View From the Top

Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.

Reflecting on what has been an extraordinary month for all global asset classes, the words uttered by Polonius to Laertes in Shakespeare‟s Hamlet, “neither a borrower nor a lender be” spring appropriately to mind. During the past weeks, as the world has flirted with recession and volatility has returned to its highest levels prior to the Lehman debacle, there have been few places to hide. With growing levels of investor and public disillusionment being accompanied by a systemic deterioration in confidence, the outlook also seems far from encouraging. Nonetheless, despite these unfortunate circumstances, we at Heptagon believe that there continue to be a range of potentially attractive investment opportunities, at present, most particularly in high yield and in a long US versus short Europe equity positioning. Select investments in macro/CTA hedge funds also have their merits.

Given the mostly unprecedented nature of recent events we make no apologies for this month‟s View From The Top being somewhat longer than usual, since there is clearly a lot of ground to cover. After such tumultuous movements in global markets, the argument has been made that various asset classes – and equities in particular – are oversold and so a temporary (or technical) bounce is now possible. Although we do not deny this possibility, it needs to be seen in a radically different political and economic context to the past. Moreover, trying to „call the bottom‟ in what is perhaps a secular bear market could prove a dangerous thing to do. As we have written previously, there is a clear current need to divorce emotion from reality and second-guessing irrationality over the last weeks has proven exceptionally difficult. Finally, it is worth remembering that valuation is, and always has been, merely a necessary and not a sufficient condition for owning assets; markets can remain undervalued for a long time.

The key challenge for policymakers continues to centre on how to achieve economic growth while still deleveraging. According to Credit Suisse, there remains $8 trillion of excess leverage in developed markets. Furthermore, the problem is exacerbated by the fact that there exists a strong correlation between rising government deficits and falling corporate profits, a point made by several commentators including GMO‟s Jeremy Grantham. Investors also seem to have arrived at the conclusion that governments (and Central Banks) lack the necessary ammunition to intervene effectively in the business cycle. Consumer and corporate confidence has correspondingly begun to crater with, for example, the University of Michigan survey of US confidence now down more than twenty percentage points in the last three months and at its lowest level in almost forty years..

A major risk is hence the extent to which growing fear and risk aversion levels become self-perpetuating, pushing the world again towards global recession. To return to the words of Hamlet’s Polonius, liquidity is already beginning to fall away across the financial system, impacting both borrowers and lenders.

Growing dysfunction in the interbank markets is evidenced by the 12-month LIBOR-OIS spreads being more pronounced than at any time since 2009, while CDS spreads on European banks have more than doubled since April and are now above Lehman levels.

The Lehman precedent has been evoked by many in recent weeks, but the dislocation caused by this event (which saw the S&P drop to 680; it is at c1200 currently) would pale into insignificance were a major developed country to default on its debt. This is not an impossible scenario and would have major negative ramifications for all asset classes. The European Financial Stability Fund has enough to cover Greece, Ireland and Portugal, but not other nations. In Greece, the budget deficit continues to rise (set to top more than 10% of GDP this year versus 7.6% in 2010) just as GDP estimates are revised down (forecasters now assume a greater than 5% contraction in 2011). Meanwhile, the ECB purchases of Italian and Spanish bonds seem to have done little to stem the contagion to European banks.

If the world is to avoid either a recession or a default scenario, then it is paramount that politicians show swift and decisive coordination in their decision-making. Sadly this has not been the case in recent weeks. Even if Barack Obama and Ben Bernanke now have to operate in an increasingly hostile political environment, the problems in Europe are substantially greater. Put simply, Europe cannot function as a unified entity unless someone is in control. Germany looks best placed in this respect (given the size of its population and economy), but being in control comes at a cost – namely, a deep and ongoing level of financial support for the Eurozone‟s weaker members. However, recent surveys show a ratio of 5:1 Germans against further integration. The Finns are similarly disinclined. Voter populations in both creditor and debtor nations are clearly upset. We will be watching in particular events on 7 September when Germany‟s constitutional court is scheduled to deliver its opinion on Berlin‟s participation in EU bailouts.

Against such a troubled backdrop, it is perhaps constructive to consider what solutions may be on hand. Signalling mechanisms have had limited efficacy and the Fed‟s recent statement that it intends to keep interest rates low is perhaps indicative of its despair over the economy and its powerlessness to come up with alternative solutions. Global coordination by policymakers – with regard to a concentred round of quantitative easing, for example – sounds like a conceptually pleasing idea, but seems highly unlikely given the currently febrile political environment. Even in Europe, greater fiscal union seems like a far-flung notion given the current dissention over the proposed introduction of Eurobonds.

