driven by fiscal and monetary stimulus measures that the authorities will not be able to sustain, and statistical, in light of the significant stock replenishment by companies. Doubts on the sustainability of the recovery, particularly in the United States, could reappear later in the year, in a mirror image of last summer’s events, which prompted the Federal Reserve to engage in a new round of quantitative easing.
Two points should be underlined:
- The price of a long-term bond is highly sensitive to any rise in interest rates. If, contrary to my expectations, long-term rates rise by another 100 basis points between now and the end of the year, an investor holding a 10-year bond will have lost around 5%, including the coupon. The low level of long rates means that any increase in these is felt strongly in the price of a long-dated bond. There is therefore greater risk and volatility involved in investing in these kinds of bonds. In other words, when bond yields are at 3% and rise by 50 basis points to 3.5%, this hurts much more than if rates rose from 7% to 7.5% (what is true in one respect, is obviously also true in the other).
- As I said above and in previous posts, the increase in public debt is a major concern. Some countries are in a vicious circle and will find it difficult to avoid debt restructuring. Investors should therefore focus only on countries with better fundamentals.
To download a presentation of the general characteristics of BL-Global Flexible EUR and of its portfolio as at mid-January, please click on the following link.
After suffering from the rise of the euro in September (cfr my post from 4 October 2010), BL-Global Flexible EUR’s NAV (net asset value) had a satisfactory last three months of the year. The fund’s 3.8% gain in the fourth quarter allowed it to end the year up 12.60%.
Since the start of the year, the rise of the euro has come back to weigh on the fund’s performance. The euro has risen by around 2% against the dollar and the main Asian currencies, and by nearly 4% against the Swiss franc and the Japanese yen. As a reminder, more than half of the fund’s holdings are in currencies other than the euro, the currency in which the NAV is expressed.
Another factor that penalised the fund in the beginning of the year was its long/short equity strategy. Given the low level of interest rates, the fund tends to invest a large portion of its assets in quality companies and hedge part of the resulting equity risk by selling futures on the US, UK and European indices. This strategy is currently working against the fund. Stock market indices are being driven higher by sectors such as banks and insurance in which the fund does not invest, while the defensive sectors that the fund favours are being overlooked by the markets. By way of example, the chart below shows the performance of four sectors in the Stoxx Europe 600 index since the start of the year: banks, insurance, food&beverage and healthcare.
At the start of October 2010, I wrote that the rebound of the euro and the underperformance of quality companies, which had dragged down BL-Global Flexible EUR’s performance in September, would not last and that fundamentals would get the upper hand again. I think that this will again be the case in the next weeks and months. Events that could, in my opinion, bring about a shift in the currently very positive investor psychology include new fears on the sustainability of the US recovery, a deepening of the European crisis and the reaction of the authorities in the developing countries to inflationary pressures, which are starting to mount in these regions.
In sum, BL-Global Flexible EUR’s investment strategy at the start of this year remains unchanged. The macroeconomic environment remains characterised by major macroeconomic problems and overvalued stock markets on one hand, and, on the other, very low interest rates and - within stock markets - quality companies that are attractively valued and often paying out attractive dividends. This environment will continue to support a long quality / short market strategy. In geographical terms, the growth differential and much better fundamentals continue to favour the developing markets, which is why we continue to give priority to Asia. Finally, we are starting to take advantage of the sharp rise in long-term interest rates to boost our bond holdings in the portfolio.
Some thoughts about the European crisis
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually, and then suddenly.”
(Ernest Hemingway: The Sun Also Rises)
After being relegated to the background by expectations of a new round of monetary easing by the Federal Reserve, the problems in the eurozone have resurfaced again. Here are some of my thoughts about this:
- Greece and Ireland’s problem is one of solvency and not liquidity. Levels of debt in these countries quite simply exceed their ability to honour their debt. Lending to Ireland at a rate of 5.82%, as decided by the Eurogroup and the EU finance ministers on 28 November, will not improve the ability of the country to repay its debt;
- A solvency problem is not resolved by adding more debt to the pile. A company in debt has three main choices: either it restructures its debt, it raises more capital, or increases its ability to repay debt by increasing its cash flow. For a country to 'increase its cash flow', nominal growth has to exceed the interest rate that it pays on its debt. By doing this, the country lowers its public debt to Gross Domestic Product (GDP) ratio and enters a virtuous circle. On the other hand, if the interest rate paid on the debt exceeds its nominal GDP growth, the country enters a vicious circle. Germany is currently in a virtuous circle; the peripheral countries (Southern Europe and Ireland) are in a vicious circle;
- The fact that the core (Northern Europe) countries are managing to finance themselves at attractive rates (partly due to the crisis) while the peripheral countries pay increasingly exorbitant rates further widens the competitiveness gap between these regions. The gap exists because of diverging unit labour costs (labour costs adjusted for productivity gains) and is the main challenge for the survival of the euro in its current state. Diverging trends in labour costs are mainly due to the fact that the peripheral countries did not take advantage of the low interest rates they inherited when they first joined the eurozone to clean up their public finances or undertake productive investments. What the low interest rates did do, however, was to create a situation of excessive consumption and soaring house prices;
- As members of the eurozone, these countries do not have the possibility of resorting to currency devaluation to restore competitiveness. Any rebalancing will have to be done by focusing on labour costs, which must rise much more slowly in the peripheral countries than in the core countries. Given that labour costs are almost stagnant in the core countries, this means that they will have to fall in the peripheral countries. Such an adjustment is painful and would involve a drastic reduction in the standard of living, which is not likely to be accepted by the population;
- The budget austerity measures generally recommended by organisations such as the IMF do not work in the current situation. The fall in public spending and the rise in taxes result in lower economic growth and affect tax revenue. This in turn leads to a worsening in the budget deficit and the debt level and the need to embark on new rounds of austerity measures, and so on. In the past, a country experiencing a crisis brought about by escalating debt or a weakened banking system could resort to austerity packages and currency devaluation, while taking advantage of strong international growth. Today the debt problem, the fragility of the banking sector and weak nominal growth is common to most of the industrialised countries. In this context, large-scale budget austerity without currency devaluation is tantamount to economic suicide;
