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.

The end of the year is, for many, a season of celebration and also a time to look optimistically ahead to the following twelve months. Notwithstanding the respite of recent days, for many watchers of global markets, there is not a lot to cheer; and, the outlook for 2012 may be at least as difficult as that endured over 2011. Appropriate positioning with regard to macro developments has been at the forefront of successful investment decision-making during the last year and we expect a similar dynamic to develop over the next.

It is against this background that we currently see little reason to change our broadly cautious asset allocation approach, favouring fixed income over equity with selective investments in hedge fund managers. Having raised cash in early November we are, nonetheless, also positioned to move quickly, particularly should there be factors (coherent policy leading to greater confidence and better growth) that would allow us to adopt a more constructive stance.

The need for a flexible and pragmatic stance is reinforced by the observation that many of the more ‘traditional’ tools used for investment decisions have not worked in recent times, a problem exacerbated by the deliberate and growing instances of state and central bank interventions across bond and currency markets. It behoves market participants to accept and position for the fact that we most likely find ourselves in a structural bear market (perhaps similar to the late 1970s and early 1980s) characterised by the multi-year deleveraging of a debt burden that may realistically never be paid back. Many (and politicians particularly) remain in denial of this latter point, specifically to the detriment of the investment community. Deteriorating levels of confidence in policymakers’ ability to act only deepens the problem.

Moreover, irrespective of near-term political outcomes (especially in Europe), global recession is most likely coming and looks set to dominate the agenda in 2012. The use of the term ‘global’ is deliberate since prospects in the world’s three major economic regions – the US, Europe and China – all look negative; each has its own problems, but these are intensified by trade and banking interlinkages. Such a scenario does not, of course, preclude the scope for mini-rallies, but pressure is set to remain oriented in a downward direction.

To start with Europe, since this has been the main focus of most recent investor attention, we are drawn to the assertion made by Carmen Reinhart and Ken Rogoff in their superb work, This Time Is Different: Eight Centuries of Financial Folly, namely, “what one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it generally does.” European policymakers control

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their own destiny. It is clear what needs to be done and the oft-cited ‘muddle through’ approach is, quite simply, not working. In brief, the following three things need to happen: the European Central Bank (ECB) must provide a back-stop for the European Financial Stability Fund; a firm timetable for Eurobonds needs to be drawn up; and plans for a move to full fiscal union should be put in train.

Expectations are high ahead of the next scheduled summit of European Ministers on 8/9 December. However, we have been here before and broken promises have, unfortunately, become the norm. Agreement on the above is very different to actual implementation (especially if this also means ratification by national vote). In particular, it is far from clear whether the EU’s members will accept the implicit loss of sovereignty that comes with greater union.

Furthermore, there is the risk that by the time Europe gets round to doing what is needed, confidence will already have deteriorated to such an extent that anything that is done will essentially be too little, too late. It may indeed already be too late: Germany’s failed bond auction in late November is the best indicator so far of lost faith, while reports (cited by Reuters) suggest that money being deposited with the ECB (rather than with other national banks) is now higher than it was pre-Lehman. Meanwhile, Europe is already moving closer to credit crunch and recession. Not only are banks refusing to lend to each other, but the most recent purchasing managers survey (of 47.2 for the EU in November) already implies severe contraction, while Credit Suisse estimates that fiscal tightening could take a further 1.2% off European GDP in 2012.

A lack of political consensus, weak credit channels and adverse fiscal policy are all also set to dominate the agenda in the US next year. The failure of the Super Committee to agree on a debt reduction plan is an indictment on the impasse reached in American politics. Moreover, with 2012 being an election year, there is likely to be a further stasis in policymaking, intensifying the risks to the economy, with near-term decision-making set to remain on hold. We also note that fiscal tightening could take 1.8% off next year’s GDP (data again courtesy of Credit Suisse), while lending standards are currently deteriorating (October’s Senior Loan Officer Survey saw a 15pp contraction relative to the previous quarter) and CEO confidence levels are at their lowest in a year.

Although Europe and the US comprise only 50% of global GDP, it is hard to see China and other emerging economies making up the difference and driving meaningful near-term global growth. As we have written before, not only is China’s largest export market the European Union, but also US and European banks dominate lending to emerging economies. Slowdown in already occurring as evidenced by a number of factors, of which the following are among the most concerning to us: the last survey of Chinese purchasing managers reported the sharpest decline in almost three years, while the most recent

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data from the Institute of International Finance shows that inter-bank lending in Asia is currently running at its lowest level ever reported.

Against this concerning background, it is clear to us what needs to be done, and quickly. In three steps, the following: co-ordinated policymaking, principally (much) more quantitative easing; selective default; and greater supply-side initiatives that will result in increased competitiveness. The latter two matter particularly in peripheral Europe. The reason these initiatives have not happened so far seems to us less a matter of political will (note the Fed’s mandate remains to pursue price stability and full employment, while both Ben Bernanke and Mario Draghi are classically-schooled monetarists) and more one of political intransigence. Whether these moves happen next year remains to be seen.

The above picture suggests an obvious need for near-term caution. At Heptagon, equity exposure was progressively reduced over 2011 and current allocations favour fixed income. We have almost no exposure either to continental Europe or to emerging markets within investors’ portfolios and took the decision to raise cash at the start of November. Risk assets would fall further in the event of a global recession and economic stagnation typically implies low equity returns and superior bond returns.

The following six strategies currently dominate our thinking. A number of these may be considered consensual, but it does not necessarily mean that they are wrong, especially given the current importance of capital preservation:

•   Favour fixed income: particularly managers that are able to invest across the credit spectrum (government bonds, corporate credit, rates etc.) and have the ability to take on negative duration;
•   Highyieldstillattractive:defaultrisksstilllooklow(especiallyonashortdurationbasis)andyields are compelling, although we note this asset class may be volatile in the event of increasing risk aversion levels;
•   Very selective equity investments: Stocks globally do not yet look cheap, especially on a Shiller P/E basis. Companies that offer high quality growth and sustainable dividend yields screen most compellingly and we believe a premium will remain attached to large-cap, geographically diversified, US-listed businesses;
•   A weaker Euro: under almost all scenarios relating to the European Union’s ultimate future, its currency should weaken, especially given the region’s near-term risks and below-average growth prospects. A weaker Euro would also help boost regional competitiveness. A rate of at least 1.20 relative to the US Dollar (which correspondingly should strengthen) may constitute fair value;
•   Selective hedge fund allocations: Many managers have endured a difficult year, but those using systematic trading strategies ought to benefit, particularly when fundamentals reassert themselves. Funds that offer low correlations to other asset classes are also attractive; and

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 Remain invested in gold: Despite a >20% rise year-to-date, the precious metal constitutes a defensive holding, a perceived ‘safe haven’ (not a fiat currency) that has the potential to continue outperforming for at least as long as real interest rates remain negative. Listed gold mining stocks may also represent an alternative means of gaining some exposure.

Investors have endured much in the last twelve months including the ‘cruel summer’ we wrote extensively about earlier this year. When thinking about the near-term, the opening line of Shakespeare’s Richard III, “now is the winter of [our] discontent,” springs to mind. We remain pragmatic, continually evaluating our view as new information becomes available. Be prepared for potential discontent, but also be hopeful, and potentially optimistic, that policymakers are willing to act in a swift, timely and effective manner. Season’s greetings.

Alex Gunz, Fund Manager, Heptagon Capital