What seems more likely would be for the European Central Bank to cut interest rates and for the Federal Reserve to seek to flatten the yield curve further by purchasing longer-dated Treasuries. Negative real rates across developed market yield curves combined with the continued appreciation of emerging market currencies would go some way to fixing the problem of excess developed world leverage and righting the economy. Elsewhere, more targeting (easing to continue until unemployment had fallen below a certain level, for example), further labour market reforms and a more appropriately nuanced fiscal strategy (which would not choke near-term growth but address longer-term structural issues – such as the provision of Medicare/Medicaid in the US) would also help.

Whether there is the will to act decisively remains to be seen although the hands of policymakers may be forced should events continue to unravel at their recent pace. At the least, with risk levels set to remain elevated, there is a clear need to remain nimble with regard to portfolio positioning; diversification can also help to mitigate volatility. At Heptagon, we have sought to act appropriately, and our key strategies are as follows:

 High yield – looking attractive; spreads anomalous: We note that the current spread based on the Merrill Lynch High Yield Index is 766 basis points, which implies a default rate of more than 8% (assuming a recovery rate of 45%). This seems anomalous, with current default rates at below 2% and having averaged 5% over the last 25 years. Even if we were to take a negative view and assume default rates rose from current levels to 5%, then this would correspond to a spread of 580 points, leaving room for an attractive compression. A reduction in the spread of 150 points would generate a one- year IRR of 12%, which appears to us as a compelling level of risk-reward;

 Treasuries–selectiveallocationsmakesenseinadeflationaryenvironment:Datafromboth sides of the Atlantic suggest that deflation looks set to become a significantly more important concern than inflation. Within this context, it is hardly surprising to see declining yields. Developments in the West increasingly resemble those in Japan, where investors would be well to remember the thirteen- year decline in the 10-year JGB to levels of well below 1%. Rightly or wrongly, US government bonds retain their „safe haven‟ status when risky assets sell-off (and note that yields actually fell post the downgrade to America‟s credit rating). With credit concerns over fiscal and budget deficits still assuming less of a priority than the defensive merits of bonds, yields can fall further. A small allocation to select government bond managers therefore seems logical;

 Within equities, position long the US versus short Europe: Europe is likely to see a much more significant deterioration in economic growth than the US over the next six months, with recession risk proportionately higher in the former region, especially as a result of necessary fiscal tightening and relative currency strength. By contrast, looser policy (both monetary and fiscal) seems likely in the US, while the Dollar is still relatively cheap. In particular, we have a preference for defensive large cap US stocks with high levels of international exposure (McDonalds, Mead Johnson, Pepsi, for example);

 Correspondingly, the Euro looks over due a correction: The current strength of the Euro stands in clear contradiction to the slowing growth prospects being witnessed in the region. The obsession of by foreign exchange markets with interest rate differential could create a good opportunity, especially since it seems only a matter of time before the ECB cuts rates (especially with core CPI stabilising at around 1.2% and growth faltering). The departure of current ECB President Trichet on 31 October may mean the decision is left to his successor, but on a six-month timeframe a cut seems more likely than not;

 Hedge Funds – patience necessary, but compelling for the medium-term: The asset class experienced a very difficult August with disappointing returns. Nonetheless, we believe that exposure to macro and CTA (Commodity Trading Adviser) Funds will be rewarded over time. The politicisation of market drivers (in other words, the manipulation of bond yield curves and currencies by major governments) has made it hard for Managers to use traditional models and approaches. Our contention remains that while trends away from fair value can persist for some time (for example, note the Euro-Dollar trade), when they do break, talented macro managers will be well poised to deliver attractive returns;

 And finally, a word on gold: It has become (almost too) popular to describe the precious metal as a „place to hide‟ in these volatile times. Against this background, it was of little surprise to see the commodity correct abruptly in late August after an upward move that arguably went too far and too fast. Nonetheless, if more fiscal austerity and easy monetary policy remain the default recipes of policymakers and real rates stay negative, then the strategy of adding to positions on pullbacks seems a logical one. Gold retains a weighting within our portfolios.

The „cruel summer‟ scenario we had foreseen as early as June has undoubtedly played out. Whether there is further disruption to come as we progress towards the autumn remains to be seen. At the least, likely elevated volatility levels call for decisive allocation strategies. We are comfortable with the current positioning of our investors‟ portfolios, but are also prepared to act quickly if required.

Alex Gunz, Fund Manager, Heptagon Capital