- The problem in Ireland is mainly caused by the banking sector. The recent crisis was spurred by the increase in the cost of bailing out the Irish banks. Its desire to prevent its banks (which have become too big compared to the size of country) from going under pushed the Irish budget deficit sky-high. Iceland made the opposite decision: it decided to let its banks fail – their debt had risen to over10 times GDP. Iceland is currently experiencing a severe recession, but the country is starting to see the end of the tunnel, thanks also to a sharp currency devaluation. This is not the case for Ireland, where unemployment has already risen to 13% (according to the OECD, unemployment in Iceland is expected to peak at 8.1%) and a brain drain is already underway;
- Overall, the distinction between countries and their banks is becoming increasingly blurred. The reasoning becomes circular - on one hand, we cannot let Greece or Ireland restructure their debt because this debt is often held by German, French or other banks which would then suffer significant losses, putting the world financial system in peril. On the other hand, the vulnerability of the banking sector is likely to require government intervention, which will exacerbate the public debt crisis and the prospect of debt restructuring in certain countries;
- In a crisis situation, any credibility lost by governments is dangerous and likely to create a self-fulfilling prophecy (i.e. investors sell/stop buying a country’s bonds because they expect that country to default. This leads to an increase in the cost of financing of that country and brings about the default expected). Their credibility is already starting to wear down: the Irish banks behind the latest episode of the crisis had passed the stress tests in summer; Ireland was supposed to help out with the bail-out of Greece, and the announcements of 28 November do not seem realistic. In a recent note , Dylan Grice, the brilliant strategist at Société Générale, showed that the reaction of the European politicians to the crisis was typical of human behaviour when faced with events unforeseen and beyond our control:
- It is important to note that the rise in bond yields of countries like Spain and Portugal is not due to “speculation”, but to investors’ selling off (or not buying) bonds that they would have traditionally held. As an asset class, government bonds are supposed to offer security, liquidity, low volatility and negative correlation with risk assets. Those of the peripheral countries no longer offer these characteristics and are losing their natural pool of investors (pension funds, insurance companies, etc);
- Since the announcement of the bail-out of Greece in May, the 10-year German Bund yield slipped 10 basis points (0.10%), while in Italy, the bond yield rose by 50 basis points, 110 basis points in Spain, 320 basis points in Portugal and 360 basis points in Greece. These yields do not exist in a vacuum - they are the cost that countries would have to bear for their (long-term) financing needs if they had to go to the market (which will be the case at the latest in 2013 when the stabilisation fund runs out). Rising yields and the increase in credit default swaps (the cost of hedging against payment default) for the peripheral countries shows that investors do not trust the ability of these countries to pay back their debt;
- The survival of the euro in its current form depends very much on Germany. As long as the country believes that the advantages of the euro far outweigh the disadvantages, it will deploy efforts to support the currency. The problem is that the disadvantages could rapidly gain in importance: if Germany guarantees (or pretends to guarantee) the debt of problem countries, its creditworthiness will diminish and its cost of financing will increase (since October, we have seen a sharp increase in long-term German bond yields). Moreover, the country is currently experiencing robust economic growth and many companies have announced salary increases for next year. Germany has traditionally been very sensitive to risks of inflation, and a decision by the European Central Bank to keep interest rates very low (in order to help the peripheral countries) in such a situation could lead to problems in the long run;
- It has always been said that the euro was a political construction rather than an economic one. The current crisis could result in greater political integration and a kind of fiscal federalism. The eurozone would then become a large family where each would take care of the other (and bear the other’s debts). One way or another, this means that taxpayers in the core countries will have to pay the bill for bailing out the peripheral countries (rather than the one for recapitalising their banks if the peripheral countries restructure their debt). It will be very difficult for the core country governments to get voters to accept this situation;
- Current debates about a mutualisation of sovereign bond issues are moving in this direction and are the logical next step with regard to the Eurogroup’s decision of 28 November to downgrade government bonds to the status of subordinated bonds: "In all cases, in order to protect taxpayers' money, and to send a clear signal to private creditors that their claims are subordinated to those of the official sector, an ESM loan will enjoy preferred creditor status, junior only to the IMF loan." In other words, countries having received an official loan from the IMF or as part of the European Stability Mechanism (ESM) will have to pay this back first before paying back government loans. This decision means that in future, there is a greater risk that government bondholders will not get their investment back in full. And this will do nothing to solve the issue of the problem countries’ ability to finance themselves in the market at reasonable rates;
- Barring the implementation of a fiscal transfer mechanism, it is difficult to see how we can keep the euro in its current state, avoid debt restructuring in certain countries, protect the banks and come up with a solution for the Greeks and the Irish that would allow them to sort out their problems over a reasonable time frame. If anything is done, in my opinion, it will be necessary to try to break the ‘country-bank’ problem I talked about in the seventh point above. This could involve the recapitalisation of banks considered systemically important. In the current environment, I don’t think that the private sector will want to be involved in such recapitalisation, at least on a large scale. It would thus be up to the governments to inject the necessary capital by setting up a fund whose objective would be to recapitalise the problem banks in the eurozone region (why is Ireland forced to save its banks on its own when the failure of its banks would have a greater impact outside than inside the country?) I think that such a fund would make more sense than the European Financial Stability Fund (EFSF) set up recently to support eurozone countries in difficulties. Once the banks would get back on their feet again, the next step would be to examine how to restructure the debt of certain countries;
- In the end, the advantages of keeping the euro should be compared to the cost of the solutions required to save it. Burdening future generations with colossal debt just because the break-up of the single currency is 'politically unthinkable' is not acceptable.
Forecasting short-term and medium-term currency developments is extremely tricky. Despite this, investors need to have an overall framework for managing their currency allocation. Here is mine:
• The desire of many industrialised countries to debase their currency implicitly (via inflation) or explicitly (via depreciation or monetary reform) is a very worrying trend. It is a hidden form of protectionism that will result in more losers than winners;
• The two main currencies, the dollar and the euro, are both experiencing severe problems. In the case of the dollar, there is a greater risk of resorting to the printing press. The euro, on the other hand, is affected by the problems of its peripheral countries and the widening gap between Northern and Southern Europe;
• The dollar, until there is evidence to the contrary, is still a safe haven when investors become more risk averse. In the past three years, the dollar gained against the euro when the stock markets were falling and lost ground when the markets were rising;
• On the currency markets, the euro is ‘anti-dollar’. As long as China continues to show resistance to a more significant appreciation of its currency, the euro will be the default alternative for those wishing to exit from the dollar. The result is that when the dollar depreciates, it pulls down the Asian currencies with it, as well as other currencies such as sterling;
• The currencies of the industrialised countries which have sounder fundamentals and which seem less inclined to resort to printing money (Australia, Canada, Norway) have got rather expensive. At the other extreme, an ‘unloved' currency such as sterling currently seems cheap;
• Developing countries fundamentals are generally in much better shape than those of the industrialised countries;
• It is difficult to calculate the ‘intrinsic value’ of currencies. However, based on theories such as purchasing power parity, it would seem that the euro is around 10% overvalued against the dollar, which is in turn overvalued against the Asian currencies. In the long term, the dollar tends to correct its overvaluation or undervaluation against the European currencies. Its current undervaluation is not exceptional however. In the past 10 years, the dollar has been up to 25% undervalued (2008) and up to 20% overvalued (end 2000);
• Valuations and fundamentals are therefore calling for a long-term appreciation of the Asian currencies, especially since such appreciation would help to rebalance the world economy. It would also provide the Asian authorities with some ammunition in their battle against inflation, which is starting to appear in the region;
• The Asian authorities will nevertheless continue to oppose too rapid appreciations in their currencies as can be seen in the controls implemented by some of these countries (Taiwan, Thailand, South Korea, etc). Within the Asian region, it is important to differentiate: for example, the Thai baht is relatively expensive, while Hong Kong dollars, Taiwan dollars, and the Korean won are quite cheap.
Here is how these ideas are implemented in BL-Global Flexible:
The currency allocation of the fund is as follows:
The dollar’s net exposure is reduced to 15% through forward sales against the euro and the Singapore dollar;
Sterling’s net exposure is reduced to 5% through forward sales against the euro.
The currency allocation of the fund after hedging is as follows:
“Money may no longer be physically printed and distributed in the voluminous quantities of 1923. However, ‘quantitative easing’, that modern euphemism for surreptitious deficit financing in an electronic era, can no less become an assault on monetary discipline. Whatever the reason for a country’s deficit – necessity or profligacy, unwillingness to tax or blindness to expenditure – it is beguiling to suppose that if the day of reckoning is postponed economic recovery will come in time to prevent higher unemployment or deeper recession. What if it does not? It is alarming that some respected bankers and economists today, in the US as in Britain, are still able to commend ‘the printing press’ (in so many words!) as a fail?safe, a last resort. A country’s budget can indeed be balanced in that way, but at the cost, to whatever degree, of its citizens’ savings and pensions, their confidence and trust, their morals and their morale.” Adam Ferguson (2010)
As was widely anticipated, the Federal Reserve has decided to resort to a new round of quantitative easing. “QE2”, announced on Monday, will take the form of buying around 75 billion dollars of government bonds per month from now to the end of June 2011. Added to these new purchases will be some 30 to 35 billion dollars of coupon reinvestments which were expected anyway. The Fed’s objective is to create a wealth effect by inflating the value of financial assets and real estate prices which will then stimulate consumer spending and investment. In so doing, it is perpetuating the disastrous policy that began in the Greenspan era in the mid-1990s, which was in large part responsible for the structural problems that the United States is currently experiencing. Maintaining interest rates at artificially low levels has provoked a poor allocation of resources that has encouraged speculation to the detriment of productive investment. The Federal Reserve has thus confirmed that it has become a danger to the long-term economic health of the United States.
Unfortunately however, the decisions of the Federal Reserve ? the central bank of the principal reserve currency, the dollar ? do not only affect the United States but have repercussions across the global economy. As soon as the Fed signaled in August its intention to embark on this new round of quantitative easing, the dollar depreciated massively. Its decline was particularly marked against the euro given that the Asian currencies, the logical candidates for appreciation in view of their good fundamentals, are more or less correlated to the dollar. By encouraging, explicitly or not, their currency to depreciate in order to stimulate their exports, the United States are adopting a form of protectionism that is in danger of aggravating the global economic problems. In this regard it is ironic to note that, by pushing up commodities prices, the fall in the dollar is further increasing the problems of the American consumer ? witness, for example, the price of oil which has gone up by nearly 18% in the last two months.
USD/EUR exchange rate over 1 year
For fund managers, QE2 poses an additional problem. It is likely to prolong the decorrelation between the financial markets and economic reality. While a casual observer could thus think that the 16% rise in the US stock market since the end of August is based on improved economic fundamentals in the United States, in reality, this increase began with the announcement of further quantitative easing to come by the Fed’s chairman, Ben Bernanke. And, it is precisely because the economy is in such poor health that the central bank has decided to resort to this form of monetary stimulus.
S&P500 over 1 year
This divergence between the direction of the financial markets and that of the real economy could continue for some time to come (technically, the fact that the S&P500 has crossed the 1220-mark seems to be a positive signal). If it does, it is likely to test the patience and discipline of many investors who risk succumbing to the temptation of chasing the upswing, especially in an environment of very low interest rates. As many professional investors are judged on the performance of their portfolios against stock market indices, they feel cornered into taking risks on account of the monetary policies of the central banks, especially the Fed.
Trying to hook into short-term stock market runs is not an investment strategy however, especially when the trends are already well advanced and not based on solid fundamentals. The best way of protecting one’s capital and making it grow is to buy good quality assets at reasonable prices without being unduly swayed by the markets’ daily fluctuations. It is not a question of being bullish or bearish about equity markets but of identifying investments within these markets that meet this criteria. The themes to focus on remain the same:
In September, the net asset value (NAV) of the BL-Global Flexible fund fell by 1.67%. Since the start of the year, the fund has gained 8.49%. The fund’s poor performance in September may seem surprising given the strong rally on the markets in the past month and BL-Global Flexible’s (net) equity allocation of just under 40%. There are two main reasons for this:
- The rebound of the euro. Over the month, the euro advanced against all the other currencies, particularly the US dollar (+7.5%). As more than half of the fund’s assets are denominated in currencies other than the euro (even though the NAV is expressed in euro), we estimate that the decline in these currencies has cost the fund around 3% in performance;
Euro appreciation in the month of September
- The quality companies favoured by BL-Global Flexible have underperformed. While nearly 90% of BL-Global Flexible’s assets are invested in equities, a large portion (50%) of its equity exposure is hedged via the sale of futures on US, UK and European indices. This strategy can penalise the fund when quality companies underperform these indices.
Underperformance of quality companies
These phenomena can be explained by a somewhat strange scenario. In light of recent data confirming the generally fragile state of the economic recovery, the financial authorities – especially the Federal Reserve in the United States, are planning to embark on a fresh round of quantitative easing. This prospect has weighed on the dollar (fears of recourse to printing money) and boosted risk assets as it basically guarantees that extremely low interest rates will continue to dominate the environment. The prospect of quantitative easing has also pushed down investors’ aversion to risk. In this kind of environment, cyclical and financial stocks tend to outperform indices, while the opposite is true for more defensive stocks. In sum, the bad economic news has been a boon for the stock markets.
This situation will not endure and sooner or later, fundamentals will regain the upper hand. In terms of the currency markets, this implies that following a month in which market participants were preoccupied with the negative impact that the possible moves by the Federal Reserve could have on the dollar, the problems in the eurozone could once again become the main focus. On this point, it is worth mentioning that recent developments such as the rise in the cost of bailing out the banks in Ireland and Moody’s downgrading of Spain’s sovereign debt are hardly encouraging and do not really justify the recent strength of the euro.
Despite their good run in September, the (industrialised countries) stock markets have been fluctuating in a relatively narrow range for the past year. Unlike the bond markets, stock prices are not yet factoring in the economic reality characterised by weak nominal growth. There is no point forecasting short-term fluctuations on the stock markets, but I continue to believe that the next important move on the stock markets will be down. Apart from this, the themes of ‘quality’, ‘dividends’ and ‘emerging markets’ should continue to perform well – precisely the themes in which the equity component of BL-Global Flexible invests.
(1) of which 48% is covered through the sale of futures
In light of low government bond yields (the 10-year German bond yield has fallen below 2.4%) and the contraction of the interest rate differential between (investment grade) corporate and government bonds, investors need to get off the beaten track to get a higher regular income. Here are some suggestions:
In conclusion, the suggestions above come with a (much) higher volatility than traditional fixed income investments. This is the price to pay for a higher return. However, this should not constitute a major issue for investors with a long-term investment horizon.
The economic statistics published in the last few weeks show that economic activity in the leading industrialised countries is starting to slow down again. A slowdown that is hardly surprising: I’ve written on numerous occasions about the artificiality of the economic upturn of the last twelve months since it was induced by public spending. The fundamentals for a sustainable recovery were not in place given a debt-laden private sector and the fragility of the banking sector. What was surprising in the last 12 months was not the strength of the economic recovery but its weakness, when we consider the resources deployed – interest rates at historic lows and budgetary deficits at record levels for peacetime.
The renewed economic slowdown comes at a particularly delicate time. To combat the banking crisis and counter the negative impact on growth resulting from the deleveraging underway in the private sector (especially Anglo-Saxon households and banks), the authorities have accepted an unprecedented increase in their own debt, witness the massive increase in the public debt-to-GDP ratio in all countries and the explosion of the balance sheets of the central banks which have been forced to increase the monetary base to buy up dubious-quality notes held by the banks. The objective was that once the economic recovery was sustainably on track and the situation “back to normal”, governments would start to reduce their budgetary deficit and the central banks would start to unwind the exceptional measures they had put in place during the crisis.
A new slowdown in the economic situation, or even a recession, would put this objective in danger. The United States would have to take action just when unemployment rates are hovering around 10%, short-term interest rates are close to zero and the budgetary deficit is more than 10% of GDP. Before the publication of the recent very bad statistics on unemployment and the real estate market, a debate had already started between those calling for a rapid return to budgetary rigour and those coming down on the side of not rushing into any such return for fear of risking a headlong dive back into recession. The latter have been vindicated by the latest economic figures and are calling for further budgetary stimulus measures.
However, a government cannot go on racking up debt endlessly. In their book “This time is different” (1), the American professors Reinhart and Rogoff show that it is nevertheless impossible to determine a precise level of debt (in absolute value or as a percentage of GDP) that would trigger a crisis or payment default. The Russian crisis in the 1990s came at a time when the country’s debt-to-GDP ratio was only 12%, while Japan’s public debt is currently over 200% of GDP without a crisis. It all depends on investors’ confidence in the country, the presence of domestic investors, the percentage of public debt denominated in foreign currencies, the reasons at the source of the public sector debt (productive investments that increase the country’s growth potential – and therefore its capacity to honour its debt – or cash for clunkers?), and the capacity of the political authorities to impose public spending cuts or a tax hike.
That said, there are several elements that make the current situation particularly dangerous. The deterioration of public finances is now a widespread phenomenon in the industrialised countries. The examples often cited of heavily-indebted countries that have succeeded in re-establishing their budgetary situation and reducing their debt, such as Canada, Finland or Sweden in the 1990s, are a bit deceptive since at the time, these countries were the exception and not the rule and they were able to profit from robust world growth and the depreciation of their currency to enhance their fiscal receipts. Secondly, countries now have to bear the burden of a welfare state that is becoming ever more onerous with the ageing population and increased life expectancy. Current debt-to-GDP ratios, high as they are, do not take into account a number of commitments made by governments to their citizens, especially as regards pensions and health insurance. And lastly, notwithstanding historically low interest rates, debt servicing is starting to swallow up a growing proportion of government receipts. Without enormous political courage and substantial sacrifices by the population not to mortgage the future for generations to come, it will therefore be extremely difficult to reduce public spending in any meaningful way. The worry must thus be that a potential return to budgetary rigour will entail an increase in taxes despite numerous academic studies that show the negative multiplier of a tax rise on the economy. In other words, a tax rise reduces the potential for medium and long-term growth. The multiplier of a tax hike is often estimated at between -1 and -3, meaning that a 1 billion tax rise will have a contractionary impact on GDP of 1 to 3 billion over 10 years. However, to reduce the public debt-to-GDP ratio, it is vital not to ignore the ratio’s denominator, i.e. the growth aspect. To avoid a catastrophic scenario, the growth rate of GDP must exceed the interest paid on the debt. A return to budgetary rigour should then be achieved by measures that will not penalize the long-term growth potential of an economy. In their book, Reinhart and Rogoff show that cuts in public spending are preferable to higher taxes when it is a question of re-establishing the economic health of a country after a financial crisis. This is particularly the case for Europe where public expenditure already represents a significant proportion of GDP, to the detriment of the private sector.
Highest Marginal Income Tax Rate in the United States between 1925 and 1940
Source: Gluskin Sheff
So what are the consequences for the financial markets?
First of all, we are in an exceptional situation and investors should stop basing their investment strategy on what has traditionally happened in a classic cycle. Second, interest rates will remain low, partly because of structural elements weighing on growth and the risk of deflation, and partly because the authorities will do their utmost to prevent a rise in interest rates given the disastrous effect that such a rise would have on debt servicing. Hence the recent emergence of the term “financial oppression” – forcing creditors to accept a real return that is artificially low, or even negative (by, for example, encouraging the banks to massively buy government bonds). But the low level of interest rates is not a good enough reason to buy risk assets with unrealistic return expectations. As the Financial Times said recently: “The only thing worse than a low-yielding world is denying that it exists.” Unlike the bond market, so far the equity market has not factored in the new economic reality of lower growth. And lastly, as regards government borrowing, we are bound to conclude that some countries are now in a situation where the only logical outcome is debt restructuring. In general, these are countries that do not have control over their currency, where the low level of interest rates has led to over-consumption and speculative bubbles, and where a significant portion of their debt is held by foreigners. For other countries, creating inflation to reduce the real cost of debt could be tempting but we haven’t quite got to that point yet. Especially as a significant proportion of public expenditure is now indexed to inflation.
(1) Carmen Reinhart, Kenneth Rogoff: This time is different - Eight Centuries of Financial Folly, Princeton University Press.
2009 was a good year for gold investors. The gold price increased by 24% in USD and by 21% in EUR. So far in 2010, this positive performance has continued in 2010 with the gold price gaining a further 13% in USD and 32% in EUR. Such gains raise the question of whether gold has entered overbought territory and whether a price bubble is forming.
I have often said that it is hard to regard gold as anything other than speculation: its economic applications are limited and it does not generate any form of cash flow. Its lack of intrinsic value makes it impossible to put a price on it, at least by conventional yardsticks. It only derives value from the fact that others find it valuable. The only way to make money with gold is to find someone else willing to pay an even higher price. To quote Warren Buffett: “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
That said, there have been periods in history when buying gold has produced outstanding results. Between 1976 and 1980, the price of gold quintupled and in the last 10 years, it has gone from 300$ to 1200$. It is therefore interesting to look at the catalysts that favour higher gold prices.
Gold Price since 2000 (in USD)
Gold basically goes up when people lose faith in paper money. Broadly speaking, this is the case when they perceive that there is a high risk of rising inflation or when solvency risk escalates, i.e. when people fear that their bank is no longer trustworthy or that governments will no longer be able to repay their debt. Both these risks are prevalent in the current environment given the dangerously high levels of government debt. Gold is the currency of fear. It acts as a gauge for the health of the financial and monetary system.
It is important to note that given the small size of the gold market, it only takes a small number of investors to buy gold for the gold price to go up. The total amount of gold available for investment purposes (i.e. excluding jewellery and industrial applications as well as central bank reserves) represents about 0.5% of total global financial assets. Even a small increase in demand for investment purposes represents an amount of gold that cannot be met by mining or recycling, at least not in the short-term. According to the Canadian research firm, the Bank Credit Analyst, a one percentage point increase in the share of gold in investors’ portfolios would be consistent with a tripling in gold prices from current levels.
Apart from rising inflation and solvency risk, two other factors are supporting the gold price.
On the demand side, there is the emergence of Asia where gold has greater significance than in the western world. Last November, India agreed to purchase 200 tons of gold from the IMF. China will have to continue buying gold if it wants to maintain its current share in terms of total reserves. If China decided to bring that share back to the level of 10 years ago (China’s reserves have grown so rapidly over the last decade that the share of gold in its total reserves has fallen), this would significantly boost the demand for gold. Central banks of other emerging countries also seem prepared to buy gold at market prices in order to diversify their reserves.
On the supply side, output from gold mines peaked in 2001 at 2,600 tons and has been drifting down since then, especially in the traditional producer countries (Australia, Canada, South Africa and the USA). This decline cannot be easily reversed. Peter Munk, the founder of Barrick Gold, has recently said that nobody realizes how serious the supply situation is, with large deposits nearing the end of their useful lives while new production is becoming ever more difficult and expensive.
Because it is impossible to value gold using conventional metrics, analysts often look at the long-term relationship of gold with others assets or with economic variables. These include:
- the ratio of the gold price to the stock market. The ‘Gold/Dow Jones Industrial Index’ was 1 in 1980, the end of the last bull market in gold (Gold price: 850$, DJII: 850), fell to 0.025 in 1990 (Gold: 290$, DJII: 11,500) and has since risen again to 0.12 (Gold: 1200$, DJII: 10200). Some people think that this ratio could go back up to 1 again with the equity market losing half of its value and the gold price rising to 5000$ an ounce. It is important to note, however, that if one excludes the extremes, the ratio of gold to the stock market is currently more or less at its long-term median;
- the ratio of gold to oil. In 1973, one ounce of gold would have bought 42 barrels of oil. In July of 2008, one ounce of gold would have bought six barrels of oil. The current ratio of gold to oil is close to its long-term median;
- the ratio of gold to GDP. In 1980, the market value of the above-ground stock of gold relative to global GDP peaked at 25%. It fell to below 3% in 2002 and currently stands at 8%. Again it is important to bear in mind that 1980 and 2002 were extremes. If we compare the gold price to G7 per capita income, for example, we will find that this income is currently equivalent to about 40 ounces of gold whereas over the past 40 years, it has been equivalent on average to 60 ounces.
Finally, though gold has recently hit new highs in nominal terms, it is still nearly 50% below its 1980 peak in real terms, i.e. adjusted for inflation. To bring it back to that peak in real terms, a nominal price of 2,300$ per ounce would be needed. In this respect, it is interesting to see that commodities typically set new all-time highs on an inflation-adjusted basis during bull markets.
An investor looking to buy gold should however be aware that the gold price has now become highly dependent on continued investor interest. One of the properties that make gold attractive as a store of value - the fact that it is virtually indestructible – is also its weakness. Almost all of the gold ever mined is still in circulation today. Thus, even with stagnating or declining mining output, the amount of gold that could potentially come to the market is huge. According to the World Gold Council, a total of 11,125 tons of new gold supply entered the market between 2007 and 2009. This consisted of 6,402 tons from mines (gold production), 757 tons from central bank sales and 3,966 tons from the recycling of old jewellery into new gold products. During that time, only 7,646 tons were bought for the purpose of creating jewellery or for industrial and dental applications. The remainder was purchased for investment purposes. In 2009, investment demand thus accounted for nearly 40% of total demand, compared to 5% in 2000. The potential mismatch between supply and demand is even increasing given that jewellery and industrial demand is proving price-sensitive and is therefore declining because of the increase in the gold price (jewellery demand has fallen by nearly 30% between 2007 and 2009, industrial demand by 20%). There is also the possibility of some countries selling part of their gold holdings in order to consolidate their budgets. However, the fact that the Central Bank Gold Agreement, which stipulates that a maximum of 400 tons of gold per year can be sold by the central banks of the main industrialized countries, was renewed in August of 2009 for a period of five years should limit that risk. Finally, de-hedging of gold producers seems to be coming to an end (de-hedging reduces total mine supply).
To conclude, I do not think that a “gold bubble” is forming, similar to what happened (with hindsight) in 1980. Back then, the gold price increased by 80% in one month, fell back again, before going into 20 years of hibernation. By contrast, even though gold has risen a lot over the last years, there have been regular corrections of more than 10% and there has never been a parabolic increase in the price. This type of behavior is much more typical of a bull market than a bubble.
Gold Price between 1976 and 2000 (in USD)
Whether one thinks that this bull market is coming to an end or is still at an early stage depends on one’s view on the economic and financial situation. I started by saying that gold only derives value from the fact that others find it valuable. However, the same can be said about paper money. The integrity of paper money is now being questioned with more and more people fearing its implicit (inflation) or explicit (depreciation, currency reform) debasement. If the worst of the crisis is behind us, these fears should abate and investors’ interest in gold should wane. Otherwise, the future for gold remains bright.
To download a presentation of the general characteristics of BL-Global Flexible and of its portfolio as at mid-July, please click on the following link.
Summer is a good time to take a step back from the daily fluctuations on the financial markets and think about trends that could affect the financial environment in the next few years. The exercise makes even more sense this year, as the markets seem to be mainly driven by technical considerations while they wait for fundamentals to gain the upper hand.
It seems impossible today that the stock markets could return to their early 2009 levels, or even fall further, just as in October 2007, it seemed impossible that the markets could slump 60% over 18 months, or in March 2009, that they could shoot up by 70% in the space of one year. Investors tend to base their strategies and return expectations on their recent experience. At the start of the 1980s, after 15 years of virtual stagnation in share prices coupled with significant volatility, people were not interested in stocks. On the cover of its August 1979 edition, BusinessWeek magazine proclaimed the “death of equities” (‘The Death of Equities. How inflation is destroying the stock market’). Twenty years later, the Dow Jones had risen to 11,500 from 840 and investors’ faith in the markets was such that equities were considered by far the best long-term investment.
One interesting aspect is that despite a very bad decade for the stock markets during which they strongly underperformed the money and bond markets, the cult of equities still seems to be thriving. Given that the slightest technical rebound sends investors shooting back to the markets, equities have never really corrected their massive overvaluation of the end of the 1990s and remain at much higher valuations than those that led to the great bull markets of the past. At the start of the 1980s, US stocks were trading at six times earnings and paying an average dividend of 6%. Today, despite 10 years 'for nothing’, they are still two to three times more expensive. Some attribute higher equity valuations to the current low interest rates. As well as diminishing the attraction of the main alternatives to equities (cash and bonds), low interest rates also increase the present value of a company’s future earnings (earnings of €1 million in 2020 have a present value of €386,000 when discounted at a rate of 10% and of €614,000 when discounted at 5%) However, the low interest rate argument does not detract from ‘the price paid determines the return’ principle, nor does it alter the fact that when equities are bought at 20 times earnings, we should not expect the same return as if we paid 10 times those earnings. In other words, saying that equity valuations are attractive because of the low level of interest rates is tantamount to saying that equity returns should be higher than those of fixed-income investments in the coming years. Empirical studies show that an investor buying the US market at its current valuation in the past would have on average obtained a real annual (inflation-adjusted) return of around 3% in the following 10 years. 3% is indeed better than the return to be expected from a money-market or bond investment: the average yield on a German Bund or US Treasury bond is currently around 2.5% (to reach a real return of 3%, there would thus have to be annual deflation of 0.5%). Nevertheless, 3% seems to me to be well below the figure investors have in mind when they buy stocks.
Using the argument of low interest rates to justify investing in stocks also seems rather audacious when the low level of interest rates is due to an extremely fragile economic and financial environment, as is currently the case. The decline in interest rates and the rise in valuations in the 1980s and 1990s was due to falling inflation and improving economic fundamentals. Today, these fundamentals are deteriorating and interest rates cannot fall a lot further. This is hardly an ideal environment for valuation multiples to rise. One often reads that stock markets have corrected their valuation excesses and that multiples are reasonable (in the case of the United States) or even cheap (in the case of Europe). The argument being that, based on the most commonly-used equity valuation measure, the Price/Earnings ratio (PE), the markets are trading today at lower multiples than the historical average. This prompts two observations. First, this argument is only true if the denominator used in the PE ratio is 12-month forward earnings estimates. In the past such estimates tended to be far too optimistic. Moreover, they exclude non-recurring charges. The next point is that while the average long-term PE ratio is around 15, the reality is that equities rarely trade at 15 times earnings. In practice, periods during which stocks are more expensive (PE above 15) tend to alternate with less expensive periods (PE below 15). In other words, the idea of "mean reversion" implies that when markets have been overvalued for a long period (as was the case throughout most of the past 20 years), they have to 'pay the price’ in the following years by trading at below-average multiples. Take a company with earnings per share of $1 and trading at 20 times earnings (PE of 20), i.e. $20. If, five years later, its earnings per share have risen by 50% (to $1.5) but the market is only willing to pay 10 times earnings, the share price will be $15 (a fall of 25% in value).
It is possible that we will see this kind of multiple compression in the coming years. The fall in interest rates that resulted in higher multiples in the 1980s and 1990s has practically run its course. Inflation is close to zero and could soon turn into deflation (unlike falling inflation, deflation is bad news for the stock markets. History shows that once inflation drops below 1%, valuation multiples fall). The economic recovery remains very fragile: the high level of debt and the deterioration in public finances are weighing on growth in the industrialised countries. The fact that the problem is mainly on the demand side increases the deflation risk even further, especially given that although governments have managed to offset the weakness in economic activity in the private sector by increasing public spending, this may no longer be an option given the scale of budget deficits. If the economy slows again and falls into recession, there will come a time when the authorities will have no ammunition left to kick-start growth.
I think that if current ranges (~1000-1200 for S&P500, ~225-275 for DJ Stoxx 600) can hold for a little longer, the next significant move on the stock markets will be down. Traditional economic indicators (such as employment and retail sales) clearly show that the United States is not experiencing a classic recovery. As well as this, the positive impact of stimulus measures are starting to wane, the housing market is starting to decline again and recent figures show that there has been a relatively significant slowing in economic activity.
I have written many times that the upside potential for stocks (in the industrialised countries) for the next three to five years seems limited from current levels and that an investment strategy should focus on the ‘return' aspect - i.e. dividends. Of course, buying a stock for an annual dividend of 5% is much less exciting than buying for a quick 20% gain. However, it is interesting to note that the dividend theme is starting to take on increasing importance with both companies (according to Barron's magazine, the ratio of US companies increasing their dividend and those lowering it is currently 9:1) and investors, judging by capital flows that show that the quest for regular returns is rapidly becoming a secular investment theme. Demographic trends should speed up this trend as ageing baby-boomers are less inclined to take risks and tend to be more reliant on regular returns to finance their retirement. From this point of view, the fact that the dividend yield on the S&P 500 is currently around 40% below its historical average is not a good sign for the market overall.
In the following I have tried to sum up in ten points my analysis of the economic and financial situation.
1. In the past 30 years, the world economy has become very leveraged.
This is due to the declining cost of borrowing (i.e. interest rates), following the success of the monetary authorities in fighting inflation. Debt increased in two waves – the first in the 1980s, followed by consolidation in the 1990s, and a second wave which has been underway since 2000. It is the second wave of debt that has undermined the economy, initiated by the Federal Reserve’s irresponsible monetary policy in the wake of the bursting of the technology bubble. By maintaining its key interest rate at an artificially low level, the US central bank encouraged recourse to debt (consumer credit rose every month between February, 1998 and July, 2008) which notably gave rise to a real-estate bubble and the multiplication of activities having no economic added value. Other phenomena, such as the deregulation of finance, have intensified this trend. Debt levels are now very high by historical standards.
2. Two important economic players - US households and banks - have embarked on a process of deleveraging.
Just as the process of leveraging up boosted growth (borrowing money to buy a car stimulates consumption), the process of deleveraging will weigh on growth (the money used to pay back a loan cannot be spent on other things). The problems experienced by US households mean that the growth model of the past three decades – world economy driven by the United States, US economy driven by private consumption, private consumption driven by recourse to debt – is now a thing of the past. The influence of the US consumer has been even greater because the growth model of other countries or regions is often primarily based on exports rather than internal demand. Whereas in the 1970s, the world was in a situation of excess demand, today we have a situation of excess supply (which also explains why the current environment is characterised by deflationary pressure - in the 1970s, it was marked by inflationary pressure). In this situation, the US consumer was to some extent ‘the consumer of last resort’. From the beginning of 1992 to the end of 2007, there was an unprecedented 64-quarters uninterrupted string of rising consumer spending.
3. To make up for the deleveraging in the private sector, the public sector has opted to get into debt.
Over the past two years, we have seen an unprecedented increase in the level of government debt. This is due to the governments' desire to save the banks and launch stimulus measures to offset the weakness in the private economy. The situation is even more concerning in light of the fact that in many countries, demographic trends will increase pressure on public spending in coming years. Also, a big percentage of government debt in a lot of countries will have to be refinanced within the next three years.
4. The very high public sector debt levels are undermining the economy and bringing about new risks.
In their book, ‘This Time is Different’, economists Carmen Reinhart and Kenneth Rogoff note that history has shown that once the public debt to Gross Domestic Product ratio approaches 100%, economic growth slows and there is greater risk of sovereign default and/or galloping inflation as well as of a systemic crisis. Added to this is the prospect of social tensions linked to the end of the Welfare State model based on using debt to finance untenable electoral promises.
5. The high level of debt is a problem in the industrialised countries but not in the developing countries.
In most developing countries, the degree of debt is low at all levels of the economy - households, businesses and governments alike. This means that the next public debt crisis will not occur in these countries, contrary to what we had got used to seeing in the period 1980 and 2000, with the Latin American and Asian crises.6. The European and US authorities will maintain their interest rates at very low levels for a long time.
In an environment characterised by high levels of debt, weak economic growth and fiscal austerity, the European Central Bank and the US Federal Reserve will wait a long time before tightening their monetary policy. Given that the return on a money-market investment is directly linked to the central bank rates, the yield on a ‘no-risk’ investment will remain very low in the coming years. ‘Doing nothing’ is therefore also a decision and the opportunity cost of such a decision is high in a context of short-term rates close to zero.
In the longer term, the main challenge for the European and US monetary authorities will be to uphold a highly accommodating monetary policy without giving the bond markets the impression that they are abandoning their inflation control target. If this were to happen, medium- to long-term interest rates (over which the authorities have no direct control) would increase with disastrous consequences for public finances in a number of countries.
7. The myth of the ‘no-risk’ government bond is being put to the test and investors will increasingly differentiate between countries.
One year ago, the yield on the 10-year German government bond was 3.7%, while Greek bonds were offering 5.5%. Today, the yield is 2.6% and 8.1% respectively. Investors have cast doubt on the ability of Greece to honour its debt and the country has entered into a vicious circle in which the rise in medium and long-term interest rates pushes up the cost of servicing its debt, which accordingly increases the risk of restructuring and in turn justifies a further rise in the level of interest rates. In contrast, Germany is benefiting from a 'flight to quality' and finds itself in a virtuous circle. The diverging developments in the cost of financing in the two countries further widen their competitive divide, born out of the diverging developments in unit labour costs. If we generalise a little, we could say that what is true for Germany is true for northern Europe, while Greece is representative of southern Europe. The competitive gap between these two regions will result in increased pressure on the euro. The single currency’s survival in its current form is dependent on a massive solidarity effort between the European countries and unprecedented fiscal austerity in some countries. Fiscal austerity will however weigh on these countries' economic growth and they risk loosing on the tax revenue side much of what they save on the spending side.
Apart from a few exceptions, bonds issued by the governments of the industrialised countries are no longer attractive. Either they offer a very low yield, or they involve a more or less significant risk of payment default (not to mention the risk, to which some are alluding, that the increase in public debt will result in significant inflation through recourse to the printing press). Government bonds issued by the emerging countries are enjoying better fundamentals but yields on these bonds have already fallen a lot and selection will have to be made on a case-by-case basis. The same is also true for corporate bonds.
8. The traditional distinction between high-risk assets (= equities) and low-risk assets (= government bonds) makes less and less sense in the current environment.
This distinction exists because investors are used to associating risk with volatility. While share prices are known to rise and fall by 10% or more in a short space of time, this kind of variation is less common in government bonds and practically non-existent in money-market investments, which, in principle, can only rise in value unless there are negative short-term interest rates. In the current context, we could nevertheless also consider that the risk of an investment is that investors will not receive their coupon, will not get their money back, or will see the value of their investment significantly diminished by inflation.
In comparison with government bonds, equities currently offer two major advantages. First, unlike what is happening at government level, many companies are in excellent financial health. Second, equities represent real assets and for this reason offer, in theory at least, better protection against inflation.These risks should certainly no longer be ruled out and affect particularly fixed-income investments.
The fact that money-market rates are so low is obviously another factor that could boost the equity markets. I have often said that low interest rates are not a good enough reason for buying stocks - particularly when, as is the case now, low rates are the result of an extremely fragile economic situation. However, the fact remains that when interest rates are low, investors are more eager to buy stocks.
9. There is little upside potential for the US and European stock markets from current levels over a three to five year horizon.
This conclusion may be surprising coming after a particularly bad decade for the stock markets of these regions, with most indices today some 25% below their end-1999 level (excluding dividends). Under normal circumstances, one would expect that after such a disappointing performance, US and European equities would be cheap and ‘ripe’ for a new structural bull market (just as the poor performance of the markets between 1966 and 1982 gave rise to the bull market of 1982 to 2000). But this is not the case. The poor performance of the US and European markets in the past 10 years is due to equity valuations reaching extremely high levels at the start of 2000. Since then, multiples have become more reasonable. However, they are still much higher than those that in the past marked the beginning of the major bull markets, especially in light of the fact that the phenomenon which pushed up valuation multiples in the 1980s and 1990s - the decline in interest rates - has now more or less run its course.
The stock markets of the industrialised countries are therefore expected to remain volatile characterised by bull and bear cycles similar to what we have seen in the past 10 years. However, they are not likely to be much higher 5 years from now (and may even be much lower). The conclusion is that a passive buy-and-hold strategy will produce disappointing results and that an active strategy is much more appropriate in the current environment. One aspect of an active strategy is stock-picking. We give priority to quality companies (low levels of debt, high return on equity), which are strongly exposed to regions with higher growth potential and are able to pay attractive dividends to their shareholders. The (justified) premium that the market usually grants to such companies has now disappeared since they significantly underperformed during the stock market recovery in 2009.
10. The emerging markets are in a structural bull cycle.
In simplified terms, we could say that whereas the 20th century belonged to the United States, the 21st century will be Asia’s. The stock markets have begun to realise this and in the past few years, the developing markets performed much better than the industrialised markets. The trend is set to continue in light of the good fundamentals in the developing countries.
An investor should however be aware of the fact that the emerging markets will remain volatile, continuing the trend of the past few years. This is mainly due to the dependence of the emerging countries on Europe and the United States - economically dependent as they wait for internal demand to grow, and financially dependent as their financial markets remain strongly influenced by foreign capital.